What Is Cost Allocation?

Cost allocation is a key factor in any business's profitability.
Business owners can use cost allocation findings to evaluate staff performance.
The process of cost allocation involves calculating both direct and indirect expenses, such as factory labor and small quantities of materials.
This article is for business owners interested in learning how to allocate costs.

For your business to make money, you must charge prices that not only cover your expenses, but also provide a profit. Cost allocation is the process of identifying and assigning costs to the cost objects in your business, such as products, a project, or even an entire department or individual company branch.

While a detailed cost allocation report may not be vital for extremely small businesses, such as a teen's lawn service, more complex businesses require the process of cost allocation to ensure profitability and productivity.

Key takeaway: In short, if you can assign a cost to any part of your business, it's considered a cost object.

Cost allocation is the method business owners use to calculate profitability for the purpose of financial reporting. To ensure the business's finances are on track, costs are separated, or allocated, into different categories based on the area of the business they impact.

For instance, cost allocation for a small clothing boutique would include the costs of materials, shipping and marketing. Calculating these costs consistently would help the store owner ensure that profits from sales are higher than the costs of owning and running the store. If not, the owner could easily pinpoint where to raise prices or cut expenses.

For a larger company, this process would be applied to each department or individual location. Many companies use cost allocation to determine which areas receive bonuses annually.

Tip Tip: Regardless of your business size, you'll want to review and choose the best accounting software to help this process run as smoothly as possible.

Types of costs

In the boutique example above, the process of cost allocation is pretty simple. For larger businesses, however, many more costs are involved. These costs break down into seven categories.

Direct costs: These expenses are directly related to a product or service. In your business's financial statements, these costs can be linked to items sold. For a small clothing store, this might include the cost of inventory.
Direct labor: This cost category includes expenses directly related to the employee production of items or services your business sells. Direct labor costs include payroll for employees involved in making the items your business sells.
Direct materials: As the name suggests, this category includes costs related to the resources used to manufacture a finished product. Direct materials include fabric to make clothing, or the glass used in building tables.
Indirect costs: These expenses are not directly related to a product or service, but necessary to create the product or service. Indirect costs include payroll for those who work in operations. It also lists costs for materials you use in such small quantities that their costs are easy to overlook.
Manufacturing overhead: This category includes warehouse costs, and any other expenses directly related to manufacturing the products sold. Manufacturing overhead costs include payroll for warehouse managers, as well as warehouse expenses such as rent and utilities.
Overhead costs: These include expenses that support the company as a whole but are not directly related to production. Some examples of overhead costs are marketing, operations and utilities for a storefront.
Product costs: Also called "manufacturing costs" or "total costs," this category includes expenses for making or acquiring the product you sell. All manufacturing overhead costs are also listed in this category.

Example of cost allocation

To better explain the process of cost allocation and why it's necessary for businesses, let's look at an example.

Dave owns a business that manufactures eyeglasses. In January, Dave's overhead costs totaled $5,000. In the same month, he produced 3,000 eyeglasses with $2 in direct labor per product. Direct materials for each pair of eyeglasses totaled $5.

Here's what cost allocation would look like for Dave:

Overhead: $5,000 ÷ $3,000 = $1.66 per pair

Direct costs:

Direct materials: $5 per pair
Direct labor: $2 per pair
Overhead: $1.66 per pair
Total cost: $8.66 per pair

As you can see, without cost allocation, Dave would not have made a profit from his sales. Larger companies would apply this same process to each department and product to ensure sufficient sales goals. [Read related article: How to Set Achievable Business Goals]

How to allocate costs

Cost objects vary by business type. The cost allocation process, however, consists of the same steps regardless of what your company produces.

1. Identify cost objects.

To begin allocating costs, you'll need to list the cost objects of your business. Remember that anything within your business that generates an expense is a cost object. Review each product line, project and department to ensure you've gathered all cost objects.

2. Create a cost pool.

Next, gather a detailed list of all business costs. It's a good idea to categorize the costs based on the reason for each amount. Categories should cover utilities, insurance, square footage and any other expenses your business incurs.

3. Allocate costs.

Now that you've listed cost objects and created a cost pool, you're ready to allocate costs. As demonstrated in the example above, add up the costs of each cost object. At a glance, your report should justify all expenses related to your business. If costs don't add up correctly, use the list to determine where you can make adjustments to get back on track.

What is cost allocation used for?

Cost allocation is used for many reasons, both externally and internally. Reports created by this process are great resources for making business decisions, monitoring productivity and justifying expenses.

External reports are usually calculated based on generally accepted accounting principles (GAAP). Under GAAP, expenses can only be reported in financial statements during the time period the associated revenue is earned. For this reason, overhead costs are divided and allocated to individual inventory items. When the inventory is sold, the overhead is expensed as a portion of the cost of goods sold (COGS).

Internal financial data, on the other hand, is usually reported using activity-based costing (ABC). This method assigns all products to the overhead expenses they caused. This process may not include all overhead costs related to operations and manufacturing.

Cost allocation reports show which cost objects incur the most expenses for your business and which products or departments are most profitable. These findings can be a great resource to pair with employee monitoring software when evaluating productivity. If you determine that a cost object is not as profitable as it should be, you should do further evaluations on productivity. If another cost object is found to exceed expectations, you can use the report to find staff members who deserve recognition for their contributions to the company.

Did you know? Recognition is one of the best ways to keep employees motivated.

What is a cost driver?

A cost driver is a variable that can change the costs related to a business activity. The number of invoices issued, the number of employee hours worked, and the total of purchase orders are all examples of cost drivers in cost accounting.

While cost objects are related to the specific process or product incurring the costs, a cost driver sheds light on the reason for the incurred cost amounts. These items can take different forms – including fixed costs, such as the initial fees during the startup phase. Cost drivers give a bird's-eye view of the entire company and how each department operates.

Did you know? FYI: It's common for only one cost driver to be used with very small businesses, since they are focused on using minimal reporting to estimate overhead costs.

Benefits of cost allocation

It simplifies decision-making. Cost allocation gives you a detailed overview of how your business expenses are used. From this perspective, you can determine which products and services are profitable, and which departments are most productive.
It assists in staff evaluation. You can also use cost allocation to assess the performance of different departments. If a department is not profitable, the staff productivity may need improvement. Cost allocation can also be an indicator of departments that exceed expectations and deserve recognition. Awards and recognition are a great way to motivate staff and, in turn, increase productivity. [Read related article: Best Business Productivity Apps]

Even if you operate a very small business, it's a great idea to learn the process of cost allocation, especially if you anticipate expansion in the future. Since the method can be complex, it's ideal to use accounting software as an aid. Whether you choose to start allocating costs on your own with software or hire a professional accountant, it's a process no business owner can afford to overlook.