Cost Allocation: Definition, Terms & Examples

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  • 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
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Lesson Transcript
Instructor: Brianna Whiting

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

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.

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