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Allocation Base in Cost Accounting: A Beginner's Guide

Table of contents, what is allocation base in cost accounting, why is allocation base important in cost accounting, a brief overview of cost allocation methods, allocation base in different cost accounting systems, various types of allocation bases, choosing the right allocation base, calculating costs using allocation bases, allocation base and its relationship with cost behavior, allocation bases’ application in decisions, impact of technology on allocation bases, common mistakes with allocation bases.

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The allocation base in cost accounting is a critical element used to assign costs to different cost objects . It’s an essential tool that helps companies evenly and fairly distribute costs.

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Allocation bases are pivotal in cost accounting as they help businesses accurately distribute costs. This, in turn, improves transparency and decision-making. Recognizing the most effective allocation base lets companies efficiently manage their resources and grasp their cost structure.

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There exist several cost allocation methods – direct allocation, step-down allocation, and reciprocal allocation being the common ones. Each method offers distinct benefits and constraints, allowing accurate distribution of costs based on the chosen allocation base.

Allocation Bases within Job-Order Costing and Process Costing

In job-order and process costing systems, allocation bases could include labor hours, machine hours, units produced, direct material and labor costs. These allocation bases provide the foundations for cost assignment to specific units, products, or projects.

Allocation Bases and Activity-Based Costing (ABC)

Within ABC, allocation bases may comprise various activity drivers like customer orders or machine setups. These bases provide more precise overhead cost distribution to product lines or services considering their unique activities.

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Direct Labor Hours, Machine Hours, and Direct Material Costs as Allocation Bases

The allocation base can take various forms depending on the main cost components. It can be direct labor hours, machine hours, or direct material costs. By accurately tracing these variables, companies can correctly allocate associated costs to different cost objects.

Other Types of Allocation Bases in Cost Accounting

Alternately, allocation bases could also be units of output, square footage, or the employee count, among others. The choice of an allocation base relies heavily on the principal cost drivers within a company.

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What Influences the Selection of Allocation Base?

Certain factors guide the choice of an appropriate allocation base, such as the cost nature, homogeneity of cost objects, and data collection simplicity and precision.

The Risks of Choosing the Wrong Allocation Base

Choosing a wrong allocation base may result in inaccurate cost allocation and flawed decision-making. It’s imperative for companies to carefully evaluate different allocation bases to identify the most suitable one.

Best Approaches to Identify the Right Allocation Base

Suitable approaches to identify the right allocation base include conducting a robust cost analysis , consulting accounting experts, and regularly updating allocation methodologies to align with company’s evolving needs.

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Cost Allocation Using Allocation Bases: A Step-by-step Process

The process of cost allocation involves identifying relevant costs, selecting a suitable allocation base, calculating the allocation rate , and assigning costs based on allocation base usage or consumption.

Examples and Complex Allocation Base Cases

Applications range from simple to complex allocation base scenarios. For complex situations, companies often leverage advanced software solutions or seek cost accounting experts’ help to navigate through intricate allocation processes.

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About Variable and Fixed Costs

Allocation bases provide insights into cost behaviors within an organization. In cost accounting, costs are classified into variable and fixed. While variable costs change with production volume, fixed costs remain constant.

Challenges in Managing Cost Behavior Using Allocation Bases

Challenges may arise in managing cost behavior through allocation bases. These include accurately reflecting cost variations within cost objects and selecting more suitable allocation bases for complicated cost structures.

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Cost Allocation and Pricing Strategies

Allocation bases are crucial in determining pricing strategies. By understanding the cost structure through precise cost allocations, businesses can set appropriate pricing levels.

Profitability Analysis and Outsourcing Decisions

Allocation bases also play a crucial role in profitability analysis and outsourcing decisions. Accurate cost allocation helps businesses recognize profitable areas and make informed decisions around resource allocation and cost management.

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Allocation Base and The Future of AI and Machine Learning

We’re moving towards a future where allocation bases will be greatly influenced by artificial intelligence (AI) and machine learning. These technologies enhance cost allocation accuracy and efficiency by continually optimizing allocation methodologies.

Incorrect Allocation Bases and Inaccurate Rate Calculations

Incidents of incorrect allocation bases and inaccurate rate calculations are common. To avoid these, companies must carry out a thorough evaluation and consult with experts when needed.

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Allocation Base: The Takeaway

Allocation bases are vital in cost accounting for a systematic and fair cost distribution. For beginners in cost accounting, understanding the types of allocation bases and their relationship with cost behaviors is crucial. Technological advancements also promise to improve and automate cost allocation processes in the future.

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Allocation bases

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An allocation base is the basis on which Cost accounting allocates overhead costs. An allocation base can be a quantity, such as machine hours that are used, kilowatt hours (kWh) that are consumed, or square footage that is occupied. Allocation bases are mostly used to assign overhead costs to inventory that is produced. For example, an IT department allocates its expenses according to the number of computers that each department uses.

There are three types of allocation bases in Cost accounting:

Predefined dimension member allocation bases

Hierarchy allocation bases

Formula allocation bases

The predefined dimension member allocation bases are created automatically when a dimension member of one the following types is created:

Statistical dimension members

Cost element dimension members

The predefined dimension member allocation bases that are based on a cost element dimension member consider the values only from the data source provider, such as the general ledger or budget.

Example 1: Use a cost element dimension member as the allocation base

This example shows how to create a cost allocation rule to allocate cost element 10002 (Employee insurance) to the balance that is recorded on cost element 10001 (Salaries). The allocation rule is defined based on the ratio of each department's salaries to total salaries. (Review needed!)

In the general ledger, the chart of account is defined as follows.

Chart of account Main account Description Main account type
Shared 10001 Salaries Expense
Shared 10002 Employee insurance Expense

Define a cost element dimension, and configure the data connector. After the data is imported, the following entries are created in Cost accounting.

Cost element dimension name Cost element Description Type
Cost elements 10001 Salaries Primary
Cost elements 10002 Employee insurance Primary
Name Description Cost element dimension
10001 Salaries Cost elements
10002 Employee insurance Cost elements

In the general ledger, the following entries have been posted:

  • The entries that show the Salaries main account come from the Payroll system and are posted to cost centers.
  • The expense for employee insurance is manually posted to a default cost center.
Accounting date Cost center Description Main account Description Amount in accounting currency
03-01-2017 CC001 HR 10001 Salaries 2,000.00
03-01-2017 CC002 FI 10001 Salaries 5,000.00
03-01-2017 CC003 IT 10001 Salaries 3,000.00
03-01-2017 CC099 Default cost center 10002 Employee insurance 1,000.00

After the general ledger source data is processed, the following entries are created in Cost accounting.

Cost entries

Cost object Description Cost element Description Cost behavior Amount Accounting date
CC001 HR 10001 Salaries Unclassified 2,000.00 03-01-2017
CC002 FI 10001 Salaries Unclassified 5,000.00 03-01-2017
CC003 IT 10001 Salaries Unclassified 3,000.00 03-01-2017
CC099 Default cost center 10002 Employee insurance Unclassified 1,000.00 03-01-2017

In this simplified example, a cost allocation rule is created to allocate cost element 10002 (Employee insurance) relative to the balance that is recorded on cost element 10001 (Salaries).

Cost distribution rule

Cost object dimension hierarchy node Cost element dimension hierarchy node Cost behavior Allocation base
CC099 10002 Unclassified 10001

Perform overhead calculation

After cost element 10001 (Salaries) is applied as the allocation base, the result of the overhead calculation is as follows.

Cost object Description Magnitude Allocation factor Amount
CC001 HR 2,000 (2,000 ÷ 10,000) × 1,000.00 200.00
CC002 FI 5,000 (5,000 ÷ 10,000) × 1,000.00 500.00
CC003 IT 3,000 (3,000 ÷ 10,000) × 1,000.00 300.00
Journal Journal type Fiscal calendar period Year Period Version
00001 Cost distribution calculation journal Fiscal 2017 Period 1 Overhead calculation / 01-02-2017 11:51:00 PM / Ledger /2017 / Period 1

Cost object balance journal entries

Accounting date Cost object Description Cost element Description Cost behavior Amount
31-01-2017 CC099 Default cost center 10002 Employee insurance Unclassified 1,000.00
Cost object Description Cost element Description Cost behavior Amount Accounting date
CC099 Default cost center 10002 Employee insurance Unclassified -1,000.00 31-01-2017
CC001 HR 10002 Employee insurance Unclassified 200.00 31-01-2017
CC002 FI 10002 Employee insurance Unclassified 500.00 31-01-2017
CC099 IT 10002 Employee insurance Unclassified 300.00 31-01-2017

Example 2: Use a statistical dimension member as the allocation base

Statistical dimension members can be used as allocation bases to define policies or report non-monetary consumption by cost objects. You can manually create statistical dimension members or import them from a file by using the Data management import/export tool.

Statistical dimension name Statistical element Description Unit
Statistical elements FTE Full time employees Ea
Statistical elements Electricity Electricity consumption kWh

When a statistical dimension member is saved, a corresponding record is created in the predefined dimension member allocation bases.

Name Description Statistical element dimension
FTE Full time employees Statistical elements
Electricity Electricity consumption Statistical elements

Statistical measures can come from various sources:

  • Electricity consumption can be measured by meters that are installed in different areas of the company.
  • Tables hold statistical measures. For example, the HcmEmployment table holds a list of all employees and the cost centers that they work for.
Name Cost center Description Worker type
Employee A CC001 HR Employee
Employee B CC002 FI Employee
Employee C CC002 FI Employee
Employee D CC003 IT Employee
Employee F CC003 IT Employee

All the tables that contain financial dimensions can be used as sources for statistical measures.

Cost accounting supports a collection of statistical measures by using the following data connections:

  • Data management import/export tool
  • Statistical measures

To pull statistical measures from the system, a statistical measure provider template is required. For more information, see Statistical measure provider template. (Will add a link once this article is written.)

Statistical measure provider templates

Name Function Source table Sum field Date field
FTE’s Count HcmEmployment Not applicable Not applicable

After the statistical measure source data is processed, the following entries will be created in Cost accounting.

Statistical entries

Cost object Description Accounting date Statistical dimension member Description Magnitude
CC001 HR 31-01-2017 FTE’s Full time employees 1.00
CC002 FI 31-01-2017 FTE’s Full time employees 2.00
CC003 IT 31-01-2017 FTE’s Full time employees 2.00

Here is an example of a cost distribution rule if the FTE’s predefined dimension member allocation basis is assigned as the allocation base in it.

Cost object Description Magnitude Allocation factor
CC001 HR 1.00 (1/5) × Amount
CC002 FI 2.00 (2/5) × Amount
CC003 IT 2.00 (2/5) × Amount

You can use the Imported statistical measures data entity to import statistical measures into Cost accounting. You can also use the Data management import/export tool. In Excel, the consumption of electricity is recorded as follows.

Accounting date Dimension member Magnitude Source identifier
31-01-2017 CC001 2,450.00 Electricity
31-01-2017 CC002 4,100.00 Electricity
31-01-2017 CC003 15,000.00 Electricity
Cost object Name Accounting date Statistical dimension member Description Magnitude
CC001 HR 31-01-2017 Electricity Electricity consumption 2,450.00
CC002 FI 31-01-2017 Electricity Electricity consumption 4,100.00
CC003 IT 31-01-2017 Electricity Electricity consumption 15,000.00

Here is an example of a cost distribution rule if the Electricity predefined dimension member allocation basis is assigned as the allocation base in it.

Cost object Description Magnitude Allocation factor
CC001 HR 2,450.00 (2,450 ÷ 21,550) × Amount
CC002 FI 4,100.00 (4,100 ÷ 21,550) × Amount
CC003 IT 15,000.00 (15,000 ÷ 21,550) × Amount

Cost accountants can manually create the hierarchy allocation bases by applying a cost object dimension hierarchy node to an existing allocation base. In this way, you can limit the range of the original predefined dimension member allocation basis. One predefined dimension member allocation basis can be used to create several hierarchy allocation bases. Ranges can be maintained in the cost object dimension hierarchy that is associated with the hierarchy allocation bases.

Example: Hierarchy allocation bases that are based on full-time employees in the organization

Here is an example of a cost object dimension hierarchy that can be created to describe a simplified organization.

Hierarchy name Node level 0 Node level 1 Node level 2 Dimension members
Organization CEO CFO FICO CC001
Organization CEO CFO HR CC002
Organization CEO CIO IT CC003

The FTE’s predefined dimension member allocation basis that was created in the previous section holds the following entries.

