Cost allocation
Cost allocation is a basic concept of cost accounting, which prescribes the process of assigning the cost of one cost object to another one. This is usually done by simply applying mathematical operations of the rule of three. Such a process is needed as companies are not able to directly allocate all costs from their cost categories to the corresponding cost centre and the respective cost object. It’s common business, that cost centres are exchanging performances and therefore also charge each other for it. The resulting overheads or indirect costs are a typical example of why cost allocation is used (Berkau 2020, p. 274). The indirect costs that occur due to the internal services, can’t be traced in an economically plausible or cost-effective manner - even though they usually make up a considerable amount of costs, that need to be allocated to a cost object (e.g., products or distribution channels). There are four general purposes for allocating indirect costs to cost objects:
- Support of managerial decision making by providing information,
- Justification of cost as well as the assessment of reimbursement,
- Evaluation of the company’s income and assets for reporting purposes,
- Increase of the motivation of employees and managers (Bhimani et al. 2015, p. 124).
How to allocate cost
Generally speaking, cost allocation is done in the three following steps:
Step 1: Overheads/indirect costs, such as personnel or material costs, are determined by financial accounting and assigned to the respective cost centre. If several cost centres are charged with the same cost category, the underlying costs are assigned via cost allocation.
Step 2: In the case of a mutual exchange of services between cost centres, the costs of the sending cost centre are allocated to the receiving cost centre in order to reimburse the service provided.
Step 3: In the last step, the total costs of the cost centres are assigned to the cost objects. This overhead application is done by using cost rates to charge the final part of the cost structure. This cost allocation can be done in full cost accounting as well as in marginal cost accounting, whereby in marginal cost accounting only the proportional costs are considered, and the fixed amount flows directly into the profit and loss account (Berkau 2020, pp. 274-275).
Methods of cost allocation
Cause-effect principle
This principle follows the simple rule that the objects that cause the costs should also be charged with them. It is therefore the most common method of cost allocation, as it allows for a high degree of transparency and a clear delineation of cost responsibility. In practice, however, this method is often not applicable, as it is not possible (or simply too much effort) to trace which object actually caused and consumed which share of the costs incurred. Another typical problem is that resources are usually utilized by several objects, and the consumption is not measured for each individual object, but as a total value for an entire period. Therefore, companies resort to simpler and less accurate allocation methods unless the cost amount is too large and the relevance for decision-making is too high. As the name suggests, the case-effect principle requires a clear cause-and-effect relation to be able to allocate the indirect costs (Taschner, Charifzadeh 2020, p. 75).
Example:
Company X manufactures three different products, which are its cost objects to which the energy costs (total of 14,000 €) must be allocated. It’s assumed that company X is able to measure the energy consumption of each product. The cost per kWh is 0.20 €, which results in the following cost allocation:
| Product 1 | Product 2 | Product 3 | Total | |
|---|---|---|---|---|
| kw/h per product | 3 | 4 | 5 | |
| Cost per kw/h | 0.60 € | 0.80 € | 1 € | |
| Volume | 12,000 | 4,000 | 3,500 | 19,500 |
| Indirect cost allocated | 7,200 € | 3,200 € | 3,500 € | 13,900 € |
As the table above suggests, the cause-effect principle couldn’t allocate all energy costs as 100 € is missing. This gap occurs due to one of the main problems of this allocation method. The respective gap could occur due to inaccurate measurement of the energy usage by each product, or by scrap in production. In order to allocate the remaining 100 € another allocation method needs to be applied (Taschner, Charifzadeh 2016, p. 102).
Proportionality principle
As stated before, a clear relationship between an indirect cost item and a cost object can often not be found, or it’s at least too effortful to determine the exact relation. Therefore, also the mathematical relationship is undefined since the consumption of one cost object is unknown. Nevertheless, there usually is an identifiable cost driver for each indirect cost item. Based on this cost driver, the company is able to allocate the indirect cost by using the proportionality principle. Hence, it also relies on a (hypothetical) cause-and-effect relationship between the indirect cost item and cost object, but it assumes a linear relationship between resources consumed and the cost driver quantity. This assumption means, that if the cost driver quantity decreases by 10 %, the indirect costs also decrease by 10 %. Due to that fundamental assumption, the quality of the cost allocation highly depends on the quality of the cost driver.
Example:
Company X would in this case need to find an appropriate cost driver that is assumed to influence its energy costs (14,000 €) proportionally in order to allocate them. The company decides to use machine hours, as it assumes a correlation between energy costs and the underlying working hours.
| Product 1 | Product 2 | Product 3 | Total | |
|---|---|---|---|---|
| Machine hours per unit | 0.5 | 0.7 | 1 | |
| Volume | 12,000 | 4,000 | 3,500 | 19,500 |
| Total machine hours required | 6,000 | 2,800 | 3,500 | 12,300 |
| Indirect cost allocated | 6,829 € | 3,187 € | 3,984 € | 14,000 € |
As shown in the table above, the total energy costs have been allocated to the underlying products. However, due to the assumed linear relationship between cost drivers and energy costs, this represents a less precise cost allocation but is still a commonly used method as it can be measured with less effort (Taschner, Charifzadeh 2016, pp. 97-103).
Average Principle
The average principle is the simplest but also least accurate cost allocation method. It’s mostly used if no cost driver can be identified. It allocates the indirect costs by simply dividing the total costs by the number of cost objects. Hence, this method completely abandons any physical relationship between the consumption of the cost and its allocation.
Example:
Company X now uses the average principle to allocate its energy cost (14,000 €) to its cost objects (three products):
| Product 1 | Product 2 | Product 3 | Total | |
|---|---|---|---|---|
| Number of cost objects | 3 | |||
| Indirect cost allocated | 6,829 € | 3,187 € | 3,984 € | 14,000 € |
As mentioned before, this cost allocation method is simple but doesn't give deep insight into the cost structure as it is unprecise and an oversimplification. Nevertheless, its usage can mainly be justified by a relatively low amount and minor importance of an indirect cost item (Taschner, Charifzadeh 2016, pp. 99-104).
| Cost allocation — recommended articles |
| ABC method — Cost calculation — Direct costing — Cost per unit — LIFO Reserve — Standard productivity — Normal cost — Double counting — Segment margin |
References
- Berkau, C. (2020). Management Accounting. International Syllabus. 6th ed. Tübingen: UVK Verlag.
- Bhimani, A., Horngren, C. T., Datar, S. M., Rajan M. (2015). Management and cost accounting. Harlow, England, New York: Pearson (Always learning).
- Taschner, A.; Charifzadeh, M. (2020). Management accounting in supply chains. Wiesbaden, Germany: Springer Gabler.
- Taschner, A., Charifzadeh, M. (2016). Management and Cost Accounting. Tools and Concepts in a Central European Context. 1st Edition. Weinheim: Wiley-VCH GmbH.
Author: Robin Jungert
