What is cost allocation?

Definition of Cost Allocation

Cost allocation is the assigning of a cost to several cost objects such as products or departments. The cost allocation is needed because the cost is not directly traceable to a specific object. Since the cost is not directly traceable, the resulting allocation is somewhat arbitrary. Because of the arbitrariness, some people describe cost allocation as the spreading of a cost.

Accountants have made efforts to improve the cost allocation techniques. Over time, manufacturers' overhead allocations have moved from a plant-wide rates to departmental rates. Some allocations that were allocated on the basis of direct labor hours are now based on machine hours. In order to improve those bases of allocations, some accountants are implementing activity based costing. The goal is to reduce the arbitrariness by identifying the various root causes of the overhead costs.

Examples of Cost Allocations

The following are only a few of the many cost allocations that occur in some companies or organizations:

  • The cost of a manufacturing building is allocated to each of the years that the building is expected to be used. Each year's depreciation is allocated to the departments that use the building. Each department's allocated cost is then allocated/assigned to the products that are processed in the department.
  • The electricity that is used in the production facility as measured by a single meter is allocated to the departments using the electricity. Each department's electricity is then allocated/assigned to the products processed in the department.
  • The cost of raw land that was purchased for $1 million is going to be developed into 80 residential lots of various sizes and 10 business lots of different sizes. The $1 million cost must be allocated to the resulting 90 lots in a meaningful way so that the developer can report the profit of selling two residential lots and the largest of the business lots. The basis for the allocation is likely to be the net realizable values of the lots.
  • The annual salary and benefits of an employee that spends time in three main functions of a nonprofit organization.