A cost must be distributed between cost centers that report to the organization's chief financial officer (CFO). It's acknowledged that the correct allocation ratio is the number of full-time employees (FTEs) by cost center.

Name Allocation base Cost object dimension hierarchy Cost object dimension hierarchy node
Number of FTEs in CFO FTE’s Organization CFO

A Preview function lets you validate the hierarchy allocation basis that is created, based on statistical entries in the system.

Allocation base details

Cost object Description Magnitude
CC001 HR 1.00
CC002 FI 2.00

Here is an example of a cost distribution rule if the Number of FTEs in CFO hierarchy allocation basis is assigned as the allocation base in it.

Cost object Description Magnitude Allocation factor
CC001 HR 1.00 (1/3) × Amount
CC002 FI 2.00 (2/3) × Amount

Formula allocation bases let you define advanced formulas to achieve the correct allocation basis. You can manually create formula allocation bases.

When you create a formula allocation base, you select which statistical dimension and cost element dimension should be the basis for the formula. All allocation bases that come from the previously selected dimensions can be used in a formula allocation base.

Previously defined formula allocation bases can be used to define a new formula allocation base.

In formula allocation base factors, you create an alias, and associate it with either an allocation base or a constant. The aliases are then used to define the formula.

You can use the following operators to define your formula.

Symbols Text
( ) Parentheses
< Smaller than
> Larger than
+ Addition
Subtraction
* Multiplication

Traditional IF statements aren't supported. However, you can create statements and validate whether they are true.

Statement Validation Result
a > b True 1
a > b False 0

Example 1: A simple formula

Electricity bills often consist of two parts:

  • A fixed fee for being connected to grid
  • A cost that is associated with consumption per kWh

The Electricity predefined dimension member allocation basis has already been defined and holds these values.

If the fixed fee must now be evenly spread over cost objects that consume electricity, you have two options for allocating the costs:

  • Create a new predefined allocation base, Electricity fixed, and then apply a statistical measure of 1.00 for each cost object that consumed electricity.
  • Create a formula allocation base, Electricity fixed, that takes advantage of the Electricity predefined allocation base that is already defined in the system. The benefit of this option is that data must be loaded into Cost accounting for only one Electricity statistical dimension member.

Formula allocation base

Name Cost element dimension Statistical dimension Formula
Electricity fixed Statistical elements

Before the Formula field can be filled, you must specify the alias that should be used in the formula.

Formula allocation base factors

Alias Constant Allocation base
a Electricity
b 0.01

Note that 0 (zero) isn't supported as a constant.

Name Cost element dimension Statistical dimension Formula
Electricity fixed Statistical elements a > b

A Preview function lets you validate the formula allocation base that is created, based on statistical entries in the system.

Cost object Description Formula Magnitude
CC001 HR 2,450.00 > 0.01 1.00
CC002 FI 4,100.00 > 0.01 1.00
CC003 IT 15,000.00 > 0.01 1.00

Here is an example of a cost distribution rule if the Electricity formula allocation base is assigned as the allocation base in it.

Cost object magnitude allocation factor

Cost object Name Magnitude Allocation factor
CC001 HR 1.00 (1/3) × Amount
CC002 FI 1.00 (1/3) × Amount
CC003 IT 1.00 (1/3) × Amount

Example 2: An advanced formula

For this example, the cost of electricity should not just follow the actual electricity that is consumed in kWh. Management wants to incorporate incentive for lowering electricity usage.

Rule Rate
a <= 10000,00 kWh 0.75
a > 10000,00 kWh 1.15

A new formula allocation base, Electricity usage, is created.

Name Cost element dimension Statistical dimension Formula
Electricity usage Statistical elements
Alias Constant Allocation base
a Electricity
b 10,000.00
c 0.75
d 1.15
Name Cost element dimension Statistical dimension Formula
Electricity fixed Statistical elements ((a > b) × ((b × c) + (a – b) × d)) + ((a <= b] × a × c)
Cost object Name Formula Magnitude
CC001 HR ((2,450.00 > 10.000.00) × ((10,000.00 × 0.75) + (2,450.00 – 10,000.00) × 1.15)) + ((2,450.00 <= 10,000.00) × 2,450.00 × 0.75) 1,837.50
CC002 FI ((4,100.00 > 10.000.00) × ((10,000.00 × 0.75) + (4,100.00 – 10,000.00) × 1.15)) + ((4,100.00 <= 10,000.00) × 4,100.00 × 0.75) 3,075.00
CC003 IT ((15,000.00 > 10.000.00) × ((10,000.00 × 0.75) + (15,000.00 – 10,000.00) × 1.15)) + ((15,000.00 <= 10,000.00) × 15,000.00 × 0.75) 1,3250.00

Here is a closer look at the formula for CC003 (IT):

((15,000.00 > 10,000.00) × ((10,000.00 × 0.75) + (15,000.00 – 10,000.00) × 1.15)) + ((15,000.00 <= 10,000.00) × 15,000.00 × 0.75) = 13,250.00

(1 × (7,500.00 + 5,000.00 × 1.15)) + (0 × 15,000.00 × 0.75)

1 × 7,500.00 + 5,750.00 + 0

Here is an example of a cost distribution rule if the Electricity fixed formula allocation base is assigned as the allocation base in it.

Cost object Description Magnitude Allocation factor
CC001 HR 1,837.50 (1,837.50 ÷ 18,162.50) × Amount
CC002 FI 3,075.00 (3,075.00 ÷ 18,162.50) × Amount
CC003 IT 13,250.00 (13,250.00 ÷ 18,162.50) × Amount

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  • Allocation Base

Dive into the intricacies of Business Studies with a comprehensive exploration of the Allocation Base, a fundamental concept in cost accounting. This article will help you decode its meaning, understand its application, and unravel its importance in strategic decision-making. With insights into the formula, influences on its selection, and implications of various bases, this guide provides all the knowledge required to master this critical business tool. Discover how the business environment and corporate strategy could affect the choice of an Allocation Base, shaping the future of your enterprise.

Allocation Base

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What potential implications can the choice of allocation base have in business accounting and operations?

What are some potential pitfalls of the allocation base?

What can affect the overhead allocation rate in the allocation base formula?

What kind of cost allocation bases are commonly used in accounting?

What is the allocation base formula in cost accounting?

How does the allocation base differ from direct costs in cost accounting?

What is the allocation base in business studies?

Give examples of common allocation bases used in the allocation base formula.

What is cost allocation base in intermediate accounting?

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What are the roles of the cost allocation base in businesses?

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Understanding the Allocation Base in Intermediate Accounting

In the realm of accounting and business studies, the term 'allocation base' holds a pivotal role. It essentially serves as the yardstick to systematically spread costs across various departments, products, or services within a company, enabling accurate financial forecasting and performance measurement.

The allocation base, also known as the cost driver, is an accounting measure used to allocate indirect costs to the cost objects. The allocation base can be either financial or non-financial metrics, depending on the nature of the underlying costs.

Defining the Allocation Base: What it Means in Business Studies

An allocation base allows businesses to distribute costs in a fair and logical manner. Often, it's not feasible to directly link costs to products or services, and that's where the allocation base proves its value. It helps in capturing the consumption of resources used by the various cost objects in an organization.

Let's illustrate this concept through an example:

Consider a manufacturing company that produces different types of widgets. The factory overhead, including utilities and maintenance, cannot be directly tracked to individual widget types. To assign the overhead costs fairly among the widgets, an allocation base such as machine hours might be used. If Widget A required 500 machine hours and Widget B required 1500 machine hours, and the total overhead was £2000, the allocated overhead would be £500 for Widget A, and £1500 for Widget B.

Walking Through the Allocation Base Formula: A Simple and Essential Guide

The allocation base is the foundation of indirect cost allocation . But how do you calculate it? It's a straightforward process, represented by the following formula:

This formula results in an allocation rate, which provides a standard to prorate indirect costs across cost objects based on their consumption of the associated cost driver.

In our widget company example:

If a business had indirect costs of £2000 and the total machine hours were 2000 (500 for Widget A and 1500 for Widget B), we would calculate the allocation base as follows:

So, for every hour a machine is used, £1 of overhead costs are assigned.

It's worth noting that the choice of allocation base is critical and should reflect the actual consumption of overhead costs. If machine hours do not significantly affect the overall overhead, it would not be an appropriate allocation base. In such cases, alternatives such as direct labour hours or direct material costs may be more suitable.

Applying the Allocation Base in Cost Accounting

Mastering the utilization of the allocation base is crucial in the field of cost accounting. By accurately splitting indirect expenses across cost objects, companies can achieve more realistic product costing, precise profitability analysis , and informed decision-making.

Importance of the Cost Allocation Base: How it Drives Business Decisions

The impact of the cost allocation base is evident in various areas, ranging from pricing strategies to budget planning, and even in assessing departmental efficiency. In essence, an appropriately selected allocation base presents a true and fair view of costs, steering businesses in their strategic and operational decisions.

First, product pricing heavily relies on accurate cost calculations. By distributing indirect costs accurately across products, businesses can determine their true cost of production. This information is essential for pricing decisions, allowing companies to maintain a profitable margin while staying competitive in the market. In the absence of an appropriate allocation base, a company could underprice or overprice its products, leading to potential losses or missed opportunities.

Second, an allocation base guides managers in budget planning. With an accurate understanding of how resources are used, managers can project future costs and make appropriate budget allocations. This not only leads to controlled spending but also optimizes resource utilization. As part of internal financial management, understanding the allocation base can also aid in identifying inefficiencies and improving operations.

Third, cost allocation affects performance evaluation. When costs are allocated fairly across departments, the resulting performance measures can reveal departmental efficiency and effectiveness. Managers can then use this information to benchmark and motivate improvement.

Product PricingDetermines the true cost of production essential for profitable pricing.
Budget PlanningSupports accurate future cost projection and budget allocation.
Performance MeasurementPromotes fair evaluation of departmental efficiency and effectiveness.

The Implications of Using Different Allocation Bases

Choosing an allocation base is not a one-size-fits-all approach. Different bases will yield different results, and the implications can significantly impact the financial performance and decisions of a business.

  • Direct Labour Hours: This is a common base, especially in labour-intensive industries. If the majority of overhead costs are driven by labour activity, this base can accurately allocate overheads across cost objects. However, if a company moves towards automation, this base can lead to a skewed allocation.
  • Machine Hours: For capital-intensive industries, machine hours can be an effective allocation base. But again, if machines are not the primary cost driver, using this base may distribute costs disproportionately, giving a distorted view of profitability.
  • Direct Material Costs: In industries where materials form a significant part of the costs, direct material costs can be used as an allocation base. This is suitable if changes in material consumption correspond to changes in indirect costs. If this relationship does not hold, another base will be more appropriate.

Remember, the ultimate aim is to choose an allocation base that best reflects the consumption of overheads. Proper analysis and judgment are required to ensure that the chosen base represents the cause-and-effect relationship of overhead costs. A wrongly selected base can lead to distorted product costs, erroneous pricing, and inaccurate performance measures. Therefore, regular evaluation and adjustments are key to maintaining an appropriate allocation base .

Factors Influencing the Selection of an Allocation Base

Selecting the right allocation base is paramount in cost allocation. The right base can reflect the true cost consumption and render fairness in overhead allocation . Several factors, therefore, need consideration during the selection process, including the nature of the industry, type of production, technology used, and corporate strategy. Let's delve deeper into these factors and their implications.

Deciding on the Right Allocation Base: Factors That Matter

Whether you're deciding between direct labour hours, machine hours, or direct material costs, picking the most suitable allocation base can seem like a complex task. To break it down, you should focus on four key factors: industry type , production type , technology level , and the cause-and-effect relationship between indirect costs and potential allocation bases.

1. Industry Type: Different industries can have different cost structures. In labour-intensive industries, direct labour hours might be an appropriate allocation base as labour generally drives the overhead costs. Conversely, in capital-intensive industries like manufacturing, machine hours or machine-related metrics could provide a more accurate reflection of the overhead consumption.

2. Production Type: The type of products made or services offered also influence the selection. For instance, in batch production, production runs or batch hours can accurately capture the overhead costs associated with each batch. In contract-driven businesses like construction, contract value might be a better base.

3. Technology Level: The allocation base should align with the level of technology used in the business. In a highly mechanised environment, machine-focused bases can be more appropriate. But, if a company is significantly automating its operations, factors other than conventional machine hours, like electricity consumption, could become a more suitable base.

