The Best Cost Allocation Methods—with Examples
When providing a product or service, you incur necessary costs that are not directly related to your offering. Cost allocation addresses this issue by assigning overhead costs to offer a clearer picture of your company's profitability and efficiency.
Whether you’re weighing up whether to discontinue a product, close a business unit, or drop a client, you need to consider costs. If costs do not reflect the real value of delivering a product or service, it’s difficult to know whether it’s profitable, identify how and why any problems exist, or make smarter decisions.
Around 92% of corporate leaders consider ineffective resource allocation the most significant barrier to implementing effective strategies. While internal politics may play a role, unreliable cost attribution is often an addressable culprit.
Proper cost allocation allows you to avoid costly mistakes like letting go of promising ventures. At the same time, it highlights inefficiencies and motivates managers to address fixable issues. For example, cost allocation can identify variances in costs across teams with similar cost structures, prompting poorer performing managers to tweak operational costs and look for efficiencies to realign with others.
What is cost allocation?
Cost allocation means distributing and assigning costs among cost objects. Cost objects refer to items you can use to measure costs separately. They can be internal like a department, job, business unit, program, or assembly, or external, such as services, products, or activities.
Appropriately allocating costs to these cost objects is critical for calculating profitability and conducting financial reporting.
Types of costs
Irrespective of industry, most business’ costs fall into three categories: direct, indirect, and overhead.
1. Direct costs
Direct costs are costs that you can attribute to a cost object like a service, product, or project.
For a manufacturer, direct costs include raw materials and direct labor. If a car manufacturer pays $300K for the parts of an engine and $150K in labor costs for each unit, its total direct costs would be $450K.
As you produce more cars, these direct costs would also increase.
But what about the money you spend for factory supervisors and quality control?
2. Indirect costs
Costs that you cannot attribute directly to a product or service like factory supervisors, quality control, and material handling costs are indirect costs.
Assume your company manufactured 25 cars.
If you paid $50k for factory supervisors and $25K for your quality control department, total indirect costs would be $75K. Then, allocate $75K amount to a cost object, which would be 25 cars.
For each car produced, you spent $3K ($75K divided by 25) for indirect costs.
Now, how about the department outside the production line? Like admin or accounting?
3. Overhead costs
Costs do not end at production. Outside the manufacturing plant, the business needs to pay for admin, accounting, research and development, and legal fees. These overhead costs are necessary for running the business, but are not directly related to production.
Businesses will incur overhead costs whether it renders a service or not. Since overhead functions do not make money directly, businesses have to allocate overhead costs to operating departments.
Cost allocation methods
Within the business, departments can either be an operating department that produces a product or service or a supporting department. Cost allocation spreads overhead costs to operating departments in the fairest possible way.
Most businesses use three methods for cost allocation:
The direct method is the simplest and most practical way to allocate costs. Here, operating departments absorb costs from support departments based on identified cost objects.
For simplicity, assume that a car company has two production departments: engineering and manufacturing.
The company spends $51,300 for maintaining the accounting department and $75,000 for the legal department. Assume that the company allocates costs based on a predetermined percentage.
If the engineering department receives 20% of accounting costs and 30% of legal costs, allocated costs to the department will be $10,260 (20% of $51,300) for accounting and $22,500 (30% of $75,000) for legal expenses.
For the manufacturing department, allocated costs would be the remaining portion of $41,040 (80% of $51,300) for accounting and $52,500 (70% of $75,000) for legal.
Total allocated costs would be:
$32,760 ($10,260 accounting plus $22,500 legal)
$93,540 ($41,040 accounting plus $52,500 legal)
After cost allocation, operating departments would carry costs previously under support departments. Many small businesses use this method due to its simplicity.
But what if some accounting costs are due to services provided to the legal department?
Under the direct method, nothing will change. Cost allocation will ignore any service provided by one support department to another.
If your business requires one support department to provide service to another, the direct method may not provide the most accurate way to allocate costs. But if your support departments do not provide services to each other, the direct method could be an appropriate cost allocation strategy.
Sequential (or step) method
When a company's support department provides services to another support department, the sequential or step method may be more reliable.
The step method allows you to allocate costs from one support department to another before assigning costs to the operating departments.
The first step is to identify which department provides the greatest amount of service to another department.
Using the example above, assume that that the support departments allocate expenses using the following allocation ratio:
Accounting costs: 20% to legal, 20% to engineering, 60% to manufacturing
Legal costs: 10% to accounting, 27% to engineering, 63% to manufacturing
Therefore, the accounting department allocates 20% or $10,260 to the legal department, and the legal department assigns 10% or $7,500 of its expenses to the accounting department.
