Cost allocation

May 04, 2019

Cost allocation is the process of identifying, aggregating, and assigning costs to cost
objects. A cost object is any activity or item for which you want to separately measure
costs. Examples of cost objects are a product, a research project, a customer, a sales
region, and a department.

Cost allocation is used for financial reporting purposes, to spread costs among
departments or inventory items. Cost allocation is also used in the calculation of
profitability at the department or subsidiary level, which in turn may be used as the
basis for bonuses or the funding of additional activities. Cost allocations can also be
used in the derivation of transfer prices between subsidiaries.

Example of Cost Allocation

The African Bongo Corporation (ABC) runs its own electrical power station in the
hinterlands of South Africa, and allocates the cost of the power station to its six
operating departments based on their electricity usage levels.

Cost Allocation Methods

The very term "allocation" implies that there is no overly precise method available for
charging a cost to a cost object, so the allocating entity is using an approximate method
for doing so. Thus, you may continue to refine the basis upon which you allocate costs,
using such allocation bases as square footage, headcount, cost of assets employed, or
(as in the example) electricity usage. The goal of whichever cost allocation method you
use is to either spread the cost in the fairest way possible, or to do so in a way that
impacts the behavior patterns of the cost objects. Thus, an allocation method based on
headcount might drive department managers to reduce their headcount or to outsour ce
functions to third parties.

Cost Allocation and Taxes

A company may allocate costs to its various divisions with the intent of charging extra
expenses to those divisions located in high-tax areas, which minimizes the amount of
reportable taxable income for those divisions. In such cases, an entity usually employs
expert legal counsel to ensure that it is complying with local government regulations
for cost allocation.

Reasons Not to Allocate Costs

An entirely justifiable reason for not allocating costs is that no cost should be charged
that the recipient has no control over. Thus, in the African Bongo Corporation example
above, the company could forbear from allocating the cost of its power station, on the
grounds that none of the six operating departments have any control over the power
station. In such a situation, the entity simply includes the unallocated cost in the
company's entire cost of doing business. Any profit generated by the departments
contributes toward paying for the unallocated cost.

What is the Working Capital Formula?

The working capital formula is:

Working capital = Current Assets – Current Liabilities

The working capital formula tells us the short-term, liquid assets remaining after
short-term liabilities have been paid off. It is a measure of a company’s short-term
liquidity and important for performing financial analysis, financial modeling, and
managing cash flow.

Below is an example balance sheet used to calculate working capital.

Example calculation with the working capital formula
As an example, a company can increase its working capital by selling more of its
products. If the price per unit of the product is $1000 and cost per unit in inventory is
$600, the company’s working capital will increase by $400 for every unit, because
either cash or accounts receivable will increase.

Comparing the working capital of a company against its competitors in the same
industry can demonstrate its competitive position. If Company A has working capital
of $40,000 while Companies B and C have $15,000 and $10,000, respectively,
Company A can spend more money to grow its business faster than its competitors.

What is working capital?

Working capital is the difference between a company’s current assets and current
liabilities. It is a financial measure, which calculates whether a company has enough
liquid assets to pay its bills that will be due in a year. When a company has excess
current assets, that amount can then be used to spend on its day-to-day operations.

Current assets, such as cash and equivalents, inventory, accounts receivable and
marketable securities, are resources a company owns that can be used up or
converted into cash within a year.

Current liabilities are the amount of money a company owes such as accounts
payable, short-term loans and accrued expenses, which are due for payment within a
year.

Positive vs negative working capital

Having positive working capital can be a good sign of the short-term financial health
for a company because it has enough liquid assets remaining to pay off short-term
bills and to internally finance the growth of their business. Without additional
working capital, a company may have to borrow additional funds from a bank or turn
to investment bankers to raise more money.

Negative working capital means assets aren’t being used effectively, and a company
may a liquidity crisis. Even if a company has lots invested in fixed assets, it will face
financial challenges if liabilities come due too soon. This will lead to more borrowing,
late payments to creditors and suppliers and, as a result, a lower corporate credit
rating for the company.
When negative working capital is ok
Depending on the type of business, companies can have negative working capital
and still do well. Examples are grocery stores like Walmart or fast-food chains like
McDonald’s that can generate cash very quickly due to high inventory turnover rates
and by receiving payment from customers in a matter of a few days. These
companies need little working capital.

Products that are bought from suppliers are immediately sold to customers before
the company even gets a chance to pays the vendor or supplier. In contrast, capital-
intensive companies that manufacture heavy equipment and machinery usually can’t
raise cash quickly, as they sell their products on a long-term payment basis. Since
they can’t sell fast enough, cash won’t be available immediately during tough
financial times, so having enough working capital is desirable.