4. Cause-and-Effect Relationship: Fundamentally, the allocation base should reflect the cause-and-effect relationship with the overhead costs. That is, changes in the allocation base should correspond with changes in the overhead costs it’s meant to distribute. If such a relationship doesn't exist, the chosen base will not provide a fair allocation.

How Do Business Environment and Corporate Strategy Influence Allocation Base Choice?

The business environment and corporate strategy not only shape a company's operations but can also guide the cost allocation process and influence the choice of an allocation base. Let's explore this in detail:

Business Environment: External factors such as market conditions, customer demands, and regulatory requirements can intervene with the selection of an allocation base. For instance, if customers demand transparency in pricing, companies might use more direct bases rather than complex allocation methods to determine product costs. Changes in the regulatory landscape can also necessitate adjustments in the allocation process to meet compliance requirements.

Corporate Strategy: The strategic direction of the business can have substantial implications on the choice of an allocation base. A company adopting a cost-leadership strategy would focus on stringent cost control and might choose bases that provide detailed insights into cost drivers and allow for accurate overhead tracing. Conversely, a firm following a differentiation strategy might lean towards more aggregated allocation bases as their focus would be more on product uniqueness than individual cost components.

In conclusion, the choice of an allocation base is not static but is subject to changes in the company's internal and external environment. By continually monitoring and adjusting to these changes, a company can ensure that the allocation base remains appropriate and serves its cost accounting needs.

Bear in mind, however, accuracy and relevance should be balanced with simplicity and ease of understanding. Overly complex allocation methods can overwhelm users, straining their comprehension and diminishing the value of information derived from cost allocation.

Allocation Base - Key takeaways

  • Allocation Base: Also known as the cost driver, it is an accounting measure used to spread out indirect costs to cost objects. It helps in capturing the consumption of resources used by various cost objects in an organization. The allocation base can be either financial or non-financial metrics, depending on the nature of the underlying costs.
  • Allocation Base Formula: Total indirect costs divided by total cost driver values. This formula yields an allocation rate, which is used to distribute indirect costs across cost objects based on their consumption of the associated cost driver.
  • Importance of the Cost Allocation Base: Careful selection and utilization of the allocation base are essential to accurate financial forecasting and performance measurement. An appropriate allocation base can influence decisions in areas such as product pricing, budget planning, and assessing departmental efficiency.
  • Implications of Different Allocation Bases: The choice of allocation base can significantly influence the financial performance of a business. For instance, using direct labor hours, machine hours, or direct material costs can highlight different aspects of cost structures. The goal is to choose a base that accurately reflects the consumption of overheads within the business.
  • Factors Influencing the Selection of an Allocation Base: Several factors, including industry type, production type, level of technology, and the cause-and-effect relationship of the costs and the allocation base, should be considered in choosing the allocation base. The business environment and corporate strategic direction could also influence the selection of an allocation base.

Flashcards in Allocation Base 27

Allocation base influences accuracy in cost data, product pricing strategies, budgeting and cost control, and external financial reporting. The chosen allocation base should accurately reflect overhead cost behaviour for successful decision-making.

Potential pitfalls include overhead allocation based on volume, use of a single cost driver oversimplifying overhead behaviour, and arbitrary allocation that might not accurately reflect costs.

If the allocation base is significantly small, or if 'Total Overhead Costs' fluctuate substantially while the 'Total Allocation Base' remains constant, the overhead allocation rate can be affected and become inconsistent or disproportionately high.

Common cost allocation bases include direct labour hours, direct labour cost, machine hours, square footage, and units produced. These are chosen based on the nature of the business operations and the overhead costs.

The allocation base formula aids in the distribution of indirect costs. It incorporates a cost pool, which contains the indirect costs to be distributed, and an allocation base, representing the units over which costs will be spread.

While direct costs can be easily traced to a cost object and typically vary directly with output, the allocation base is used to distribute indirect costs that cannot be directly traced and may or may not vary with output.

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How to Calculate Cost Allocation

by Carter McBride

Published on 26 Sep 2017

Cost allocation assigns a specific cost to a project. An example of a cost that needs allocation would be an electric bill for several different projects. A cost object is a task or a job. An example cost object would be manufacturing widgets. There are numerous ways to determine the allocation; however, it is important to not just arbitrarily assign costs. Since there are numerous ways to allocate costs, it is important a company chooses an appropriate base. The base can range from direct labor hours to units produced.

Calculate the total amount of the costs needing assignment. For example, a company wants to allocate electricity costs for producing two products. Electricity costs are $50,000 for the year.

Determine the base to use and the percentages to allocate based on the base. For example, the company wants to use direct labor hours as its base. For Product A, the company needs 1,400 direct labor hours. For Product B, the company needs 1,600 direct labor hours. Therefore, 1,400 direct labor hours divided by 3,000 direct labor hours equals an allocation base of about 46 percent for Product A. Then 1,600 direct labor hours divided by 3,000 direct labor hours equals an allocation base of about 54 percent for Product B.

Multiply the total cost by the allocation base. In our example, for Product A, $50,000 times 46 percent equals $23,000. For Product B, $50,000 times 54 percent equals $27,000.

Module 7: Costing Methods

Calculating costs, learning outcomes.

  • Calculate an overhead rate, manufacturing overhead, and unit costs

Overhead costs are all of those costs that a business incurs that cannot be directly related to a particular product. Remember our discussion about indirect costs—these costs fall into our overhead.

Rent, utilities, mortgage interest, production supervisors and maintenance staff all are costs that will need to be allocated by calculating an overhead rate. We can use historical data to calculate a predetermined overhead rate which can be applied based on an allocation base. An allocation base is defined as the measure used to assign overhead costs to products and services. The most commonly used allocation bases are direct-labor hours, direct labor cost, units of product (if there is only one product made) or machine hours.

Once the total overhead cost has been calculated, it is then divided between the production based on whichever allocation base the company has determined most effective.

Predetermined overhead rate = Estimated total manufacturing overhead cost

Estimated total amount of the allocation base:

There are four steps to determine this rate, and it is done prior to the start of the period.

  • Estimate the allocation base that will be required for next period’s estimated production level.
  • Estimate the total fixed manufacturing overhead costs for the coming period and the variable manufacturing overhead cost per unit of the allocation base.
  • Use the cost formula** to estimate the total manufacturing overhead cost for the next period.
  • Finally compute the predetermined overhead rate.

So let’s do a little practice!

Overhead applied to a particular job =

predetermined overhead rate × Amount of the allocation base incurred by the job

Let’s assume we calculated our estimated total manufacturing overhead cost at $50,000 for the coming period and our estimated total amount of the allocation base in direct labor hours at 10,000 hours.

$50,000/ 10,000= $5 per hour. Our predetermined overhead rate would be $5 per direct labor hour.

If a widget takes 2 hours to make, we would then allocate 2 × $5 or $10 to the costs involved in making the widget  as our overhead costs.

What would happen if the widget took .5 hours to make? Then we would use our $5 per direct labor hour, × .5 = $2.50 per hour

Practice Questions

  • Calculating Costs. Authored by : Freedom Learning Group. Provided by : Lumen Learning. License : CC BY: Attribution

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  • Cost Classifications
  • Relevant Cost of Material
  • Manufacturing Overhead Costs
  • Conversion Costs
  • Quality Costs
  • Revenue Expenditure
  • Product Cost vs Period Cost
  • Direct Costs and Indirect Costs
  • Prime Costs and Conversion Costs
  • Relevant vs Irrelevant Costs
  • Avoidable and Unavoidable Costs
  • Cost Allocation
  • Joint Products
  • Accounting for Joint Costs
  • Service Department Cost Allocation
  • Repeated Distribution Method
  • Simultaneous Equation Method
  • Specific Order of Closing Method
  • Direct Allocation Method

Cost allocation is the process by which the indirect costs are distributed among different cost objects such as a project, a department, a branch, a customer, etc. It involves identifying the cost object, identifying and accumulating the costs that are incurred and assigning them to the cost object on some reasonable basis.

Cost allocation is important for both pricing and planning and control decisions. If costs are not accurately calculated, a business might never know which products are making money and which ones are losing money. If cost are mis-allocated, a business may be charging wrong price to its customers and/or it might be wasting resources on products that are wrongly categorized as profitable.

Cost allocation is a sub-process of cost assignment , which is the overall process of finding total cost of a cost object. Cost assignment involves both cost tracing and cost allocation. Cost tracing encompasses finding direct costs of a cost object while the cost allocation is concerned with indirect cost charge.

Steps in cost allocation process

Typical cost allocation mechanism involves:

  • Identifying the object to which the costs have to be assigned,
  • Accumulating the costs in different pools,
  • Identifying the most appropriate basis/method for allocating the cost.

Cost object

A cost object is an item for which a business need to separately estimate cost.

Examples of cost object include a branch, a product line, a service line, a customer, a department, a brand, a project, etc.

A cost pool is the account head in which costs are accumulated for further assignment to cost objects.

Examples of cost pools include factory rent, insurance, machine maintenance cost, factory fuel, etc. Selection of cost pool depends on the cost allocation base used. For example if a company uses just one allocation base say direct labor hours, it might use a broad cost pool such as fixed manufacturing overheads. However, if it uses more specific cost allocation bases, for example labor hours, machine hours, etc. it might define narrower cost pools.

Cost driver

A cost driver is any variable that ‘drives’ some cost. If increase or decrease in a variable causes an increase or decrease is a cost that variable is a cost driver for that cost.

Examples of cost driver include:

  • Number of payments processed can be a good cost driver for salaries of Accounts Payable section of accounting department,
  • Number of purchase orders can be a good cost driver for cost of purchasing department,
  • Number of invoices sent can be a good cost driver for cost of billing department,
  • Number of units shipped can be a good cost driver for cost of distribution department, etc.

While direct costs are easily traced to cost objects, indirect costs are allocated using some systematic approach.

Cost allocation base

Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools to different cost objects. A good cost allocation base is something which is an appropriate cost driver for a particular cost pool.

T2F is a university café owned an operated by a student. While it has plans for expansion it currently offers two products: (a) tea & coffee and (b) shakes. It employs 2 people: Mr. A, who looks after tea & coffee and Mr. B who prepares and serves shakes & desserts.

Its costs for the first quarter are as follows:

Mr. A salary16,000
Mr. B salary12,000
Rent10,000
Electricity8,000
Direct materials consumed in making tea & coffee7,000
Direct raw materials for shakes6,000
Music rentals paid800
Internet & wi-fi subscription500
Magazines400

Total tea and coffee sales and shakes sales were $50,000 & $60,000 respectively. Number of customers who ordered tea or coffee were 10,000 while those ordering shakes were 8,000.

The owner is interested in finding out which product performed better.

Salaries of Mr. A & B and direct materials consumed are direct costs which do not need any allocation. They are traced directly to the products. The rest of the costs are indirect costs and need some basis for allocation.

Cost objects in this situation are the products: hot beverages (i.e. tea & coffee) & shakes. Cost pools include rent, electricity, music, internet and wi-fi subscription and magazines.

Appropriate cost drivers for the indirect costs are as follows:

Rent10,000Number of customers
Electricity8,000United consumed by each product
Music rentals paid800Number of customers
Internet & wifi subscription500Number of customers
Magazines400Number of customers
19,700

Since number of customers is a good cost driver for almost all the costs, the costs can be accumulated together to form one cost pool called manufacturing overheads. This would simply the cost allocation.

Total manufacturing overheads for the first quarter are $19,700. Total number of customers who ordered either product are 18,000. This gives us a cost allocation base of $1.1 per customer ($19,700/18,000).

A detailed cost assignment is as follows:

Tea & CoffeeShakes
Revenue50,00060,000
Costs:
  Salaries16,00012,000
  Direct materials7,0006,000
  Manufacturing overheads allocated11,0008,800
Total costs34,00026,800
Profit earned16,00033,200

Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000

Manufacturing overheads allocated to Shakes = $1.1×8,000

by Irfanullah Jan, ACCA and last modified on Jul 22, 2020

Related Topics

  • Cost Behavior

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Cost Allocation

True Tamplin, BSc, CEPF®

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on June 08, 2023

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Table of contents.

Cost allocation is a process in which businesses and individuals identify the costs incurred by activity and distribute them to appropriate accounts .

This allows for better decision-making when determining how much should be spent on different business areas.

