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Cost Allocation

Cost Allocation Assignment / Homework Help
Costs incurred by a company can be broadly divided into two viz. direct costs and indirect costs. Direct costs, as the name suggests, are directly related to a particular product or service. Indirect costs are costs that are incurred for the normal operations of the company but are costs that cannot be directly attributable to any particular product or service. However, these costs must be considered for the purpose of arriving at total cost of product or service and also to determine their sale price. The question that arises is "How should one allocate these indirect costs to a product or service?"

Cost allocation is the process whereby indirect costs are allocated to the products or services in proportions to which products or services are benefited by these costs. The allocation is based on a percentage that represents a reasonable and equitable basis for allocation. In simple words, cost allocation is the process of allocating costs to particular cost centers. It basically deals with allocation of costs on an equitable and reasonable basis to cost centers without any arbitrary or ad-hoc apportionment of costs.

One of the important considerations in cost allocation is to ensure that costs allocated are complete and are reconciled to the costs actually incurred and reported in the financial statements. Unlike traditional costing methods where cost allocations were made either on volume or output, modern costing techniques like Activity Based Costing use 'cost drivers' to allocate cost in most appropriate and logical way to cost centers. A cost driver is any activity that causes a cost to be incurred. Cost drivers are identified for different indirect costs and allocated to different cost centers on the basis of these drivers. This ensures more logical and practical cost allocation than the traditional cost allocation system.

Given below are some examples of indirect costs and how they can be allocated to different cost centers based on their cost drivers.

Indirect Costs Cost Driver / Basis of cost allocation
Maintenance costs Number of machine hours
Materials handling costs Number of orders
Inspection costs Number of inspections

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