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Cost Accounting: Definition and Types With Examples

There’s also a simple way called the direct materials cost method that uses an allocation base of the same value as the variable rate. Using FAC or Variable costing can provide more accurate reporting on your company’s financials. Some of the common examples of indirect costs are security, electricity, administration, etc.

  • An employee working the assembly line is considered direct labor, a direct cost.
  • For unprofitable cost objects, the company’s management can cut the costs allocated and divert the money to other more profitable cost objects.
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BlackLine’s glossary provides descriptions for industry words and phrases, answers to frequently asked questions, and links to additional resources. The revenue cycle refers to the entirety of a company’s ordering process from the time an order is placed until an invoice is paid and settled. The inability to apply payments on time and accurately can not only lock up cash, but also negatively impact future sales and the overall customer experience.

What are the Benefits of Cost Allocation?

It involves identifying, gathering and assigning costs to different products or services. Cost allocation is important because the costs of producing or providing a product or service determines how much the company can sell it for and how much profit they can make. The very term “allocation” implies that there is no overly precise method available for charging a cost to a cost object, so the allocating entity is using an approximate method for doing so. Thus, you may continue to refine the basis upon which you allocate costs, using such allocation bases as square footage, headcount, cost of assets employed, or (as in the example) electricity usage. The goal of whichever cost allocation method you use is to either spread the cost in the fairest way possible, or to do so in a way that impacts the behavior patterns of the cost objects.

The break-even point—which is the production level where total revenue for a product equals total expense—is calculated as the total fixed costs of a company divided by its contribution margin. One of the most common mistakes is to allocate indirect expenses based on current production volume. Other issues include not performing cost allocation at all or using arbitrary rates rather than industry standards. When deciding how to allocate these types of expenses, companies should consider their company’s size and what it will cost to produce a certain amount of output. There are many ways to allocate expenses, including the high/low method and step-up/down.

By assigning costs accurately, organizations can assess the current budget and identify areas where additional funds may be needed. For example, if your company produces two products, A and B (and each product has its own direct labor cost), you would first need to determine how many units of Product A are produced for every unit of Product B sold. Fixed costs are allocated among departments or projects based on how they benefit each area. For example, comparing the cost of producing one product versus another can help decide which should be produced more often based on its profitability compared with other goods or services offered by a company.

Common Cost Allocation Methods

Internal financial data, on the other hand, is usually reported using activity-based costing (ABC). This process may not include all overhead costs related to operations and manufacturing. The basis for allocating costs may include headcount, revenue, units produced, direct labor hours or dollars, machine hours, activity hours, and square footage. Cost allocation helps determine if specific departments are profitable or not. If the cost object is not profitable, the company can evaluate the performance of the staff members to determine if a decline in productivity is the cause of the non-profitability of the cost objects. A cost allocation base is the unit, activity, or item that allocates costs in an organization.

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Why should you consider using Cost Allocation?

To better explain the process of cost allocation and why it’s necessary for businesses, let’s look at an example. In the boutique example above, the process of cost allocation is pretty simple. For a larger company, this process would be applied to each department or individual location.

It is important to identify and use a cost allocation methodology that is detailed and documented, so that the costs are allocated accurately and each cost center is allocated its fair share. Organizations should also review cost allocation regularly to ensure accuracy and stay up-to-date. Over time, manufacturers’ overhead allocations have moved from a plant-wide rates to departmental rates. Some allocations that were allocated on the basis of direct labor hours are now based on machine hours. In order to improve those bases of allocations, some accountants are implementing activity based costing.

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. 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. A company may allocate costs to its various divisions with the intent of charging extra expenses to those divisions located in high-tax areas, which minimizes the amount of reportable taxable income for those divisions.

Cost accounting can be much more flexible and specific, particularly when it comes to the subdivision of costs and inventory valuation. Cost-accounting methods and techniques will vary from firm to firm and can become quite complex. If the variance analysis determines that actual costs are higher than expected, the variance is unfavorable. If it determines the actual costs are lower than expected, the variance is favorable. Taking these factors into account when allocating cost allows businesses and individuals to understand better how much money they need coming in (revenue) compared with how much they must spend (costs).

Definition and Examples of Cost Allocation

This team of experts helps Finance Strategists maintain the highest level of accuracy and professionalism possible. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Learn how to optimize existing processes, collaborate efficiently, and provide more value to your organization. It’s important to remember that cost objects will vary depending on your business and industry.

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