Types of Costs

There are types of costs to consider during the process of cost allocation. They include:

  • Fixed costs . These are expenses that remain the same no matter how many units of production have been made or sold. For example, a business spends $100,000 on rent every month. Even if the company can only produce and sell 50 units of a product in one month (when they normally make and sell 100), this cost remains at $100,000 for that given time period.
  • Variable costs . These expenses depend on the amount of production or sales made within a given period, such as raw materials used for making products. For example, it costs a furniture shop $50 to make a chair—$20 for raw materials such as wood, cane, metal, leather, and fabrics, and $30 for the direct labor involved in making one chair.

Below shows how the variable costs change as the number of chairs made varies.

Variable_Costs_Sample

As the production output of chairs increases, the bakery’s variable costs also increase. When the furniture shop does not make any chair, its variable costs drop to zero.

  • Indirect costs . These are expenses that cannot be directly linked to the making or selling of goods or services, such as administrative salaries, office expenses, security expenses, and utilities.
  • Direct Costs. These are costs that can be directly linked to the making or selling of goods or services. For example, if a company pays for equipment rental to produce their product, this cost is considered direct because it links back to how many units have been produced.

Why Is Cost Allocation Important?

Cost allocation is an important part of any business. The following points reflect why you should always be sure to allocate all your expenses:

  • It helps in accurate decision-making. When costs are known, it is easier to determine which strategies will most benefit the business or individual.
  • Allocating cost enables comparison between different products and services.

For example, comparing the cost of producing one product versus another can help decide which should be produced more often based on its profitability compared with other goods or services offered by a company.

  • It helps in understanding which departments are more profitable than others. Identifying the cost of different areas of business allows for better decision-making at the departmental level, and overall.
  • It can help identify problem areas within a company to allow for improvements or changes that might be beneficial for future production or sales.

Taking these factors into account when allocating cost allows businesses and individuals to understand better how much money they need coming in (revenue) compared with how much they must spend (costs).

This makes setting prices easier since there is an understanding of what each unit sold brings in revenue-wise.

Common Mistakes People Make When Allocating Costs

  • Not accounting for overhead . Overhead is a general term that refers to indirect expenses, which are not directly attributed to the cost of goods sold (COGS) or fixed costs.
  • Not taking into account which projects are currently generating revenue and which ones aren’t.
  • Not allocating indirect expenses equally among departments and projects within a company.
  • Not considering how fluctuating revenue affects indirect expenses. If you’re seeing a lot of variability in revenue over time, you need to account for that when allocating costs.
  • Using the incorrect allocation method. There are many different methods for allocating costs and using more than one can help you get a better idea of where your business is spending its money.

Process of Cost Allocation

The following is an overview of how to allocate costs and some tips on what you should take into consideration when doing so.

Step One: Identify Your Costs

The first step is to identify all of your costs. This includes both direct and indirect expenses, as well as fixed or variable costs.

Step Two: Allocate Indirect Costs Between Departments or Products

Indirect costs should be allocated between departments, projects, and products based on a fair allocation plan that reflects their use in those areas.

For example, suppose your company produces two products, products A and B.

In that case, you will need to construct a cost-allocation plan that reflects the allocation of overhead expenses between these areas.

Step Three: Allocate Fixed Costs Among Departments or Projects

Fixed costs are allocated among departments or projects based on how they benefit each area.

For example, if Product A produces a specific product that is used for Product B, it would be appropriate to allocate the fixed costs associated with producing Product A between these two products.

Step Four: Allocate Variable Costs Among Departments or Projects

Variable costs are allocated among departments or projects based on how much of each cost driver they use.

For example, if your company produces two products, A and B (and each product has its own direct labor cost), you would first need to determine how many units of Product A are produced for every unit of Product B sold.

You can then use this information to allocate the variable costs associated with producing each product based on their respective rates.

Step Five: Use Cost-Volume-Profit Analysis to Determine the Best Allocation Method

If your company uses multiple products, services, or departments that incur indirect costs, cost allocation is important in determining which method will work best for reporting profits accurately.

For example, suppose you’re using a full absorption costing (FAC) system and another department within your company is using a direct labor cost system.

In that case, you may need to use more than one allocation method.

Step Six: Use Cost Allocation for Decision Making & Reporting

Cost allocation is important for both decision-making and reporting purposes.

Using cost allocation, you can determine which areas of your company are over or under-spending and how changes to specific processes will affect the overall profitability of a product or department.

Common Cost Allocation Methods

Cost allocation faqs, what is cost allocation.

Cost allocation is the process of assigning expenses to one or more cost objects. A cost object can be a product, project, department, business unit, or another grouping within an organization with costs associated with it.

How is cost allocation done?

There are many ways to allocate expenses, including the high/low method and step-up/down. There’s also a simple way called the direct materials cost method that uses an allocation base of the same value as the variable rate. Using FAC or Variable costing can provide more accurate reporting on your company’s financials.

What are the benefits of cost allocation?

Cost allocation allows you to determine where costs can be reduced and provides accurate reporting on company financials based on its relative performance. Allocating indirect expenses is also important for decision-making purposes. With this information, you can determine which areas of your business need improvement and how changes in production will affect overall profitability. Cost allocation can also show you which departments or products are spending too much money on indirect expenses, and which ones aren’t using enough of them. This enables you to make more informed staffing decisions in the future based on how your company’s needs change over time. Finally, cost allocation allows companies to compare their performance against similar businesses.

What are common mistakes people make when allocating costs?

One of the most common mistakes is to allocate indirect expenses based on current production volume. Other issues include not performing cost allocation at all or using arbitrary rates rather than industry standards. When deciding how to allocate these types of expenses, companies should consider their company’s size and what it will cost to produce a certain amount of output.

How is cost allocation performed?

Cost allocation can be done manually or through software. It’s important to keep detailed records of all your company’s expenses so you have accurate financial reports for decision-making purposes. If you don’t have cost records, the process of allocation can be time-consuming and difficult to determine. You may not know which department or product each expense is associated with, so your reports will lack accuracy.

cost allocation base formula

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

Related Topics

  • Cost Allocation Base
  • Cost Application

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  • Luxury Lifestyle: $8,000+

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What is Cost Structure?

Fixed vs. variable costs, fixed costs, variable costs, direct vs. indirect costs, direct costs, indirect costs, cost allocation, example of cost allocation, the importance of cost structures and cost allocation, additional resources, cost structure.

The different types of cost structures incurred by a business

Cost structure refers to the various types of expenses a business incurs and is typically composed of  fixed and variable costs . Costs may also be divided into direct and indirect costs. Fixed costs are costs that remain unchanged regardless of the amount of output a company produces, while variable costs change with production volume.

Direct costs are costs that can be attributed to a specific product or service, and they do not need to be allocated to the specific cost object. Indirect costs are costs that cannot be easily associated with a specific product or activity because they are involved in multiple activities.

Operating a business must incur some kind of costs, whether it is a retail business or a service provider. Cost structures differ between retailers and service providers, thus the expense accounts appearing on a  financial statement  depend on the cost objects, such as a product, service, project, customer or business activity. Even within a company, cost structure may vary between product lines, divisions or business units, due to the distinct types of activities they perform.

Key Highlights

  • Cost structure refers to the various types of expenses a business incurs and is typically composed of fixed and variable costs, or direct and indirect costs.
  • Fixed costs are incurred regularly and are unlikely to fluctuate over time. Variable costs are expenses that vary with production output.
  • Direct costs are costs that are directly related to the creation of a product and can be directly associated with that product. Direct costs are usually variable costs, with the possible exception of labor costs. Indirect costs are costs that are not directly related to a specific cost object. Indirect costs may be fixed or variable.
  • Having a firm understanding of the difference between fixed and variable and direct and indirect costs is important because it shapes how a company prices the goods and services it offers.

Fixed costs are incurred regularly and are unlikely to fluctuate over time. Examples of fixed costs are overhead costs such as rent, interest expense, property taxes, and  depreciation  of fixed assets. One special example of a fixed cost is direct labor cost. While direct labor cost tends to vary according to the number of hours an employee works, it still tends to be relatively stable and, thus, may be counted as a fixed cost, although it is more commonly classified as a variable cost where hourly workers are concerned.

Variable costs are expenses that vary with production output. Examples of variable costs may include direct labor costs,  direct material cost , and bonuses and sales commissions. Variable costs tend to be more diverse than fixed costs. For businesses selling products, variable costs might include direct materials, commissions, and piece-rate wages. For service providers, variable expenses are composed of wages, bonuses, and travel costs. For project-based businesses, costs such as wages and other project expenses are dependent on the number of hours invested in each of the projects.

As alluded to earlier, direct costs are costs that are directly related to the creation of a product and can be directly associated with that product. Direct material is an example of a direct cost.

Direct costs are almost always variable because they are going to increase when more goods are produced. As discussed earlier, an exception to this is labor. Employee wages may be fixed and unlikely to change over the course of a year. However, if the employees are hourly and not on a fixed salary then the direct labor costs can increase if more products are manufactured.

Indirect costs are costs that are not directly related to a specific cost object like a function, product or department. They are costs that are needed for the sake of the company’s operations and health. Some other examples of indirect costs include overhead , security costs, administration costs, etc. The costs are first identified, pooled, and then allocated to specific cost objects within the organization.

Indirect costs may be either fixed or variable costs. An example of a fixed cost is the salary of a project supervisor assigned to a specific project. An example of a variable indirect cost would be utilities expense. This expense may fluctuate depending on production (for example, there would be an increase in utility expense if a manufacturing plant is running at a higher capacity utilization ).

Having a firm understanding of the difference between fixed and variable and direct and indirect costs is important because it shapes how a company prices the goods and services it offers. Knowing the actual costs of production enables the company to price its products efficiently and competitively.

Cost allocation is the process of identifying costs incurred, and then accumulating and assigning them to the right cost objects (e.g. product lines, service lines, projects, departments, business units, customers, etc.) on some measurable basis. Cost allocation is used to distribute costs among different cost objects in order to calculate the profitability of different product lines.

A cost pool is a grouping of individual costs, from which cost allocations are made later. Overhead cost, maintenance cost and other fixed costs are typical examples of cost pools. A company usually uses a single cost-allocation basis, such as labor hours or machine hours, to allocate costs from cost pools to designated cost objects.

A company with a cost pool of manufacturing overhead uses direct labor hours as its cost allocation basis. The company first accumulates its overhead expenses over a period of time (for example, a year) and then divides the total overhead cost by the total number of labor hours to find out the overhead cost “per labor hour” (the overhead allocation rate ). Finally, the company multiplies the hourly cost by the number of labor hours spent to manufacture a product to determine the overhead cost for that specific product line.

Cost Structure - Example of Cost Allocation

To maximize  profits , businesses must find every possible way to minimize costs. While some fixed costs are vital to keeping the business running, a  financial analyst  should always review the financial statements to identify possible excessive expenses that do not provide any additional value to core business activities.

When an analyst understands the overall cost structure of a company, they can identify feasible cost-reduction methods without affecting the quality of products sold or service provided to customers. The financial analyst should also keep a close eye on the cost trend to ensure stable cash flows and no sudden cost spikes occurring.

Cost allocation is an important process for a business because if costs are misallocated, then the business might make wrong decisions, such as over/underpricing a product, or invest unnecessary resources in non-profitable products. The role of a financial analyst is to make sure costs are correctly attributed to the designated cost objects and that appropriate cost allocation bases are chosen.

Cost allocation allows an analyst to calculate the per-unit costs for different product lines, business units, or departments, and, thus, to find out the per-unit profits. With this information, a financial analyst can provide insights on improving the profitability of certain products, replacing the least profitable products, or implementing various strategies to reduce costs.

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Cost Allocation

The process of identifying a company’s costs and assigning those costs to cost objects

Christopher Haynes

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds  asset management  firm with $20 billion under management, and as an investment banking analyst in  SunTrust Robinson Humphrey 's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Sid Arora

Currently an investment analyst focused on the  TMT  sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a  BS  from The Tepper School of Business at Carnegie Mellon.

  • What Is Cost Allocation?
  • Types Of Costs
  • How To Allocate Costs
  • Why Do We Need To Allocate Costs?
  • Examples Of Cost Allocation & Calculations

What is Cost Allocation?

Cost allocation is the process of identifying a company’s costs and assigning those costs to cost objects. Cost objects are the products, services, and activities of different departments of a company. 

This process of allocating costs helps a business determine which parts of the company are responsible for what costs. 

Sometimes it is difficult to draw the connection between allocated costs and their cost objects. When this happens, companies can use spreading costs. 

