Allocating Costs

Definition: Allocating costs is an accounting principle that identifies the material, logistic, and transportation resources needed to produce a specific good or service. By allocation, we mean identifying the resources required to produce a good or service regardless of who will use it or where it will be used. This concept is relevant to allocating costs between different projects in a company. For example, financial analysts may allocate costs amongst various projects in a firm according to their importance to the firm’s bottom line and risk tolerance.

Allocations are an accounting practice used to measure the impact of changes in price on sales in a given period. An allocation may involve a single tangible item such as inventory or facilities, or it may involve several virtual elements such as computer hardware or software. 

Allocated costs are expected to be incurred regardless of whether or not the goods are sold. For example, labor may be assigned a cost because it is a fixed cost that must be met irrespective of whether or not a unit is produced. Even if a unit is sold, the charge of the worker will not be refunded since it was not incurred in producing the goods. Allocation leads to best management practices when determining how best to spend your company’s money.

The allocation’s effect on sales is measured by comparing actual sales during the period with projections based on past growth patterns or decline. Accounting for allocations prevents the recognition of individual variations in prices, leading to mismeasurement and fraud.

Allocating costs is an accounting concept and should be used in the classification and costing of production goods. It helps determine how the costs are allocated among different productive activities in a firm. It is essential to allocate costs because it helps determine if there is enough money available to pay unpaid overhead costs over time or if the firm will have to raise subscription prices or cut production costs to stay profitable.

Allocation is a very general concept with many applications. It has been used for centuries to group-related costs and allocates them economically. Essentially, allocation is the process of determining how costs should be allocated in a particular situation.  It involves deciding which costs should be borne by customers, employees, investors, or government agencies. The allocation may be taken from operations or maintenance, capital expenditures, or any combination of the above.

Advantages of Allocation

  • By properly planning and assigning resources, an organization can accomplish many goals, including increasing efficiency, reducing costs, and improving quality. Therefore, this process is important and considered fundamental to running an efficient business.
  • In compliance, an allocation methodology involves setting aside funds from annual sales proposals in a manner that may be used to purchase or refinance receivables. This procedure prevents money from being wasted in non-receivable payments to obtain limited credit or operating advances that are not likely to be paid off during the product’s life cycle.
  • An allocation methodology is an essential part of the scheduling and supervision of work. It ensures that the resources (time, materials, staff) are used correctly and within the constraints imposed by the client or customer.
  • Allocating effectively means prioritizing projects that will see the most significant benefit from your time, money, and energy.
  • Allocating assets correctly means you reduce your risk level while also making it easier for you to manage your cash flow.

Disadvantages of allocation

  • Cost allocations are not appropriate for most businesses because the costs involved are usually individual rather than structural; some problems must be solved by paying more of something else, not accepted as part of the business.
  • Most cost-sharing allocation techniques are valid techniques for reducing overhead costs. But because cost-sharing is often applied arbitrarily across different projects, it can confuse about which project should be terminated more often than others.
  • Too much cost allocation can lead to ineffective use of resources and inappropriate decisions about spending an organization’s limited funds.

Allocation decisions should be based on an analysis of KPIs and departmental needs. Cost should be allocated competitively rather than walled-off like an internal department so that any allocation decisions have comparability across departments. The best way to allocate costs is to do a cost-benefit analysis. Identify the costs associated with producing a particular product and the benefits that it generates for the company. Then, using appropriate tools, determine how many resources are needed for each benefit and then divide the total cost by the number of users. The allocation rules of business aren’t set in stone. They’re constantly changing as new information comes in and old information is used to create better decisions.