What is Cost Allocation?

Cost allocation is the accounting process of assigning and categorizing business expenses. This process requires accountants and management to identify and agree upon the root causes of expenses. There are many reasons why cost allocation and accounting benefits organizations.

Why Cost Accounting Matters

Cost accounting measures are required by certain governmental agencies, voluntary health care regulatory bodies and the American Institute for Certified Public Accountants. All non-profit organizations must use cost allocations to prove to the public that all financial resources are appropriately and responsibly utilized. Cost allocations also provide accurate departmental costs, which helps management reduce financial waste. Accurate product cost data enhances the quality of financial reporting and decision-making. Resources are more frugally used because companies can monitor and control variable costs, such as shipping or vendor charges.

Related Resource: How Much Does a Cost Accounting Professional Make?

Cost Categories

Most organizations similarly categorize their business costs. First, there are labor costs, such as wages and salaries, and fringe benefit costs, such as insurance and workers’ compensation costs. Second, there are property and facility costs that take up a large portion of revenue. These usually include rent, utilities, maintenance, property taxes and mortgage interest. Third, equipment and depreciation costs allow organizations to recover money used to purchase equipment. Fourth, telephone and communication costs are usually kept separate from information technology costs. Fifth, program supply expenses are directly charged to departments that order them. Six, training costs include online coursework, off-site seminars and industry association conferences. There are professional services costs, which usually refer to things like accounting services, and auto costs, which cover traveling and vehicle maintenance.

An Allocation Plan

Most companies create formal plans to allocate miscellaneous costs. These are standardized methods for allocating expenses that difficult to identify or those that benefit multiple business activities. When developing an allocation plan, accounting professionals usually include organization-wide budgets that breakdown expenses and revenues by activity. They also identify all general, management and program-specific costs. Allocation plans allow accountants to standardize techniques that define activities and expenses. When implementing the allocation plan, special attention is paid to personnel costs because these account for over half of all expenses. By understanding the functional duties of employees, management is able to better control costs.

Regulatory Reminder

When it comes to government contracting, state and federal agencies have very specific guidelines regarding cost allocations. In general, government mandated cost allocations in financial statements are governed by the Generally Accepted Accounting Principles (GAAP). This means that businesses and non-profit organizations are required to show that all costs are reasonable, which means they are comparable to market prices and are required to fulfill the contract. The costs must be allowable, which excludes the costs of fundraising activities, and allocable, which means they must directly benefit the overall cost objective. Cost allocations must be consistently applied and thoroughly documented.

Cost allocation is favored by large corporations that are spread across different states because they can allocate extra expenses to companies located in states with high income tax rates, which will increase the tax deductions from gross profits and reduce the amount of taxes owed.