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:

1. To support managerial decision making by providing information,
2. For the justification of cost as well as the assessment of reimbursement,
3. For evaluating the company’s income and assets for reporting purposes,
4. To increase 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

Cause-effect principle

	Product 1	Product 2	Product 3
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 €