- Cost allocation is an important factor in the profitability of any business.
- Business owners can use cost allocation findings to evaluate employees' performance.
- The process of cost allocation involves calculating both direct and indirect expenses, such as factory labor and small amounts of materials.
- This article is for business owners who are interested in learning how to allocate costs.
For your business to make money, you must charge prices that not only cover your expenses, but also provide profit. Cost allocation is the process of identifying and assigning costs to cost items in your business, such as products, a project, or even an entire department or individual company branch.
While a detailed cost allocation report may not be important for extremely small businesses, such as a teen's lawn service, more complex businesses require a process of cost allocation to ensure profitability and productivity.
Important achievements: In short, if you can specify a cost for any part of your business, it is considered a cost item.
What is cost allocation?
Cost allocation is the method business owners use to calculate profitability for financial reporting purposes. To ensure that the business's finances are on track, costs are segregated or allocated into different categories based on the area of the business.
For example, the cost allocation for a small clothing boutique would include the cost of materials, shipping and marketing. Consistently calculating these costs will help the store owner ensure that the profit from the sale exceeds the cost of owning and running the store. If not, the owner can easily decide where to raise prices or cut expenses.
For a large company, this process would apply to each department or individual location. Many companies use cost allocation to determine which sectors receive an annual bonus.
Tip: Regardless of the size of your business, you'll want to review and choose the best accounting software to help make this process run as smoothly as possible.
type of cost
In the boutique example above, the process of cost allocation is very simple. For larger businesses, however, there are many more costs involved. These costs break down into seven categories.
- Direct Cost: These expenses are directly related to a product or service. In your business's financial statements, these costs may be linked to goods sold. For a small clothing store, this may include the cost of inventory.
- direct labour: This cost category includes expenses directly related to employee production of the goods or services your business sells. Direct labor costs include payroll for employees involved in making the items your business sells.
- direct materials: As the name suggests, this category includes costs related to the resources used to manufacture the finished product. Direct materials include the fabric used to make clothes, or the glass used in making tables.
- indirect costs: These expenses are not directly related to a product or service, but are necessary to create the product or service. Indirect costs include payroll for those working in operations. It also lists the costs of materials you use in such small quantities that their costs are easy to overlook.
- manufacturing overhead: This category includes warehouse costs and any other expenses related to manufacturing the products sold. Construction overhead costs include payroll for warehouse managers, as well as warehouse expenses such as rent and utilities.
- overhead costs: These include expenses that support the company as a whole but are not directly related to production. Some examples of overhead costs are marketing, operations and utilities for a storefront.
- Product cost: Also called “manufacturing cost” or “total cost,” this category includes the expenses incurred to manufacture or obtain the product you want to sell. All manufacturing overhead costs are also listed in this category.
example of cost allocation
To better explain the process of cost allocation and why it is essential for businesses, let's look at an example.
Dave has a business that manufactures glasses. In January, Dave's overhead costs totaled $5,000. In the same month, they produced 3,000 glasses with $2 in direct labor per product. Direct content totaled $5 for each pair of glasses.
Here's what the cost allocation would look like for Dave:
Overhead: $5,000 $3,000 = $1.66 per pair
- Direct Content: $5 per pair
- Direct Labor: $2 per pair
- Overhead: $1.66 per pair
- Total cost: $8.66 per pair
As you can see, without the cost allocation, Dave would have made no profit from his sales. Large companies will apply this same process to each department and product to ensure adequate sales targets. [Read related article: How to Set Achievable Business Goals]
how to allocate cost
Cost items vary according to the type of business. However, the cost allocation process consists of the same steps, regardless of what your company produces.
1. Identify cost items.
To begin allocating costs, you must list the cost items of your business. Remember that anything that generates an expense within your business is a cost item. Review each product line, project, and department to make sure you've gathered all cost items.
2. Create a cost pool.
Next, collect a detailed list of all business costs. It's a good idea to classify costs based on the reason for each amount. Categories should include utilities, insurance, square footage and any other expenses your business incurs.
3. Allocate cost.
Now that you have listed cost objects and created a cost pool, you are ready to allocate costs. Add up the costs of each cost item as shown in the example above. At a glance, your report should justify all expenses related to your business. If costs don't add up correctly, use the list to determine where you can make adjustments to get back on track.
What is cost allocation used for?
Cost allocation is used for a number of reasons, both external and internal. The reports created by this process are great resources for making business decisions, monitoring productivity, and justifying expenses.
External reports are calculated based on generally accepted accounting principles (GAAP). Under GAAP, expenses can be reported in the financial statements only during the period in which the respective revenue was earned. For this reason, overhead costs are divided and allocated to different inventory items. When inventory is sold, overhead is incurred as a portion of the cost of goods sold (COGS).
Internal financial data, on the other hand, is typically reported using activity-based costing (ABC). This method assigns all products the overhead expenses incurred by them. This process may not include all overhead costs related to operation and manufacturing.
The cost allocation report describes which cost items cost the most and which products or departments are most profitable for your business. These findings can be a great resource to engage with employee monitoring software when evaluating productivity. If you determine that a cost item is not as profitable as it should be, you should evaluate further on productivity. If any other cost items are found to exceed expectations, you can use the report to find staff members who are eligible for recognition for their contributions to the company.
did you know? Recognition is one of the best ways to keep employees motivated.
What is a cost driver?
A cost driver is a variable that can change the costs associated with a business activity. The number of invoices issued, the number of hours worked by employees, and total purchase orders are all examples of cost drivers in cost accounting.
While cost items relate to the cost of a specific process or product, a cost driver highlights the reason for the cost amount spent. These items can take different forms – including fixed costs, such as initial fees during the startup phase. Cost drivers give a bird's eye view of the entire company and how each department works.
FYI: It is common with very small businesses to use only one cost driver, as they are focused on using minimal reporting to estimate overhead costs.
Benefits of cost allocation
- This simplifies decision making. Cost allocation gives you a detailed account of how your business expenses are used. From this perspective, you can determine which products and services are profitable and which departments are most productive.
- It helps in appraisal of employees. You can also use cost allocation to assess the performance of different departments. If a department is not profitable, there may be a need to improve the productivity of employees. Cost allocation can also be an indicator of departments that exceed expectations and deserve recognition. Rewards and recognition are a great way to motivate employees and in turn increase productivity. [Read related article: Best Business Productivity Apps]
Even if you operate a very small business, it's a good idea to learn the process of cost allocation, especially if you anticipate expansion in the future. Since the method can be complicated, it is ideal to use accounting software as an aid. Whether you start allocating costs with software yourself or hire a professional accountant, this is a process no business owner can afford to ignore.