Cost Allocation of Service Departments

Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

Making sure that you have properly allocated all relevant costs is an important part of business. In this lesson, we look at three major reasons why doing so is in every company's best interests.

Why Allocate Costs?

Your business spent $50,000 this year just to keep on running. But where did that money go specifically? Does it matter as long as you know the final amount? Yes, it sure does.

One of the major responsibilities of accounting divisions is to make sure that costs are allocated properly among different departments. While it sounds like a waste of time to move costs around that don't seem to immediately affect the bottom line of an organization, it actually matters greatly within the grand scheme of things.

In this lesson, we're going to look at three primary reasons that companies would do well to make sure that they properly allocate costs, which means to assign dollar amounts to specific expenditures. That way they can make sure everything is running well internally at the organization and meeting the demands of clients, government regulations, etc.

Internal Reasons

First and foremost, the proper allocation of costs can help a firm make sure that it is running at full efficiency without any incidences of waste. Here's a quick example to see how this would work.

Let's say that your company had an overhead budget of $50,000 a month. That may not be much to think about. However, if you properly allocated those costs and found that $30,000 of them are coming from one department that happens to only have two employees, you may need to take a look at that department! It doesn't necessarily mean that it is corrupt or the people there are cheating you out of work, but instead could point to the fact that they need more backup from others in the company.


Proper allocation of costs is also essential from a tax perspective. As you probably know, many business expenses are tax deductible. Therefore, it is to your great benefit to make sure that you keep records of as many tax deductible actions as possible. However, there are certain practices that may keep the auditors from getting suspicious.

If you have not allocated costs to separate departments, then the IRS has no way of knowing what that $50,000 in monthly overhead costs actually pays for. However, if you have properly allocated it by department, it gives a much more clear image of the fact that your company is in fact complying with the law.

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