Cost allocation methods assign costs to products or services when costs don’t match. Methods include time, physical measures, or production. It affects accounting, tax, and management decisions. Examples include allocating electricity or head office costs to retail stores.
Cost allocation methods are used to solve the accounting problem that specific costs do not always match specific products, such as products or services. Different cost allocation methods may involve basing the allocation on time, physical measures such as personnel costs, or on production. In general, methods must be rational, reasonable, and capable of clear explanation.
The main reason for having to choose between different cost allocation methods is for accounting purposes. In some cases this may be for internal use, such as management who can spot areas where profitability can be increased. In other cases, it may be for external use, such as when an investor considers buying part of the company. It can also affect accounts for tax purposes and therefore the tax due. In some cases, financial or tax regulations may restrict the methods used.
As an example of cost allocation, imagine a company that produces plastic and wooden widgets. Some cost allocation is simple: the cost of purchasing plastic is clearly assignable as a cost of producing plastic widgets. If the company sells all the widgets for the same price, but the plastic costs more to buy than the wood, the cost allocation will show that the plastic widgets are less profitable.
Other areas of cost allocation are more complicated. For example, the electricity used on the production line must be allocated among the production costs of each type of widget. Some cost allocation methods may involve looking at the proportion of time that the production line produces each type of widget. The more complicated methods might involve taking into account how many of each type were produced at this time. If the situation is difficult, such as a company that produces 50 plastic widgets a day on Monday and Tuesday, and 40 plastic widgets a day on Wednesday, Thursday, and Friday, the allocation method used can have a significant effect on the results. cost figures.
In some cases, the need to clearly allocate costs is even greater, since the differences are clearer. An example would be a company that has six retail stores and a head office. Clearly, the company will want to see how profitable each store is. You could simply ignore head office costs, or split costs evenly between each store for accounting purposes.
In this example, the company could also use more specific cost allocation methods. You could divide the head office costs based on the size of each retail store and the turnover of each store. You could even divide them based on the actual proportion of staff time dealing with specific issues for specific stores. This method would mean that a store that generated a lot of customer complaints or other head office work would end up looking less profitable than more low-maintenance stores.
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