Accounting Tips – Describing the Cost Allocation Process

One of the terms used in accounting is cost allocation. Also called cost assignment, it refers to the process of identifying cost objects, gathering costs that are incurred and assigning costs to cost objects. Cost assignment is a crucial accounting task that reveals the total cost of producing a product or rendering a service.

What makes cost assignment so vital?

Without proper calculation of costs, a company might find it difficult to distinguish between profitable and non-profitable goods or services. When costs are allocated incorrectly, a business may charge the wrong price to its clients or keep on wasting its precious resources on producing less profitable products. Cost allocation is necessary for financial reporting, spreading costs between departments and calculation of profitability at the subsidiary or departmental level. It enables the top management to determine the correct basis for offering bonuses or funding extra projects. Cost assignment is the method used to derive the best transfer prices between subsidiaries.

How to allocate costs

The process entails three different steps. These are:

  • Identification of a cost object
  • Aggregation of costs in different cost pools.
  • Assignment(cost appropriation)of costs to a cost object

To understand cost assignment accounting, you should get familiar with key terms.

  • Cost Object – It is any item or task that you wish to independently calculate costs for. It includes: a client, sales territory, department, project, branch and so on.
  • A cost pool is a major account in which various costs are gathered for the assignment process. Examples of a cost pool include insurance, factory rent, machine repair cost, labor hours, machine hours, and so on.
  • Cost driver – It refers to a variable that moves a cost. In other words, when such a variable goes up or down, it triggers the same action in a given cost. For instance, a few invoices disbursed can be a cost driver for the cost of billing division. As well, a number of units delivered to a customer can be a cost driver for the cost of distribution department.
  • Cost allocation base – This is a variable that is often used to assign or allot costs in various cost pools to various cost objects. Simply put, any appropriate cost driver for a cost pool qualifies as a cost allocation base.

Methods of allocating costs

There is no commonly used method of allocating costs to cost objects. So the advisable way is to use an approximate method and improve it with methods like cost of assets employed, headcount, square footage, electricity usage and so on. Your main aim should be to spread the cost in the most favourable manner. If a department has no control over a given cost, you are justified not to allocate it. The unallocated cost can be added to the total running costs of your business. Any profits made by the relevant department should be used to pay for the unallocated cost.

If the task becomes too difficult to handle, assign it to a third party. Alternatively, consult about its software tools. By so doing, your company could allocate costs to various departments with the intention of charging more expenses to divisions found in high tax areas. You can do so without the fear of going against the local government laws for cost assignments. With software such as the one offered by Anaplan, you can do multi-level cost allocation of indirect costs without making a mistake. What’s more, you can simplify your work by paying an affordable amount to obtain your software. For extra information on how Anaplan’s allocation software runs, visit them online and consult.

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