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