Spreading costs occur when businesses spread the responsibility for production expenses across various areas. 

When businesses can accurately allocate their costs, they are able to easily assess what particular cost objects are creating profits and losses for the company. On the other hand, if businesses are unable to allocate their costs correctly, their profit and loss calculations will be off. 

Also, businesses must charge a price for their goods and services that covers their expenses and allows them to make a profit.  

Intuitively, one can recognize the importance of cost allocation for the optimal performance of a company. Incorrect cost allocation calculations are extremely detrimental to any business and disrupt the ability to operate properly.

Cost allocation is necessary for any business, but as companies get larger and more complex, it becomes even more important to allocate costs accurately. 

Key Takeaways

Cost allocation is fundamental and necessary for any business, big or small. 

It helps with assessing profits and losses and the management of staffing. 

Cost allocation allows companies to explain the pricing of their goods and services to customers. 

Allocating costs is necessary for companies to maintain efficiency and financial accountability. 

Types of Costs

Companies have various types of costs, and it is important to be able to distinguish between the different types when allocating them. 

We can break them down into a few different categories.

  • Direct costs:  direct costs are those that can be traced to a certain product or service offered by a company. Included in direct costs are materials and labor that go into the production of a good. 
  • Indirect costs :  these expenses are those that go into the production of a good but do not have a connection to a specific cost object. Examples of indirect costs include rent, utilities, and office supplies.
  • Fixed costs : these costs remain constant, regardless of a company’s production volume. (e.g., rent)
  • Variable costs : these costs increase or decrease as a company’s volume of production changes (e.g., supplies). 
  • A few examples of fixed overhead costs include rent, insurance, and workers’ salaries. Variable overhead costs include supplies and energy expenses, which both change as the  volume of production  increases or decreases. 

How to Allocate Costs

Now that we understand the different types of costs, we can better understand the processes involved in cost allocation. Regardless of what good or service a company produces, the process remains consistent across industries. 

  • Identify  Cost Objects : anything within a business that creates an expense is considered a cost object. The first step for allocating costs is to note all the cost objects of your company. 

Electricity usage

Water usage

Fuel consumption

  • Fixed cost allocation:  this method assigns particular direct costs with cost objects. Drawing direct connections between costs and cost objects makes this method one of the most simple.
  • Proportional allocation:  proportional allocation deals with the distribution of indirect costs across associated cost objects. Sometimes proportional allocation divides costs equally across cost objects, while other times, it considers other factors (i.e., size) and divides costs accordingly. 
  • Activity-based allocation:  this method is commonly considered the more accurate method of allocating costs. Activity-based allocation utilizes precise documentation to determine costs within departments and allocates the costs appropriately. 

Why Do We Need to Allocate Costs?

A company must allocate its costs in order to optimize its business activities.

Recognizing Profits And Losses

Understanding the distribution of expenses helps companies analyze which areas of their business may be profitable or which areas may be causing a loss. This allows companies to determine whether or not certain expenses can be justified or not. 

Companies do not know how much to charge the customer’s goods and services without cost allocation. Once non-profitable cost objects are identified, companies can cut expenses in those departments and focus their efforts on profitable cost objects. 

Management Decisions

Cost allocation is also important for a company to manage its staff. In areas where the company is not profitable, it can evaluate the staff performance of that department. Often, the losses incurred by part of a company are due to the underperformance of employees. 

Similarly, companies can analyze the allocation of their costs to determine where they are profitable and award the employees of that department. 

Using cost allocation to motivate employees offers the administration of a company an objective, quantitative justification for their management decisions. 

Transfer Pricing

Transfer pricing is the practice of charging for goods and services at an arm's length. The practice is used by departments the organization to charge for the goods and services exchanged within the same firm.

Cost allocation is vital for deriving transfer pricing, the exchange price of goods or services between two companies. 

Examples of Cost Allocation & Calculations

Now we understand cost allocation, the different types, and why we need it. Here are several examples of different ways a company might allocate its costs. 

Example 1: Square Footage

Christina’s business has an office and a manufacturing space. The square footage of the office is 1,000 square feet, and the manufacturing space is 1,500 square feet. The rent for the two spaces is $10,000 per month. The company will allocate the rent expense between the two spaces. 

$10,000 (rent) / 2,500 square feet = $4 per square foot

  • Calculate the rental cost for the office

$4 x 1,000 = $4,000

This means that Christina will allocate $4,000 of the rent to the office.

  • Calculate the rental cost for the manufacturing space

$4 x 1,500 = $6,000

This means that Christina will allocate $6,000 of the rent to the manufacturing space.

Example 2: Units Produced

Alex’s manufacturing company makes water bottles. In January, Alex produced 5,000 water bottles with direct material costs of $2.50 per water bottle and $3.00 in direct labor costs per water bottle. 

Alex also had $6,500 in overhead costs in January. Using the number of units produced as his allocation method, Alex can calculate his overhead costs using the overhead cost formula. 

  • Calculate the overhead costs: 

$6,500 / 5,000 = $1.30 per water bottle

  • Add the overhead costs to the direct costs to find the total costs:

$1.30 + $2.50 + $3.00 = $6.80 per backpack

So, Alex’s total costs in January were $6.80 per backpack. If Alex had not allocated the overhead costs, he would have most likely underpriced the backpacks, which would have resulted in a loss of income. 

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What Is Cost Allocation?

Cost Allocation Explained in Less Than 5 Minutes

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Definition and Examples of Cost Allocation

How cost allocation works, types of cost allocation.

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Cost allocation is a method used to assign costs to cost objects for a specific department, project, program, or other area.

The methods for cost allocation involve simple calculations, which can be beneficial to small business owners who need accurate financial information to help them price their products or services and make overall decisions. Learning about these methods can help you get a handle on your expenses and positively affect your bottom line.

Cost allocation is a method used to assess the costs associated with cost objects in specific categories within a business. Cost objects might include a product or service you sell, a particular department within your company, or the costs of dealing with a supplier.

Cost allocation is not just for large corporations looking to reduce expenses. Small business owners can greatly benefit from cost allocation; you get a more detailed look into the actual costs associated with your business, which allows you to assess prices better and increase your profitability.

For example, you might want to determine the costs of dealing with one of your suppliers, so you’d add up all of the associated costs. These costs can include everything from the phone calls you make to the time spent dealing with issues caused by them. Additionally, you could count how much you pay for the supplies you get from them.

Cost allocation essentially works by assigning costs to smaller areas within the overall business so that you can view profits or losses at a more granular level. When you use cost allocation, you might discover that your true production cost per unit is higher than expected.

It’s important to remember that cost objects will vary depending on your business and industry.

That means you might consider increasing prices to maintain a specific profit margin . On the opposite end of the spectrum, you may decide to scrap a product that turned out to be a money pit.

To accurately calculate cost allocation, you must first identify the cost object, then begin to assess the actual cost.

Determining Costs

Spreading costs is not an exact science when it comes to cost objects. Some ways to allocate costs are based on units manufactured, square footage, number of hours, headcount, or usage.

Let’s say you have a building with a photography studio on the first floor and a salon on the second floor; you’ll use square footage as your cost object. The salon is 2,000 square feet, and the studio is 1,000 square feet. The total rent for the building is $6,000 per month. To allocate rent between the two spaces, you would first divide the total rent by the total square footage of the building:

$6,000 (overall rent) ÷ 3,000 sq. ft. (total space) = $2 per sq. ft.

Second, you’ll want to calculate the rent for the photography studio:

$2 (price per sq. ft.) x 1,000 (studio sq. ft.) = $2,000

Third, you can calculate the rent for the salon:

$2 (price per sq. ft.) x 2,000 (salon sq. ft.) = $4,000

Your rent per space should be $2,000 for the overhead expense of the studio and $4,000 for the overhead expense of the salon.

Other scenarios might include payroll cost allocation based on employee cost centers, or payment processing cost allocation based on transactions per location or franchise.

Cost objects can be just about anything you assign a cost to. Some examples of cost objects are jobs, payroll, departments, projects, financial systems, IT, and programs.

Cost allocation is based on different types of costs that fall into one of three categories, generally speaking.

Direct Costs

Direct costs are the easiest to assign to an identified cost object, because they are directly related. For example, a direct cost could be the labor required to produce a product or the materials used.

Indirect Costs

When you have an indirect cost, it is not attached to a specific cost object but still is necessary for the business to function. For example, common indirect costs could be security costs or administrative costs not related to a specific department.

Overhead Costs

Overhead costs—also called operating costs—are those costs associated with the day-to-day operations of your business. These accrue regardless of actual production, but still support productivity. Operating costs might include insurance, rent, and legal fees.

Costs can be fixed or variable depending on the type. A fixed cost is constant, while a variable cost can fluctuate depending on other factors.

The cost type factors into how you allocate the cost later. For example, if you were cost allocating rent, it would be allocated to overhead expenses. You would likely use the square-footage method to allocate the cost.

When allocating costs directly related to a product, you might use the units-produced allocation method to factor in overhead costs with the direct costs to create the product. This will allow you to determine better the price you should be asking.

Key Takeaways

  • Cost allocation helps business owners identify areas of opportunity with their products or services.
  • Cost objects can include anything you want to measure and assign a cost to, such as products, programs, projects, or even a customer.
  • Ways to allocate costs include square footage, units produced, usage, and headcount.

Warren Averett. " Types of Cost Allocation Methods for Government Contractors ."

Municipal Research and Services Center of Washington. " Cost Allocation ."

6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method

Both roommates make valid points about allocating limited resources. Ultimately, each must decide which method to use to allocate time, and they can make that decision based on their own analyses. Similarly, businesses and other organizations must create an allocation system for assigning limited resources, such as overhead. Whereas Kamil and Barry are discussing the allocation of hours, the issue of allocating costs raises similar questions. For example, for a manufacturer allocating maintenance costs, which are an overhead cost, is it better to allocate to each production department equally by the number of machines that need to be maintained or by the square footage of space that needs to be maintained?

In the past, overhead costs were typically allocated based on factors such as total direct labor hours, total direct labor costs, or total machine hours. This allocation process, often called the traditional allocation method, works most effectively when direct labor is a dominant component in production. However, many industries have evolved, primarily due to changes in technology, and their production processes have become more complicated, with more steps or components. Many of these industries have significantly reduced their use of direct labor and replaced it with technology, such as robotics or other machinery. For example, a mobile phone production facility in China replaced 90 percent of its workforce with robots. 1

In these situations, a direct cost (labor) has been replaced by an overhead cost (e.g., depreciation on equipment). Because of this decrease in reliance on labor and/or changes in the types of production complexity and methods, the traditional method of overhead allocation becomes less effective in certain production environments. To account for these changes in technology and production, many organizations today have adopted an overhead allocation method known as activity-based costing (ABC). This chapter will explain the transition to ABC and provide a foundation in its mechanics.

Activity-based costing is an accounting method that recognizes the relationship between product costs and a production activity, such as the number of hours of engineering or design activity, the costs of the set up or preparation for the production of different products, or the costs of packaging different products after the production process is completed. Overhead costs are then allocated to production according to the use of that activity, such as the number of machine setups needed. In contrast, the traditional allocation method commonly uses cost drivers, such as direct labor or machine hours, as the single activity.

Because of the use of multiple activities as cost drivers, ABC costing has advantages over the traditional allocation method, which assigns overhead using a single predetermined overhead rate. Those advantages come at a cost, both in resources and time, since additional information needs to be collected and analyzed. Chrysler , for instance, shifted its overhead allocation to ABC in 1991 and estimates that the benefits of cost savings, product improvement, and elimination of inefficiencies have been ten to twenty times greater than the investment in the program at some sites. It believes other sites experienced savings of fifty to one hundred times the cost to implement the system. 2

As you’ve learned, understanding the cost needed to manufacture a product is critical to making many management decisions ( Figure 6.2 ). Knowing the total and component costs of the product is necessary for price setting and for measuring the efficiency and effectiveness of the organization. Remember that product costs consist of direct materials, direct labor, and manufacturing overhead. It is relatively simple to understand each product’s direct material and direct labor cost, but it is more complicated to determine the overhead component of each product’s costs because there are a number of indirect and other costs to consider. A company’s manufacturing overhead costs are all costs other than direct material, direct labor, or selling and administrative costs. Once a company has determined the overhead, it must establish how to allocate the cost. This allocation can come in the form of the traditional overhead allocation method or activity-based costing..

