Learn Accounting Entries For Cost Allocation On Your Own:

Before understanding cost allocation, we need to understand what is cost object. A cost object is any item that a company wants to assign a cost to separately. It may be customers, departments or any other thing the cost of which needs to estimated seperately by management. It is a key concept used in managing the costs of a business.

Cost Allocation is the method of identifying and summarizing a cost object and then assigning a cost to cost object instead of spreading them around. Cost objects are those items that you want to track the costs of object individually. These might be external or internal.

External costs would be a company's products, services, sales teams, or activities. These are things that are outside of what goes on within the company. An internal cost could be something assigned to a unit, department, franchise, or assembly line. A cost allocation is a good tool to use on an annual basis to track changes in costs.

The best example of cost allocation is electricity. Let's take the electric bill that includes the electricity you use for production and packaging of product. Since electricity is used in office and factory as well, it would be desirable to divide it up and allocate the cost to both so that the cost of production (direct expences) can be seperated from indirect expences that are incurred to operate a business as a whole or a segment of a business and that cannot be directly associated with a cost object.

Purpose Or Benefits of Cost Allocation:

Costs are allocated for three main purposes:

1. To Obtain Desired Motivation.

Cost allocations are sometimes made to influence management behavior and thus promote goal assessment with managerial effort. Cost allocation helps to stimulate managers to make sure the benefits of the specified services exceed the costs.

2. To Compute Income And Asset Valuations.

Cost Allocation helps to measure inventory costs and cost of goods sold. These allocations also helps in accounting purposes and are also often used by managers in planning, evaluation of performance, and to motivate managers.

3. To Justify Costs Or Obtain Reimbursement.

Sometimes prices are based directly on costs, or it may be necessary to justify an accepted bid. For example, government contracts often specify a price that includes reimbursement for costs plus some profit margin. In these instances, cost allocations become substitutes for the usual working of the marketplace in setting prices.

Types Of Cost Allocation:

1. Allocation Of Joint Costs:

Costs are sometimes used jointly by more than one unit and are allocated based on cost-driver activity in the units. Examples are allocating rent to departments based on floor space occupied, allocating amortization on jointly used machinery based on machine-hours, and allocating general administrative expense based on total direct cost etc,.

2. Reallocation Of Costs From One Responsibility Centre To Another:

When one unit provides products or services to another, the costs are also transferred along with the products or services. Unit like department, exist only to support other departments, and their costs are totally reallocated. For example personnel department, laundry department in hospitals.

3. Allocation Of Costs Of A Particular Organizational Unit To Its Outputs Of Products Or Services.

The painting department of car manufacturing firm to assembly department for units assembled. The costs allocated to products or services include those allocated to the organizational unit.