Indirect cost allocation is the process of accounting for costs that do not lead to a direct result. Overhead costs are difficult to allocate to one department, so companies use methods such as case-by-case or overhead rate allocation to distribute costs based on department size.
Indirect cost allocation is the process of accounting for all costs incurred by a business or organization that do not directly lead to some type of result. As a result, these costs are often difficult to allocate to just one part of an organization, and sometimes must be shared among multiple departments. One indirect cost allocation method is the case-by-case method, which attempts to allocate overhead costs based on the department that uses them. Another method is to develop an overhead cost, which totals all overhead costs and allocates them based on the size of each department’s budget.
The budget is a crucial part of any business operation. Knowing how much money is needed to keep operations afloat for a specific period of time and keeping that capital in reserve is part of the process. Such a process becomes complicated when you need to account for costs that are not directly attributable to some type of product but are actually accrued by multiple departments at once. These costs are known as overhead costs, and companies must devise methods for allocating overhead costs that are efficient and accurate.
There are many types of indirect costs that can be accumulated by an organization. For example, if a company does not own its place of business, the rental costs are essentially shared by all departments. Salaries for individual employees can be attributed to the departments they work for, but salaries for executives who oversee all departments can be more difficult to assign. Such examples illustrate the difficulties involved with allocating overhead costs.
Fortunately, there are a few different methods that a company can employ for overhead cost allocation. One, the case-by-case method, attempts to take each indirect cost separately and allocate them accordingly. The benefit of this method is that it can provide the most accurate accounting of overhead costs, making the budget more accurate. However, such a method requires a significant amount of time to complete and can still become inaccurate when costs are shared by many departments.
Another method of assigning overhead costs occurs when the company’s management assigns an overhead rate to solve the problem. In this method, all overhead costs are added up. They are then distributed to each department depending on the size of the department’s budget. For example, imagine that a company accumulates $500 US dollars (USD) in indirect costs in a month and $1,500 dollars in direct costs. That means indirect costs make up 25 percent of the company’s $2,000 budget, and as such, each department would carry an additional 25 percent of their direct costs as their indirect cost burden.
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