Component Categories under Traditional Allocation

Traditional allocation involves the allocation of factory overhead to products based on the volume of production resources consumed, such as the amount of direct labor hours consumed, direct labor cost, or machine hours used. In order to perform the traditional method, it is also important to understand each of the involved cost components: direct materials, direct labor, and manufacturing overhead. Direct materials and direct labor are cost categories that are relatively easy to trace to a product. Direct material comprises the supplies used in manufacturing that can be traced directly to the product. Direct labor is the work used in manufacturing that can be directly traced to the product. Although the processes for tracing the costs differ, both job order costing and process costing trace the material and labor through materials requisition requests and time cards or electronic mechanisms for measuring labor input. Job order costing traces the costs directly to the product, and process costing traces the costs to the manufacturing department.

Ethical Considerations

Ethical cost modeling.

The proper use of management accounting skills to model financial and non-financial data optimizes the organization’s evaluation and use of resources and assists in the proper evaluation of costs and revenues in an organization. The IFAC provides guidance on the use of cost models and how to ethically design proper cost models: “Cost models should be designed and maintained to reflect the cause-and-effect interrelationships and the behavioral dynamics of the way the organization functions. The information needs of decision makers at all levels of an organization should be taken into account, by incorporating an organization’s business and operational models, strategy, structure, and competitive environment.” 3

Estimated Total Manufacturing Overhead Costs

The more challenging product component to track is manufacturing overhead. Overhead consists of indirect materials, indirect labor, and other costs closely associated with the manufacturing process but not tied to a specific product. Examples of other overhead costs include such items as depreciation on the factory machinery and insurance on the factory building. Indirect material comprises the supplies used in production that cannot be traced to an individual product, and indirect labor is the work done by employees not directly involved in the manufacturing process, such as the supervisors’ salaries or the maintenance staff’s wages. Because these costs cannot be traced directly to the product like direct costs are, they have to be allocated among all of the products produced and added, or applied, to the production and product cost.

For example, the recipe for shea butter has easily identifiable quantities of shea nuts and other ingredients. Based on the manufacturing process, it is also easy to determine the direct labor cost. But determining the exact overhead costs is not easy, as the cost of electricity needed to dry, crush, and roast the nuts changes depending on the moisture content of the nuts upon arrival.

Until now, you have learned to apply overhead to production based on a predetermined overhead rate typically using an activity base. An activity base is considered to be a primary driver of overhead costs, and traditionally, direct labor hours or machine hours were used for it. For example, a production facility that is fairly labor intensive would likely determine that the more labor hours worked, the higher the overhead will be. As a result, management would likely view labor hours as the activity base when applying overhead costs.

A predetermined overhead rate is calculated at the start of the accounting period by dividing the estimated manufacturing overhead by the estimated activity base. The predetermined overhead rate is then applied to production to facilitate determining a standard cost for a product. This estimated overhead rate will allow a company to determine a cost for the product without having to wait, possibly several months, until all of the actual overhead costs are determined, and to help with issues such as seasonal production or variable overhead costs, such as utilities.

Calculation of Predetermined Overhead and Total Cost under Traditional Allocation

The predetermined overhead rate is set at the beginning of the year and is calculated as the estimated (budgeted) overhead costs for the year divided by the estimated (budgeted) level of activity for the year. This activity base is often direct labor hours, direct labor costs, or machine hours. Once a company determines the overhead rate, it determines the overhead rate per unit and adds the overhead per unit cost to the direct material and direct labor costs for the product to find the total cost.

To put this method into context, consider this example. Musicality Manufacturing developed a recording device similar to a microphone that allows musicians and music aficionados to record their playing or singing along with any song publicly available. There are three products that vary in features and ability: Solo, Band, and Orchestra. Musicality was started by musicians who majored in math and software engineering while in college. Their main concern was building a quality manufacturing plant, so they used the simpler traditional allocation method. They started by determining their direct costs, which are shown in Figure 6.3 .

Musicality determines the overhead rate based on direct labor hours. At the beginning of the year, the company estimates total overhead costs to be $2,500,000 and total direct labor hours to be 1,250,000. The predetermined overhead rate is

Musicality uses this information to determine the cost of each product. For example, the total direct labor hours estimated for the solo product is 350,000 direct labor hours. With $2.00 of overhead per direct hour, the Solo product is estimated to have $700,000 of overhead applied. When the $700,000 of overhead applied is divided by the estimated production of 140,000 units of the Solo product, the estimated overhead per product for the Solo product is $5.00 per unit. The computation of the overhead cost per unit for all of the products is shown in Figure 6.4 .

The overhead cost per unit from Figure 6.4 is combined with the direct material and direct labor costs as shown in Figure 6.3 to compute the total cost per unit as shown in Figure 6.5 .

After reviewing the product cost and consulting with the marketing department, the sales prices were set. The sales price, cost of each product, and resulting gross profit are shown in Figure 6.6 .

Sales of each product have been strong, and the total gross profit for each product is shown in Figure 6.7 . Using the Solo product as an example, 150,000 units are sold at a price of $20 per unit resulting in sales of $3,000,000. The cost of goods sold consists of direct materials of $3.50 per unit, direct labor of $10 per unit, and manufacturing overhead of $5.00 per unit. With 150,000 units, the direct material cost is $525,000; the direct labor cost is $1,500,000; and the manufacturing overhead applied is $750,000 for a total Cost of Goods Sold of $2,775,000. The resulting Gross Profit is $225,000 or $1.50 per unit.

Think It Through

Computing actual overhead costs.

As manufacturing technology becomes less expensive and more efficient, the mix between overhead and labor changes so that tasks are more computerized tasks and involve less direct labor; the traditional use of direct labor hours or direct labor dollars changes accordingly. If the predetermined overhead rate is based on direct labor hours and set at the beginning of the year but manufacturing technology leads to a reduction in direct labor during the year, the number of direct labor hours may be less than estimated. This reduces the amount of overhead applied so that the overhead is more likely to be underapplied at the end of the year. Why do companies not wait until the end of the period and compute an actual overhead rate based on actual manufacturing costs and actual units?

  • 1 June Javelosa and Kristin Houser. “This Company Replaced 90% of Its Workforce with Machines. Here’s What Happened.” Futurism / World Economic Forum . https://www.weforum.org/agenda/2017/02/after-replacing-90-of-employees-with-robots-this-companys-productivity-soared
  • 2 Joseph H. Ness and Thomas G. Cucuzza. “Tapping the Full Potential of ABC.” Harvard Business Review . July-Aug. 1995. https://hbr.org/1995/07/tapping-the-full-potential-of-abc
  • 3 International Federation of Accountings (IFAC) PAIB Committee. “Evaluating and Improving Costing in Organizations.” International Good Practice Guidance . June 30, 2009. https://www.ifac.org/system/files/publications/files/IGPG-Evaluating-and-Improving-Costing-July-2009.pdf

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How to Calculate Predetermined Overhead Rate (With Examples)

Last Updated: December 17, 2023 Fact Checked

What is a predetermined overhead rate (POR)?

Predetermined overhead rate (por) formula, examples of predetermined overhead rate, uses of predetermined overhead rate (por), expert interview, expert q&a.

This article was co-authored by Madison Boehm and by wikiHow staff writer, Amber Crain . Madison Boehm is a Business Advisor and the Co-Founder of Jaxson Maximus, a men’s salon and custom clothiers based in southern Florida. She specializes in business development, operations, and finance. Additionally, she has experience in the salon, clothing, and retail sectors. Madison holds a BBA in Entrepreneurship and Marketing from The University of Houston. This article has been fact-checked, ensuring the accuracy of any cited facts and confirming the authority of its sources. This article has been viewed 17,114 times.

Calculating a predetermined overhead rate (POR) is a great way for businesses to balance expenses with production costs and sales. If you want to learn how to use this tool for yourself, you’ve come to the right place! In this article, we’ll explain what a predetermined overhead rate is, what factors are used to determine it, and how to apply the formula. We’ll also provide several examples so you can see different ways POR can influence accounting and budgeting. If you’re ready to protect your profits and get a handle on business expenses, read on!

Things You Should Know

  • A predetermined overhead rate is an estimated ratio of overhead costs calculated before a project or job begins.
  • To calculate predetermined overhead rate, use this formula: Estimated manufacturing cost / Estimated total units in allocation base.
  • An allocation base is a cost accounting descriptor based on a common activity that affects overhead costs, like labor hours, machine hours, and cost of materials.
  • Predetermined overhead rate is used to estimate future manufacturing costs so companies can plan, budget, and monitor costs.

A predetermined overhead rate is an estimated ratio of overhead costs.

  • A predetermined overhead rate is based on estimates and is used for planning purposes only. It doesn’t reflect the actual overhead cost after the project or job is completed.

Step 1 Predetermined overhead rate = Estimated manufacturing cost / Estimated total units in allocation base

  • Machine hours
  • Hours worked (direct labor hours)
  • Number of employees (direct labor costs)
  • Cost of materials (direct materials) [2] X Research source

Step 2 To estimate manufacturing cost, total up manufacturing expenses.

  • For example, to calculate POR for next year, you need to estimate next year's manufacturing cost so you can plug it into the POR formula. To estimate manufacturing costs, look at the last year's. The cost of rent and utilities is fairly static from year to year. Then, pull salary info for your current employees, machine maintenance costs from last year, and so on, to create your estimate.

Step 1 Example #1: POR based on direct labor hours

  • $20,000 (manufacturing cost) / 4,000 (direct labor hours) = 5
  • The POR is $5.00 per direct labor hour. This means that for every job order, the company can expect to incur $5 in overhead costs.

Step 2 Example #2: POR based on annual machine hours

  • $420,000 (manufacturing cost) / 75,000 (machine hours) = 5.6
  • The POR is $5.60 per machine hour. This means that for every hour of machine work, the company can expect to incur $5.60 in overhead costs.

Step 3 Example #3: POR based on direct materials cost

  • $860,000 / $600,000 = 1.43
  • The POR for the upcoming year is $1.43. This means that for every manufactured unit, the company can expect to incur $1.43 in overhead costs.

Step 4 Example #4: POR based on direct labor costs

  • 500,000 (manufacturing cost) / 200,000 = 2.5
  • The POR is $2.50. This means that for every product unit the company produces, they can expect to incur $2.50 in overhead costs.

Step 1 Setting pricing

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Thanks for reading our article! If you'd like to learn more about calculating rates, check out our in-depth interview with Madison Boehm .

  • ↑ https://learn.financestrategists.com/explanation/cost-accounting/overhead-costing/predetermined-overhead-rate/
  • ↑ https://thebusinessprofessor.com/en_US/accounting-taxation-and-reporting-managerial-amp-financial-accounting-amp-reporting/job-costing-assign-overhead-costs-explained
  • ↑ https://manufacturing-software-blog.mrpeasy.com/manufacturing-overhead/
  • ↑ https://fundsnetservices.com/predetermined-overhead-rate-formula

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BlackLine Blog

June 13, 2018

What is Cost Allocation? An Introduction to Cost Allocations

Michael shultz.

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  • Cost Allocation Example & Definition

Cost allocation is the distribution of one cost across multiple entities, business units, or cost centers. An example is when health insurance premiums are paid by the main corporate office but allocated to different branches or departments.

When cost allocations are carried out, a basis for the allocation must be established, such as the headcount in each branch or department.

  • Cost Allocation Methodology

A cost allocation methodology identifies what services are being provided and what these services cost. It also establishes a basis for allocating these costs to business units or cost centers based on their appropriate share of such cost.

The basis for allocating costs may include headcount, revenue, units produced, direct labor hours or dollars, machine hours, activity hours, and square footage.

Companies will often implement a cost allocation methodology as a means to control costs. Under an effective cost allocation methodology, business units become directly accountable for the services they consume. As a result, both the service provider and the respective consumers of that service become aware of service requirements and usage, and how such usage influences the costs incurred.

As business units begin seeing the cost of the services they consume, they can make more informed choices—such as trade-off decisions between service levels and costs, and benchmarking internal costs against outsourced providers.

  • Process for Performing Cost Allocations

Using a basis for allocation, costs are spread to each business unit or cost center that incurred the cost based on their proportional share of the cost. For example, if headcount forms the basis of allocation for insurance costs, and there are 1000 total employees, then a department with 100 employees would be allocated 10% of the insurance costs.

While there are numerous ways cost allocations can be calculated, it is important to ensure the reasoning behind them is documented. This is often done by establishing allocation formulas or tables.

