Cost allocation serves several purposes. Also referred to as cost apportionment, this practice of identifying the source of an expense and assigning the cost accordingly is an important factor in helping organizations budget resources and keep track of where costs can be cut, if necessary.
Identifying Cost Objects
A cost object is the resource that uses or benefits from the item that generates the cost. This might be a product, a project, a customer, a department or an entire region, among other possibilities. For example, an administrative assistant who helps out on several different projects within a department might have the cost of her salary allocated to each project according to the number of hours she spent on each. In this case, the projects would be the cost objects.
Besides budgeting and cost tracking purposes, businesses use cost allocation for financial reporting purposes. It’s also used for calculating the profitability of a department, which helps to inform managerial decisions. Companies also sometimes use cost allocation as a motivating factor for both management and employees, and as a means of justifying incurred expenses and determining reimbursement of costs.
One major objective of cost allocation is to assist with expense reporting for tax purposes. This may be especially true of organizations spread out over several states. Such an organization would benefit from allocating extra expenses to regional offices located in states with high income tax rates, to increase the amount of expenses that can be deducted from gross profits and reduce the amount of tax the organization will have to pay in those states.
No single method exists for allocating costs and it’s not an exact science. A company’s overall goals might help to determine the method used. While some allocation methods might have the objective of being as fair as possible to each cost object, others might have the objective of influencing the behavior of managers and employees. For example, basing allocation on the number of employees in a department might cause department managers to avoid hiring needed employees, or even to lay off workers to reduce department size.
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