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Cost Allocation

Understanding Cost Allocation

4 mins read

This article is about cost allocation and the differences between Direct and Indirect costs.

Cost allocation is the assigning of a cost to several cost objects such as products, departments or expenses. Every organization should identify their costs, specifically around how funds run through an organization, who is responsible for what costs, and how the cost objects (a product or department for which costs are accumulated or measured,) are defined. When costs are allocated correctly, the business can trace the specific cost items that are making profits for the company, or losses.

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 can be somewhat random. Due to this inconsistency, some people may describe cost allocation as the spreading of a cost.

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There are two types of costs to understand cost allocation: Direct Costs and Indirect (Overhead) Costs.

Direct Costs are expenses that a company can easily relate to a specific cost object. This may be a product, department, or project. It can also include labour, assuming that the labour is specific to a cost object.

Indirect (Overhead) Costs extend beyond the expenses the business incurs creating a product that is involved with maintaining and running a company. Indirect costs include supplies, utilities, office equipment rental, desktop computers and cell phones. In addition, these expenses also include those that are not direct but are necessary for the immediate support of the company, product, or program such as salaries paid to employees.

There are two types of costs to understand cost allocation: Direct Costs and Indirect (Overhead) Costs.

Direct Costs are expenses that a company can easily relate to a specific cost object. This may be a product, department, or project. It can also include labour, assuming that the labour is specific to a cost object.

Indirect (Overhead) Costs extend beyond the expenses the business incurs creating a product that is involved with maintaining and running a company. Indirect costs include supplies, utilities, office equipment rental, desktop computers and cell phones. In addition, these expenses also include those that are not direct but are necessary for the immediate support of the company, product, or program such as salaries paid to employees.

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The main benefit to cost allocation for organizations is that it assists in the decision-making and planning process. This allows management to review the data and make business decisions provided by finance about the cost utilization within the company.

The cost objects display which departments or products are profitable enough to justify the costs that are allocated. For unprofitable costs, the management team can then decide which costs can be cut and divert the money to other, more profitable cost objects. Finally, cost allocations provide documentation regarding costs you incurred for financial reporting.

Download this resource article Understanding Cost Allocation (pdf).

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