Once the calculation is established and cost distributions are calculated, journal entries are created to transfer costs from the providing or paying entity to the appropriate consuming entities. During each financial period, as periodic expenses are incurred, this calculation is repeated and allocating entries are made.

  • What Does a Cost Allocation System Do?

A cost allocation system consists of a way to track which entity within an organization provides a product and/or service, the entity that consumes the products and/or services, and a means of distributing this cost from the provider to the consumer or consumers. Depending on the operating structure of the company, the cost allocation may be performed by internal invoice, through a chargeback module in the ERP system, or more commonly, through journal entries performed by accounting staff each financial period.

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  • Allocation Base

Dive into the intricacies of Business Studies with a comprehensive exploration of the Allocation Base, a fundamental concept in cost accounting. This article will help you decode its meaning, understand its application, and unravel its importance in strategic decision-making. With insights into the formula, influences on its selection, and implications of various bases, this guide provides all the knowledge required to master this critical business tool. Discover how the business environment and corporate strategy could affect the choice of an Allocation Base, shaping the future of your enterprise.

Allocation Base

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What potential implications can the choice of allocation base have in business accounting and operations?

What are some potential pitfalls of the allocation base?

What can affect the overhead allocation rate in the allocation base formula?

What kind of cost allocation bases are commonly used in accounting?

What is the allocation base formula in cost accounting?

How does the allocation base differ from direct costs in cost accounting?

What is the allocation base in business studies?

Give examples of common allocation bases used in the allocation base formula.

What is cost allocation base in intermediate accounting?

How is the allocation base used in a practical scenario?

What are the roles of the cost allocation base in businesses?

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Understanding the Allocation Base in Intermediate Accounting

In the realm of accounting and business studies, the term 'allocation base' holds a pivotal role. It essentially serves as the yardstick to systematically spread costs across various departments, products, or services within a company, enabling accurate financial forecasting and performance measurement.

The allocation base, also known as the cost driver, is an accounting measure used to allocate indirect costs to the cost objects. The allocation base can be either financial or non-financial metrics, depending on the nature of the underlying costs.

Defining the Allocation Base: What it Means in Business Studies

An allocation base allows businesses to distribute costs in a fair and logical manner. Often, it's not feasible to directly link costs to products or services, and that's where the allocation base proves its value. It helps in capturing the consumption of resources used by the various cost objects in an organization.

Let's illustrate this concept through an example:

Consider a manufacturing company that produces different types of widgets. The factory overhead, including utilities and maintenance, cannot be directly tracked to individual widget types. To assign the overhead costs fairly among the widgets, an allocation base such as machine hours might be used. If Widget A required 500 machine hours and Widget B required 1500 machine hours, and the total overhead was £2000, the allocated overhead would be £500 for Widget A, and £1500 for Widget B.

Walking Through the Allocation Base Formula: A Simple and Essential Guide

The allocation base is the foundation of indirect cost allocation . But how do you calculate it? It's a straightforward process, represented by the following formula:

This formula results in an allocation rate, which provides a standard to prorate indirect costs across cost objects based on their consumption of the associated cost driver.

In our widget company example:

If a business had indirect costs of £2000 and the total machine hours were 2000 (500 for Widget A and 1500 for Widget B), we would calculate the allocation base as follows:

So, for every hour a machine is used, £1 of overhead costs are assigned.

It's worth noting that the choice of allocation base is critical and should reflect the actual consumption of overhead costs. If machine hours do not significantly affect the overall overhead, it would not be an appropriate allocation base. In such cases, alternatives such as direct labour hours or direct material costs may be more suitable.

Applying the Allocation Base in Cost Accounting

Mastering the utilization of the allocation base is crucial in the field of cost accounting. By accurately splitting indirect expenses across cost objects, companies can achieve more realistic product costing, precise profitability analysis , and informed decision-making.

Importance of the Cost Allocation Base: How it Drives Business Decisions

The impact of the cost allocation base is evident in various areas, ranging from pricing strategies to budget planning, and even in assessing departmental efficiency. In essence, an appropriately selected allocation base presents a true and fair view of costs, steering businesses in their strategic and operational decisions.

First, product pricing heavily relies on accurate cost calculations. By distributing indirect costs accurately across products, businesses can determine their true cost of production. This information is essential for pricing decisions, allowing companies to maintain a profitable margin while staying competitive in the market. In the absence of an appropriate allocation base, a company could underprice or overprice its products, leading to potential losses or missed opportunities.

Second, an allocation base guides managers in budget planning. With an accurate understanding of how resources are used, managers can project future costs and make appropriate budget allocations. This not only leads to controlled spending but also optimizes resource utilization. As part of internal financial management, understanding the allocation base can also aid in identifying inefficiencies and improving operations.

Third, cost allocation affects performance evaluation. When costs are allocated fairly across departments, the resulting performance measures can reveal departmental efficiency and effectiveness. Managers can then use this information to benchmark and motivate improvement.

Product PricingDetermines the true cost of production essential for profitable pricing.
Budget PlanningSupports accurate future cost projection and budget allocation.
Performance MeasurementPromotes fair evaluation of departmental efficiency and effectiveness.

The Implications of Using Different Allocation Bases

Choosing an allocation base is not a one-size-fits-all approach. Different bases will yield different results, and the implications can significantly impact the financial performance and decisions of a business.

  • Direct Labour Hours: This is a common base, especially in labour-intensive industries. If the majority of overhead costs are driven by labour activity, this base can accurately allocate overheads across cost objects. However, if a company moves towards automation, this base can lead to a skewed allocation.
  • Machine Hours: For capital-intensive industries, machine hours can be an effective allocation base. But again, if machines are not the primary cost driver, using this base may distribute costs disproportionately, giving a distorted view of profitability.
  • Direct Material Costs: In industries where materials form a significant part of the costs, direct material costs can be used as an allocation base. This is suitable if changes in material consumption correspond to changes in indirect costs. If this relationship does not hold, another base will be more appropriate.

Remember, the ultimate aim is to choose an allocation base that best reflects the consumption of overheads. Proper analysis and judgment are required to ensure that the chosen base represents the cause-and-effect relationship of overhead costs. A wrongly selected base can lead to distorted product costs, erroneous pricing, and inaccurate performance measures. Therefore, regular evaluation and adjustments are key to maintaining an appropriate allocation base .

Factors Influencing the Selection of an Allocation Base

Selecting the right allocation base is paramount in cost allocation. The right base can reflect the true cost consumption and render fairness in overhead allocation . Several factors, therefore, need consideration during the selection process, including the nature of the industry, type of production, technology used, and corporate strategy. Let's delve deeper into these factors and their implications.

Deciding on the Right Allocation Base: Factors That Matter

Whether you're deciding between direct labour hours, machine hours, or direct material costs, picking the most suitable allocation base can seem like a complex task. To break it down, you should focus on four key factors: industry type , production type , technology level , and the cause-and-effect relationship between indirect costs and potential allocation bases.

1. Industry Type: Different industries can have different cost structures. In labour-intensive industries, direct labour hours might be an appropriate allocation base as labour generally drives the overhead costs. Conversely, in capital-intensive industries like manufacturing, machine hours or machine-related metrics could provide a more accurate reflection of the overhead consumption.

2. Production Type: The type of products made or services offered also influence the selection. For instance, in batch production, production runs or batch hours can accurately capture the overhead costs associated with each batch. In contract-driven businesses like construction, contract value might be a better base.

3. Technology Level: The allocation base should align with the level of technology used in the business. In a highly mechanised environment, machine-focused bases can be more appropriate. But, if a company is significantly automating its operations, factors other than conventional machine hours, like electricity consumption, could become a more suitable base.

4. Cause-and-Effect Relationship: Fundamentally, the allocation base should reflect the cause-and-effect relationship with the overhead costs. That is, changes in the allocation base should correspond with changes in the overhead costs it’s meant to distribute. If such a relationship doesn't exist, the chosen base will not provide a fair allocation.

How Do Business Environment and Corporate Strategy Influence Allocation Base Choice?

The business environment and corporate strategy not only shape a company's operations but can also guide the cost allocation process and influence the choice of an allocation base. Let's explore this in detail:

Business Environment: External factors such as market conditions, customer demands, and regulatory requirements can intervene with the selection of an allocation base. For instance, if customers demand transparency in pricing, companies might use more direct bases rather than complex allocation methods to determine product costs. Changes in the regulatory landscape can also necessitate adjustments in the allocation process to meet compliance requirements.

Corporate Strategy: The strategic direction of the business can have substantial implications on the choice of an allocation base. A company adopting a cost-leadership strategy would focus on stringent cost control and might choose bases that provide detailed insights into cost drivers and allow for accurate overhead tracing. Conversely, a firm following a differentiation strategy might lean towards more aggregated allocation bases as their focus would be more on product uniqueness than individual cost components.

In conclusion, the choice of an allocation base is not static but is subject to changes in the company's internal and external environment. By continually monitoring and adjusting to these changes, a company can ensure that the allocation base remains appropriate and serves its cost accounting needs.

Bear in mind, however, accuracy and relevance should be balanced with simplicity and ease of understanding. Overly complex allocation methods can overwhelm users, straining their comprehension and diminishing the value of information derived from cost allocation.

Allocation Base - Key takeaways

  • Allocation Base: Also known as the cost driver, it is an accounting measure used to spread out indirect costs to cost objects. It helps in capturing the consumption of resources used by various cost objects in an organization. The allocation base can be either financial or non-financial metrics, depending on the nature of the underlying costs.
  • Allocation Base Formula: Total indirect costs divided by total cost driver values. This formula yields an allocation rate, which is used to distribute indirect costs across cost objects based on their consumption of the associated cost driver.
  • Importance of the Cost Allocation Base: Careful selection and utilization of the allocation base are essential to accurate financial forecasting and performance measurement. An appropriate allocation base can influence decisions in areas such as product pricing, budget planning, and assessing departmental efficiency.
  • Implications of Different Allocation Bases: The choice of allocation base can significantly influence the financial performance of a business. For instance, using direct labor hours, machine hours, or direct material costs can highlight different aspects of cost structures. The goal is to choose a base that accurately reflects the consumption of overheads within the business.
  • Factors Influencing the Selection of an Allocation Base: Several factors, including industry type, production type, level of technology, and the cause-and-effect relationship of the costs and the allocation base, should be considered in choosing the allocation base. The business environment and corporate strategic direction could also influence the selection of an allocation base.

Flashcards in Allocation Base 27

Allocation base influences accuracy in cost data, product pricing strategies, budgeting and cost control, and external financial reporting. The chosen allocation base should accurately reflect overhead cost behaviour for successful decision-making.

Potential pitfalls include overhead allocation based on volume, use of a single cost driver oversimplifying overhead behaviour, and arbitrary allocation that might not accurately reflect costs.

If the allocation base is significantly small, or if 'Total Overhead Costs' fluctuate substantially while the 'Total Allocation Base' remains constant, the overhead allocation rate can be affected and become inconsistent or disproportionately high.

Common cost allocation bases include direct labour hours, direct labour cost, machine hours, square footage, and units produced. These are chosen based on the nature of the business operations and the overhead costs.

The allocation base formula aids in the distribution of indirect costs. It incorporates a cost pool, which contains the indirect costs to be distributed, and an allocation base, representing the units over which costs will be spread.

While direct costs can be easily traced to a cost object and typically vary directly with output, the allocation base is used to distribute indirect costs that cannot be directly traced and may or may not vary with output.

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What Is Activity-Based Costing (ABC)?

How activity-based costing (abc) works, requirements for activity-based costing (abc), benefits of activity-based costing (abc).

  • Corporate Finance

Activity-Based Costing (ABC): Method and Advantages Defined with Example

cost allocation base formula

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

Key Takeaways

  • Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services. 
  • The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task with a specific goal.
  • An activity is a cost driver , such as purchase orders or machine setups. 
  • The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate the amount of overhead and indirect costs related to a particular activity. 

ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. 

Investopedia / Theresa Chiechi

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.

This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. 

The formula for activity-based costing is the cost pool total divided by cost driver, which yields the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity. 

The ABC calculation is as follows:  

  • Identify all the activities required to create the product. 
  • Divide the activities into cost pools, which includes all the individual costs related to an activity—such as manufacturing. Calculate the total overhead of each cost pool.
  • Assign each cost pool activity cost drivers, such as hours or units. 
  • Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers. 
  • Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate. 
  • Multiply the cost driver rate by the number of cost drivers. 

