Cost Allocation

Cost allocation (also called cost assignment) is the process of finding cost of different
cost objects such as a project, a department, a branch, a customer, etc. It involves
identifying the cost object, identifying and accumulating the costs that are incurred
and assigning them to the cost object on some reasonable basis.

Cost allocation is important because it the process through which costs incurred in
producing a certain product or rendering a certain service is calculated. If costs are
not accurately calculated, a business might never know which products are making
money and which ones are losing money. If cost are misallocated, a business may
be charging wrong price to its customers and/or it might be wasting resources on
products that are wrongly categorized as profitable.

Mechanism
Typical cost allocation mechanism involves:

Identifying the object to which the costs have to be assigned,

Accumulating the costs in different pools,
Identifying the most appropriate basis/method for allocating the cost
Cost object
Cost object is an item for which a business need to separately estimate cost.

Examples of cost object include a branch, a product line, a service line, a customer, a
department, a brand, a project, etc.

Cost pool
Cost pool is the account head in which costs are accumulated for further assignment
to cost objects.

Examples of cost pools include factory rent, insurance, machine maintenance cost,
factory fuel, etc. Selection of cost pool depends on the cost allocation base used. For
example if a company uses just one allocation base say direct labor hours, it might
use a broad cost pool such as fixed manufacturing overheads. However, if it uses
more specific cost allocation bases, for example labor hours, machine hours, etc. it
might define narrower cost pools.

Cost driver
Cost driver is any variable that ‘drives’ some cost. If increase or decrease in a
variable causes an increase or decrease is a cost that variable is a cost driver for that
cost.

Examples of cost driver include:

Number of payments processed can be a good cost driver for salaries of Accounts
Payable section of accounting department,
Number of purchase orders can be a good cost driver for cost of purchasing
department,
Number of invoices sent can be a good cost driver for cost of billing department,
Number of units shipped can be a good cost driver for cost of distribution department,
etc.
While direct costs are easily traced to cost objects, indirect costs are allocated using
some systematic approach.

Cost allocation base

Cost allocation base is the variable that is used for allocating/assigning costs in
different cost pools to different cost objects. A good cost allocation base is something
which is an appropriate cost driver for a particular cost pool.

Example
T2F is a university café owned an operated by a student. While it has plans for
expansion it currently offers two products: (a) tea & coffee and (b) shakes. It employs
2 people: Mr. A, who looks after tea & coffee and Mr. B who prepares and serves
shakes & desserts.
Its costs for the first quarter are as follows:

Mr. A salary 16,000

Mr. B salary 12,000
Rent 10,000
Electricity 8,000
Direct materials consumed in making tea & coffee 7,000
Direct raw materials for shakes 6,000
Music rentals paid 800
Internet & wi-fi subscription 500
Magazines 400

Total tea and coffee sales and shakes sales were $50,000 & $60,000 respectively.
Number of customers who ordered tea or coffee were 10,000 while those ordering
shakes were 8,000.

The owner is interested in finding out which product performed better.

Solution

Salaries of Mr. A & B and direct materials consumed are direct costs which do not
need any allocation. They are traced directly to the products. The rest of the costs
are indirect costs and need some basis for allocation.

Cost objects in this situation are the products: hot beverages (i.e. tea & coffee) &
shakes. Cost pools include rent, electricity, music, internet and wi-fi subscription and
magazines.

Appropriate cost drivers for the indirect costs are as follows:

Rent 10,000 Number of customers
Electricity 8,000 United consumed by each product
Music rentals paid 800 Number of customers
Internet & wifi subscription 500 Number of customers
Magazines 400 Number of customers
19,700

Since number of customers is a good cost driver for almost all the costs, the costs
can be accumulated together to form one cost pool called manufacturing overheads.
This would simply the cost allocation.

Total manufacturing overheads for the first quarter are $19,700. Total number of
customers who ordered either product are 18,000. This gives us a cost allocation
base of $1.1 per customer ($19,700/18,000).

A detailed cost assignment is as follows:

Tea & Coffee Shakes

Revenue 50,000 60,000
Costs:
Salaries 16,000 12,000
Direct materials 7,000 6,000
Manufacturing overheads allocated 11,000 8,800
Total costs 34,000 26,800
Profit earned 16,000 33,200

Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000

Manufacturing overheads allocated to Shakes = $1.1×8,000

Cost accumulation involves the use of a formal cost accounting system to collect cost
information. By collecting and analyzing cost information, management can make
more informed decisions about the operations of a business. Cost accumulation
systems fall into two main categories, which are:

Job cost system. Accumulates materials, labor, and overhead costs about individual
jobs.
Process system. Accumulates costs by cost center and then assigns average costs
to products.