Cost Allocation: Definition, Methods, Plan, Importance

Companies incur various costs when producing their products or services. Companies must assign these costs to those items to calculate profits from them. However, this process may not be as straightforward. Sometimes, companies must also allocate common costs to various objects to establish the cost incurred on those items. For that purpose, companies can use cost allocation.

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What is Cost Allocation?

Cost allocation refers to a process where companies identify and aggregate different costs incurred during production. Once established, companies assign these costs to the specific products or services produced during the period. Cost allocation is also crucial in determining the costs for jobs, projects, departments, and other cost objects.

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Cost allocation is crucial when assigning indirect and shared costs to specific cost objects. Usually, companies can track the direct costs of those objects. However, allocating other relevant costs to cost objects is also an essential part of the costing process. Cost allocation is a part of the cost assignment process that companies use to establish the total cost of a cost object.

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How does Cost Allocation work?

Cost allocation allows companies to assign indirect costs to a cost object. However, it requires the identification of that cost object beforehand. The first step in this process is establishing the object where a company wants to assign costs. Cost objects can be a product, service, project, department, etc. They can be any item where a company seeks to establish costs separately.

Subsequently, companies identify and aggregate costs related to those objects, known as cost pools. Similarly, companies also establish the cost driver that contributes to these costs. Once determined, companies can allocate the costs in those pools by dividing them by the relevant cost drivers. Companies must also decide the most appropriate base for assigning these costs.

What are Cost Allocation Methods?

Cost allocation methods refer to the techniques used to assign costs to various cost objects. The primary objective of using these techniques is to distribute cost pool amounts over those objects fairly. Usually, companies use the following cost allocation methods to achieve that. However, there is no specific cost allocation method that every company must use.

Instead, cost allocation methods differ from one company to another. Some techniques are prevalent among most companies. However, these use a logical way of distributing costs over cost objects. Most of these methods use the same principles. Regardless of the cost allocation method used, the objective remains the same.

What is the importance of Cost Allocation?

The primary objective of cost allocation is to distribute various costs over a cost object. This process is crucial for several reasons. Firstly, it can be critical in decision-making. Costs are a part of the decisions made regarding pricing and planning. Through cost allocation, companies can make well-informed decisions about these areas.

Cost allocation can also be crucial for controlling purposes. Companies use the information obtained through this process to establish how various departments operate. Consequently, they can identify areas of high wastage or low efficiency. It helps companies make their processes and departments more efficient.

Conclusion

Cost allocation helps allocate various costs to a cost object. It involves identifying and aggregating costs first. Consequently, it requires assigning those costs to an established cost object. Companies may use several methods to achieve that. However, there is no standardized way to allocate costs to cost objects. Cost allocation can be highly crucial for companies.