As an activity-based costing example, consider Company ABC that has a $50,000 per year electricity bill. The number of labor hours has a direct impact on the electric bill. For the year, there were 2,500 labor hours worked, which in this example is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. For Product XYZ, the company uses electricity for 10 hours. The overhead costs for the product are $200, or $20 times 10.

Activity-based costing benefits the costing process by expanding the number of cost pools that can be used to analyze overhead costs and by making indirect costs traceable to certain activities. 

The ABC system of cost accounting is based on activities, which are any events, units of work, or tasks with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. Activities consume overhead resources and are considered cost objects.

Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders.

There are two categories of activity measures: transaction drivers, which involve counting how many times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

Unlike traditional cost measurement systems that depend on volume count, such as machine hours and/or direct labor hours, to allocate indirect or overhead costs to products, the ABC system classifies five broad levels of activity that are, to a certain extent, unrelated to how many units are produced. These levels include batch-level activity , unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.

Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity. 

Second, it creates new bases for assigning overhead costs to items such that costs are allocated based on the activities that generate costs instead of on volume measures, such as machine hours or direct labor costs. 

Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation , utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.

Chartered Global Management Accountant. " Activity-Based Costing (ABC) ."

cost allocation base formula

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  • Using General Ledger

Create an Allocation Rule with a Formula Component

This example demonstrates how to create an allocation rule with a formula component.

You are the General Accountant for InFusion America Inc. You are tasked with creating an allocation rule with a formula component.

Rules are based on formulas. The formulas use multiple criteria. For example, you can use account balances or statistical amounts to allocate shared revenue or costs across multiple organizational units. You can define complex computations based on variables from various charts of accounts. You can group journal formulas together and run them sequentially to update account balances in a step-by-step process.

Creating an Allocation Rule with a Formula Component

Click the Navigator .

Click the Journals link from the General Accounting work area to access the Journals work area.

Click the Create Allocation Rules link.

In the Enterprise Performance Management System Workspace, click the Navigate menu.

Select Administer and then Calculation Manager .

On the System View tab of Calculation Manager, expand the Essbase tree.

Expand the VF_USA_Accounting_Flexfield tree item.

Expand the db tree node.

Right-click the Rules tree item and select New .

In the New Rule dialog box, enter EMEA Overhead Distribution in the Name field and click OK .

You design a rule by dragging components from the Rule Palette to the Rule Designer flow chart. Each component performs a separate task. You can add Point of View, Allocation, or Formula components to your rule.

You enter additional rule details on the Properties tab.

On the Properties tab, complete the fields, as shown in this table.

Name

Reserve for bad debts.

Description

This formula rule calculates the reserve needed for bad debts.

In the Rule Palette area, drag the Point of View object to the Rule Designer area.

In the Point of View area, enter POV in the Caption field.

Click in the Ledger field.

Click the Actions button for the Ledger field.

Select Member.

In the Member Selector dialog box, expand the Ledger tree.

Expand the All Ledgers tree item.

Click the EMEA_PC_PL tree item.

Click the Select button to move the ledger to the selected panel.

Repeat the preceding steps to complete the fields, as shown in this table.

Company

"[All Company Values].[3888]"

Cost_Center

"000"

Program

"[All Program Values].[0000]"

Location

"[Location]@[0000]"

Division

"[All Division Values].[0000]"

Product

"[All Product Values].[0000]"

Intercompany

"[All Intercompany Values].[0000]"

Currency

"USD"

Currency Type

"Total"

Click the Actions button for the AccountingPeriod field.

Select Variable.

In the Select Variable dialog box, select Database in the Category field.

Select the Accounting_Period variable and click OK .

To define the formula, drag the Formula object from the Rule Palette to the POV loop in the Rule Designer.

On the Formula tab, enter Bad Debts Calculation in the Caption field.

Click in the Enter formula field.

Click the Actions button for the Enter formula field.

In the Member Selector dialog box, select Scenario in the Dimensions field.

Expand the Scenario tree and click the Actual tree node.

Click the Select button to move Actual to the Selections panel.

Repeat the preceding steps to select the remaining dimensions and members for the formula and complete the fields, as shown in this table.

Balance Amount

Ending Balance

Amount Type

YTD

Account

1399

To enter a formula to create 5 percent of total accounts receivable as reserve for bad debts, in the Enter formula field, at the end of the formula you just created, enter *.05*-1.

To specify the target members, click in the Enter member name field.

Click the Actions button.

In the Member Selector dialog box, expand the Account tree until the account 75555 appears.

Click account 75555.

Click the Select button to move the account to the Selections panel.

To specify offset members, on the Formula tab, enter "13005" in the Offset Member field.

Click Save .

Click the Validate button and then the OK button to acknowledge validation of the rule.

To deploy the rule, click the Quick Deploy button in the toolbar.

On the Deployment Status dialog box, click OK to acknowledge successful deployment.

IMAGES

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COMMENTS

  1. Cost Allocation Base

    Table of Contents. Cost allocation base can be defined as a factor that is the common denominator for systematically linking a cost or group of costs to a cost object such as a department or an activity. Where cost object is a product, the narrower term cost application base is often used.

  2. Allocation Base

    Now the allocation base of the warehouse is $10,000. If 100 cars are produced in a month, each car will share an overhead rent cost of = Number of Cars / Monthly Rent. Car will Share an Overhead Rent Cost = 10,000 / 100 = $100. So $100 is the Allocation rate. Each car uses $100 of warehouse rent to finish itself.

  3. Cost Allocation

    The company should also determine the cost allocation base, which is the basis that it uses to allocate the costs to cost objects. 2. Accumulate costs into a cost pool. After identifying the cost objects, the next step is to accumulate the costs into a cost pool, pending allocation to the cost objects. When accumulating costs, you can create ...

  4. Allocation Base in Cost Accounting: A Beginner's Guide

    Allocation Bases within Job-Order Costing and Process Costing. In job-order and process costing systems, allocation bases could include labor hours, machine hours, units produced, direct material and labor costs. These allocation bases provide the foundations for cost assignment to specific units, products, or projects.

  5. Cost Allocation: Methods & Calculations for Improved Profitability

    Use the cost allocation formula and cost allocation method to assign expenditures to departments and projects with accuracy. Cost Allocation Definition. ... Determine the Base for Sharing the Costs. Depending on the type of business, you can divide the costs based on different factors. The most popular ones include:

  6. Allocation bases

    An allocation base is the basis on which Cost accounting allocates overhead costs. An allocation base can be a quantity, such as machine hours that are used, kilowatt hours (kWh) that are consumed, or square footage that is occupied. Allocation bases are mostly used to assign overhead costs to inventory that is produced. ... Create a formula ...

  7. Allocation Base: Formula, Cost, Implications & Factors

    The allocation base can be either financial or non-financial metrics, depending on the nature of the underlying costs. Allocation Base Formula: Total indirect costs divided by total cost driver values. This formula yields an allocation rate, which is used to distribute indirect costs across cost objects based on their consumption of the ...

  8. How to Calculate Cost Allocation

    Multiply the total cost by the allocation base. In our example, for Product A, $50,000 times 46 percent equals $23,000. For Product B, $50,000 times 54 percent equals $27,000. Cost allocation assigns a specific cost to a project. An example of a cost that needs allocation would be an electric bill for several different projects.

  9. Calculating Costs

    Let's assume we calculated our estimated total manufacturing overhead cost at $50,000 for the coming period and our estimated total amount of the allocation base in direct labor hours at 10,000 hours. $50,000/ 10,000= $5 per hour. Our predetermined overhead rate would be $5 per direct labor hour. If a widget takes 2 hours to make, we would ...

  10. Cost Allocation

    Total number of customers who ordered either product are 18,000. This gives us a cost allocation base of $1.1 per customer ($19,700/18,000). A detailed cost assignment is as follows: Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000. Manufacturing overheads allocated to Shakes = $1.1×8,000.

  11. Cost allocation

    Let us understand the concept of cost allocation plan with the help of a suitable example as given below. This process can be understood by way of the following example. A company produces two products, "A" and "B" on the premises of the same factory. Factory Rent = $1,00,000. Units Produced of "A" = 30,000.

  12. 3.4: Using Activity-Based Costing to Allocate Overhead Costs (Part 1)

    The next step is to find an allocation base that drives the cost of each activity. Step 3. Identify the cost driver for each activity. A cost driver 6 is the action that causes (or "drives") the costs associated with the activity. Identifying cost drivers requires gathering information and interviewing key personnel in various areas of the ...

  13. Cost Allocation

    Cost allocation is a process in which businesses and individuals identify the costs incurred by activity and distribute them to appropriate accounts. ... There's also a simple way called the direct materials cost method that uses an allocation base of the same value as the variable rate. Using FAC or Variable costing can provide more accurate ...

  14. Cost Structure: Direct vs. Indirect Costs & Cost Allocation

    The role of a financial analyst is to make sure costs are correctly attributed to the designated cost objects and that appropriate cost allocation bases are chosen. Cost allocation allows an analyst to calculate the per-unit costs for different product lines, business units, or departments, and, thus, to find out the per-unit profits.

  15. Cost Allocation

    Using the number of units produced as his allocation method, Alex can calculate his overhead costs using the overhead cost formula. Calculate the overhead costs: $6,500 / 5,000 = $1.30 per water bottle. Add the overhead costs to the direct costs to find the total costs: $1.30 + $2.50 + $3.00 = $6.80 per backpack.

  16. Allocation base definition

    An allocation base is the basis upon which an entity allocates its overhead costs. An allocation base takes the form of a quantity, such as machine hours used, kilowatt hours consumed, or square footage occupied. Cost allocations are mostly used to assign overhead costs to produced inventory, as required by several accounting frameworks.

  17. What Is Cost Allocation?

    Fact checked by Kiran Aditham. In This Article. Definition and Examples of Cost Allocation. How Cost Allocation Works. Types of Cost Allocation. Photo: miodrag ignjatovic / Getty Images. Cost allocation is the process of identifying cost objects and assigning costs for financial reporting. Learn when and how to allocate costs for your business.

  18. 6.1 Calculate Predetermined Overhead and Total Cost under the

    Component Categories under Traditional Allocation. Traditional allocation involves the allocation of factory overhead to products based on the volume of production resources consumed, such as the amount of direct labor hours consumed, direct labor cost, or machine hours used. In order to perform the traditional method, it is also important to understand each of the involved cost components ...

  19. How to Calculate Predetermined Overhead Rate: Formula & Uses

    1. Predetermined overhead rate = Estimated manufacturing cost / Estimated total units in allocation base An allocation base is a cost accounting descriptor based on a common activity or factor, like labor hours. The "unit" is the number in the allocation base. For example, if the allocation base is labor hours, then the total number of labor ...

  20. What is Cost Allocation? An Introduction to Cost Allocations

    Cost Allocation Example & Definition. Cost allocation is the distribution of one cost across multiple entities, business units, or cost centers. An example is when health insurance premiums are paid by the main corporate office but allocated to different branches or departments. When cost allocations are carried out, a basis for the allocation ...

  21. How to Calculate Overhead Absorption Rate

    Overhead Absorption Formula. The formula for overhead absorption is: Overhead absorption rate = total overhead cost ÷ total units of the allocation base. The allocation base is a measure of the activity that drives the indirect costs. These might differ depending on the type of company. Let's see how it works in a real-life example.

  22. Allocation Base: Formula, Cost, Implications & Factors

    The allocation base can be either financial or non-financial metrics, depending on the nature of the underlying costs. Allocation Base Formula: Total indirect costs divided by total cost driver values. This formula yields an allocation rate, which is used to distribute indirect costs across cost objects based on their consumption of the ...

  23. Cost allocation methods

    These allocation options are as follows: Allocate based on sales. Costs are apportioned based on the net sales reported by each entity. Since high sales volume does not necessarily equate to high profits, this approach can result in a low-profit entity being burdened with a substantial corporate allocation. Allocate based on profits.

  24. Activity-Based Costing (ABC): Method and Advantages ...

    Activity-Based Costing - ABC: Activity-based costing (ABC) is an accounting method that identifies the activities that a firm performs and then assigns indirect costs to products. An activity ...

  25. Create an Allocation Rule with a Formula Component

    You are the General Accountant for InFusion America Inc. You are tasked with creating an allocation rule with a formula component. Rules are based on formulas. The formulas use multiple criteria. For example, you can use account balances or statistical amounts to allocate shared revenue or costs across multiple organizational units.