Cost Allocation: Definition, Terms & Examples

An error occurred trying to load this video.

Try refreshing the page, or contact customer support.

Coming up next: Direct Method of Cost Allocation: Process, Pros & Cons

You're on a roll. Keep up the good work!

Take Quiz Watch Next Lesson
 Replay
Your next lesson will play in 10 seconds
  • 0:00 What Is Cost Allocation?
  • 0:53 Basic Definitions
  • 2:05 Benefits of Cost Allocation
  • 2:45 Identify & Allocate
  • 3:28 Accumulate, Attribute,…
  • 4:40 Lesson Summary
Save Save Save

Want to watch this again later?

Log in or sign up to add this lesson to a Custom Course.

Log in or Sign up

Timeline
Autoplay
Autoplay
Speed Speed Audio mode

Recommended Lessons and Courses for You

Lesson Transcript
Instructor
Brianna Whiting

Brianna has a masters of education in educational leadership, a DBA business management, and a BS in animal science.

Expert Contributor
Steven Scalia

Steven completed a Graduate Degree is Chartered Accountancy at Concordia University. He has performed as Teacher's Assistant and Assistant Lecturer in University.

Have you ever wondered how a business determines costs? In this lesson we will learn about cost allocation. We will define the term and apply it to some examples. The lesson will conclude with a summary of key concepts.

What Is Cost Allocation?

Let's imagine that you just started your own business where you sell jams and vegetables you canned yourself. While some steps, like picking out the types of jars you will use and deciding on the varieties that you will sell, have been relatively easy, you have run into a snag.

You suddenly realize you're not familiar with some of the more crucial financial aspects of running a business. For example, you're not sure where to begin recording the money you spend so that you have an understanding of the expenses and costs to run your new business.

You decide to take an online course in financing and accounting, and the first thing you learn is how to recognize the many different aspects of your business so that you can assign them the appropriate cost. What you are essentially learning is cost allocation, which will be the focus of this lesson.

Basic Definitions

You may be wondering, what exactly is cost allocation? Cost allocation is the task of identifying, accumulating, and assigning costs to cost objects. A cost object is any item that a company wants to assign a cost to separately. An example might be a project, a department or a branch within a company. So, cost allocation is the process of determining a cost object and then assigning a cost to that cost object.

For example, let's look at the electric bill that includes the electricity you use to can your goodies. Since you do most of your canning in your home, some of the electricity usage is business-related and some of it is personal. So, you might decide to take the cost object, the electric bill, and divide it up or allocate the cost to both your business and your own personal expenses based on usage.

Another important definition is cost driver. A cost driver is something that can change an activity's cost. In other words, it is some factor that can change and affect the costs to perform an activity. An example might be the activity of production. A cost driver for production could be the actual machines as well as the employees that operate them.

Benefits of Cost Allocation

All companies want to reduce costs and increase profits. It is because of this that cost allocation may be utilized. Cost allocation allows a company to see exactly where its money is spent. Knowing this information helps a company use its resources effectively. A company may look at the costs of a resource and only use that resource until it costs too much to do so. At that time, a company can use cost allocation to try and decrease the demand for that resource so that it reduces its costs and increases its profits.

So, now we know what cost allocation is, and why it is used, but let's look at the process in a little more detail.

Identify and Allocate

The first step is to identify the cost object. We cannot assign costs to something if we do not know what that something is. If we take our example from earlier, we might realize that another cost object is the jam division of the business. This means, we want to separate the costs of the business so that the jam division has its own costs.

To unlock this lesson you must be a Study.com Member.
Create your account

Additional Activities

Cost Allocation - A Business Case:

The case study below will allow you to apply your knowledge of Cost Allocation by (1) setting up a cost allocation system for management and (2) explaining its benefits.

Case:

You are the chief accountant at Funky Socks, a company that makes novelty socks for people of all ages. Funky Socks has two main divisions, Funky Socks For Men and Funky Socks For Women. Both of these divisions use the same materials (e.g., wool, cotton, etc.) to make their socks as well as the same assembly process. The difference is simply the design of the socks and how they are marketed. You receive a call from the Chief Executive Officer, Bobby Alpaca.

"My two division managers are always fighting. They are constantly arguing that the other division is wasting too much of the company's resources and that their bonuses (based on divisional income) are unfair because divisional income is unfair. The Men and Women division share the same factory, and I want them to learn how to work together in harmony. That being said, I have no way to verify their claims. I spoke with a consultant who told me about cost allocation. I need two things from you; see attached."

Required:

1. Explain how a cost allocation system can reduce the friction between the two divisional managers, especially when it comes to their bonuses. Right now, the company allocates all common costs 50/50 to each division since all the CEO cares about is the overall profitability.

2. The consultant provided a list of some cost objects that the company should monitor as a starting point. Provide an example of a cost driver for each of these objects.

ItemCost Driver example
Cleaning services
Electricity
Property taxes on factory
Human Resources personnel wages
Joint Marketing team wages

Solution:

1.

Having a cost allocation system will result in less friction because the divisional results will have more fairness. Right now, the company allocates its joint costs 50/50. This is unfair because, if one division is very careful in minimizing these costs, they are not fairly rewarded since all common costs are split equally. In addition, this system provides you with a framework to support the bonuses paid, which can also appease them.

2.

See below. Note that these are simply examples.

ItemCost Driver example
Cleaning servicesSquare footage occupied by each division
ElectricityNumber of units produced/number of hours in production
Property taxes on factorySquare footage occupied by each division
Human Resources personnel wagesNumber of employees in each division
Joint Marketing team wagesSales by each division/Number of ads by each division

Register to view this lesson

Are you a student or a teacher?

Unlock Your Education

See for yourself why 30 million people use Study.com

Become a Study.com member and start learning now.
Become a Member  Back
What teachers are saying about Study.com
Try it risk-free for 30 days

Earning College Credit

Did you know… We have over 200 college courses that prepare you to earn credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.

To learn more, visit our Earning Credit Page

Transferring credit to the school of your choice

Not sure what college you want to attend yet? Study.com has thousands of articles about every imaginable degree, area of study and career path that can help you find the school that's right for you.

Create an account to start this course today
Try it risk-free for 30 days!
Create an account
Support