Learn more about a company’s Working Capital Cycle, and the timing of when cash
comes in and out of the business.

Adjustments to the working capital formula

While the above formula and example are the most standard definition of working
capital, there are other more focused definitions.

Examples of alternative formulas:

 Current Assets – Cash – Current Liabilities (excludes cash)

 Accounts Receivable + Inventory – Accounts Payable (this represents only the “core”
accounts that make up working capital in day-to-day operations of the business)

cash flows

Cash flow is the net amount of cash and cash-equivalents being transferred
into and out of a business. At the most fundamental level, a company’s ability
to create value for shareholders is determined by its ability to generate
positive cash flows, or more specifically, maximize long-term free cash flow.
There is an indirect and a direct method for calculating cash flows from operating activities.

Calculating Cash Flows

Cash flows refer to inflows and outflows of cash from activities reported on an income
statement. In short, they are elements of net income. Cash outflows occur when
operational assets are acquired, and cash inflows occur when assets are sold. The resale
of assets is normally reported as an investing activity unless it involves the purchase
and sale of inventory, in which case it is reported as an operating activity. There are two
different methods that can be used to report the cash flows of operating activities: the
direct method and the indirect method.

The Direct Method

For items that normally appear on the income statement, cash flows from operating
activities display the net amount of cash that was received or disbursed during a given
period of time. The direct method for calculating this flow involves deducting from cash
sales only those operating expenses that consumed cash. In this method, each item on
an income statement is converted directly to a cash basis, and each cash effect is directly
reported. To employ this direct method, use the following equation:

 add net sales

 add ending accounts receivable
 subtract beginning accounts receivable
 add ending assets (prepaid rent, inventory, et al)
 subtract beginning assets (prepaid rent, inventory, et al)
 subtract ending payables (tax, interest, salaries, accounts payable, et al. )
 add ending payables (tax, interest, salaries, accounts payable, et al. )

Once the cash inflows and outflows from operating activities are calculated, they are
added together in the “Operating Activities” section of the cash flow statement to obtain
the net cash flow for a company’s operating activities.

Indirect Method

In the indirect (addback) method for calculating cash flows, the accrual basis net income
is established first. This net income is then indirectly adjusted for items that affected the
reported net income but did not involve cash. The indirect method adjusts net income
(rather than adjusting individual items in the income statement) for the following
phenomena: changes in current assets (other than cash), changes in current liabilities,
and items that were included in net income but did not affect cash.

Indirect Method

The indirect method adjusts net income (rather than adjusting individual items in the
income statement) for:

1. changes in current assets (other than cash) and current liabilities, and
2. items that were included in net income but did not affect cash.

The indirect method uses net income as a starting point, makes adjustments for all
transactions for non-cash items, then adjusts for all cash-based transactions. An
increase in an asset account is subtracted from net income, and an increase in a liability
account is added back to net income. This method converts accrual-basis net income (or
loss) into cash flow by using a series of additions and deductions. The following rules
can be followed to calculate cash flows from operating activities:

 Decrease in non-cash current assets are added to net income;

 Increase in non-cash current asset are subtracted from net income;
 Increase in current liabilities are added to net income;
 Decrease in current liabilities are subtracted from net income;
 Expenses with no cash outflows are added back to net income (depreciation and/or
amortization expense are the only operating items that have no effect on cash flows in the
period);
 Revenues with no cash inflows are subtracted from net income;
 Non operating losses are added back to net income;
 Non operating gains are subtracted from net income.

Under the indirect method, since net income is a starting point in measuring cash flows
from operating activities, depreciation expenses must be added back to net income. So,
depreciation expense is shown (or captioned) on the statement of cash flows. Also, in
the indirect method cash paid for taxes and cash paid for interest must be disclosed.

Direct Method Versus Indirect Method

Consider a firm reporting revenues of $125,000. During the reporting period, the firm’s
accounts receivables increased by $36,000. Therefore, cash collected from these
revenues was $89,000. Operating expenses reported during the period were $85,000,
but accounts payable increased during the period by $5,000. Therefore, cash operating
expenses were only $80,000. The net cash flow from operating activities, before taxes,
would be:

Cash flow from revenue: 89,000

Cash flow from expenses: (80,000)

Net cash flow: 9,000

The indirect method would find these cash flows as follows.

Revenue: 125,000

Expenses: (85,000)

Net Income: 40,000

The adjustments for cash flow would then be made to this amount of net income.
$36,000 would be subtracted due to the increase in accounts receivable, and $5,000
would be added due to the increase in accounts payable. This leaves us with the amount
of $9,000 for net income.