Based on the numbers above, we will allocate accounting costs first since it provides a greater service.
If total accounting expenses is $51,300 with 20% charges to legal, 20% to engineering, and the remaining for manufacturing you have:
$10,260 (20% of $51,300) to the legal department.
$10,260 (20% of $51,300) to engineering
$30,780 (60% of $51,300) to manufacturing
After allocation, legal costs would now be $85,260 ($75,000 + $10,260 allocated from accounting). In allocating legal costs, we will ignore the 10% cost assigned to the accounting department.
Using the remaining 90% — (27% assigned to engineering and 63% to manufacturing) we get: 30% (27/90) to engineering and 70% (63/90) to manufacturing:
$25,578 (30% of $85,260) for engineering
$59,682 (70% of $85,260) to manufacturing
After allocation, total allocated costs would be
$35,838 ($10,260 accounting plus $25,578 legal)
$90,462 ($30,780 accounting plus $59,682 legal)
The step-down method provides greater accuracy than the direct method, but it does not recognize reciprocal services.
You will notice how the accounting department assigned costs to the legal department, but there was no way for the legal departments to allocate costs back to the accounting department. Under the step method, you cannot allocate costs backward, only forward.
Among the three cost allocation methods, the reciprocal or algebraic formula method provides the highest accuracy. It starts with creating a formula that represents the cost incurred by the supporting department.
Assume total accounting expenses equal $51,300 and legal department costs are $75,000. Accounting allocates 20% of its costs to legal and Legal assigns 10% to accounting.
Using A to represent the accounting department and L for the legal department, we have:
Equation 1= A: $51,300 + 0.1L
In Equation 1, $51,300 pertains to the total accounting department costs, and 0.1L is for the 10% of legal costs allocated to the accounting department. Using the same concept, we can come up with the equation for the legal department.
Equation 2: L = $75,000 + 0.2A
Next, we have to get the value of A by substituting equation 2 in equation 1.
A = $51,300 + 0.1L
A = $51,300 + 0.1($75,000 + 0.2A)
A= $51,300 + $7,500 + 0.02A
A= $58,800 + 0.02A
0.98A = $58,800
A = 60,000
Using the value of A above, we can compute for L.
L = $75,000 + 0.2A.
L= $75,000 + 0.2($60,000)
L= $75,000 + $12,000
L = $87,000
Now, we have the values for A and L that we need to allocate among the existing departments.
Starting with the accounting expenses, we will allocate $60,000 as follows: 20% to legal, 20% is for engineering, and 60% to manufacturing.
$12,000 (20% $60,000) of to legal department
$12,000 (20% $60,000) to engineering
$36,000 (60% $60,000) to manufacturing
After allocating accounting expenses, total costs related to the legal department would now be $87,000 ($75,000 + $12,000) and for the accounting department it would be -$8,700 ($51,300 - $60,000).
The $60,000 allocated out of the accounting department is greater than the total accounting cost of $51,300 since it includes the allocated legal department costs. Because of this, we have a negative number for the total accounting department costs, but it zeros out after we complete the allocation from the legal department.
Next, allocate $87,000 from the legal department as follows: 10% to accounting, 30% to engineering, and 60% to manufacturing resulting in:
$8,700 (10% of $87,000) to the accounting department
$26,100 (30% of $87,000) to engineering
$52,200 (60% of $87,000) to manufacturing
After allocation, balances for both the legal department and the accounting department would now be zero.
Total costs allocated to operating units would be:
$38,100 ($12,000 from accounting + $26,100 from legal) to engineering
$88,200 ($36,000 from accounting +$52,200 from legal) to manufacturing
Why cost allocation matters to startup companies
For any company, especially for a startup with limited resources, an appropriate cost allocation strategy could spell the difference between growing bigger and going bankrupt. Proper cost allocation helps you calculate the true profitability of a business unit or campaign, analyze next steps like continuing programs vs. abandoning them, and motivate managers and employees better with measurable cost attribution vs. contribution.
A critical step to cost allocation is having full visibility and control over costs. Lola Spend delivers real-time insight and spend management to minimize cash burn.
Poor cost allocation ultimately hampers decision-making. Your business may decline an opportunity or pursue a losing initiative because of erroneous data. Cost transparency and clarity are necessary to drive growth and make the most out of your resources.