Cost Allocation in Cost Accounting

In cost accounting, the process of allocating indirect costs to a product involves judgment. Unlike direct costs (which are traced), indirect costs are allocated, and that requires estimates. The process isn’t easy, but it’s vital. You need to allocate indirect costs carefully to understand the cost of an object, such as a product or service.

Here are several reasons why cost allocation is important:

  • The process helps you make economic decisions — for example, whether or not to accept a special order.

  • The information helps you evaluate and motivate your staff.

  • Cost allocation supports the costs you report to customers when making bids for jobs.

  • The information is used in financial reports you send to external parties.

Decisions (economic decisions) about special orders and outsourcing require indirect cost information — generated, of course, by cost allocations. You can’t make a management decision about costs without allocating indirect costs.

Many companies reward employees based on company profit or by meeting other financial goals. It works like this: In order to forecast profit — and review the results — you need to allocate indirect costs. These indirect costs affect your bottom line. Careful allocation of indirect costs helps you calculate financial goals. You then use those goals to evaluate and reward employee performance.

Many industries sign contracts with customers, particularly for long-term projects. Say you’re building a factory for someone. Your contract states that you receive payments based on a percentage of completion; for example, you’re due a payment when the work is 25 percent complete.

One way to measure completion is to calculate the costs you’ve incurred. (After all, if you’ve spent 25 percent, you must be 25 percent done, right?) Cost allocation supports costs you report to fulfill a contract requirement.

Finally, cost allocation provides documentation regarding costs you use for financial reporting. A portion of those costs is allocated to the product. For example, when you report inventory on your balance sheet, you’re using cost allocation.

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