The Three Purposes of Cost Allocation

Instructor: Beth Loy

Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.

This lesson focuses on the three main purposes for allocating costs. These are to: 1) make decisions, 2) reduce waste, and 3) determine pricing. At the conclusion of this lesson, you should be familiar with these and be able to give examples for each.

What Is Cost Allocation?

Do you ever reconcile your checking account to see where you are spending your money? Maybe it seems like you should have more cash available at the end of the month. Well, if you have balanced your checking account and categorized your costs in the process, you have done a cost allocation. Maybe you allocated the costs based on housing, transportation, and living expenses. If so, you also know why a cost allocation is important.

Say we are running a large farm that produces bananas, oranges, and apples. Let's call our farm BOA Fruits. The company sells its products at a farmer's market, at a fruit stand, and to a wholesaler. It wouldn't be unusual for us to track our costs. If we want to know what sections of our company are costing us the most, we can do a cost allocation.

Cost Allocation is when an accountant identifies, summarizes, and assigns costs to cost objects instead of spreading them around. Cost objects are those items that you want to track the costs of individually. These might be external or internal. External costs would be a company's products, services, sales teams, or activities. These are things that are outside of what goes on within the company. An internal cost could be something assigned to a unit, department, franchise, or assembly line. A cost allocation is a good tool to use on an annual basis to track changes in costs.

Allocating costs serves three main purposes. These are to: 1) make decisions, 2) reduce waste, and 3) determine pricing. Let's look into these in more detail.

Cost Allocation for Decision Making

One of the main purposes for allocating costs is to provide information for decision making. Knowing what department or product is taking a greater proportion of funds is important for weighing alternatives in both the short and long run. Cost allocation is an important planning tool for reducing costs and increasing profits. It can also be a cost motivator, giving managers incentives for making sure that costs are not accumulated carelessly. Managers will be more likely to operate their departments with greater efficiently.

Let's look at BOA Fruits and how it uses cost allocation for decision making. Before the fiscal year ends, BOA Fruits has to make decisions about where we are going to distribute our produce for the next year.

A cost allocation tells us two important things. First, our costs for producing bananas has been reduced due to a new type of banana plant that extends how long a banana will stay ripe. Second, our fruit stand doubled its sales from the previous year.

We decide to double the size of the fruit stand and double the number of bananas produced. This is an example of how cost allocation is vital for explaining growth options for BOA Fruits.

Cost Allocation for Reducing Waste

A second reason for investing the time in doing a cost allocation is to find ways to reduce waste. If a specific department is using twice as many office supplies as another, we need to determine whether that department has a legitimate reason tied to this allocation. If one franchise pays double for its utilities compared to others, a cost allocation will identify this and the company can look into ways to recycle, improve heating and cooling costs, and update equipment.

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