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What Is Cost Allocation?

Table of Contents

Entrepreneurs, small business owners and managers need accurate, timely financial data to run their operations. Specifically, understanding and connecting costs to items or departments helps them create budgets, develop strategies and make the best business decisions for their organizations. This is where cost allocation comes in. Detailed cost allocation reports help businesses ensure they’re charging enough to cover expenses and make a profit. 

While a detailed cost allocation report may not be vital for extremely small businesses, more complex businesses require cost allocation to optimize profitability and productivity.

What is cost allocation?

Cost allocation is the process of identifying and assigning costs to business objects, such as products, projects, departments or individual company branches. Business owners use cost allocation to calculate profitability. Costs are separated or allocated, into different categories based on the business area they impact. These amounts are then used in accounting reports . 

For example, say you’re a small clothing manufacturer. Your product line’s cost allocation would include materials, shipping and labor costs. It would also include a portion of the operation’s overhead costs. Calculating these costs consistently helps business leaders determine if profits from sales are higher than the costs of producing the product line. If not, it can help the owner pinpoint where to raise prices or cut expenses .

For a larger company, cost allocation is applied to each department or business location . Many companies also use cost allocation to determine annual bonuses for each area.

Types of costs

If you’re starting a business , the cost allocation process is relatively straightforward. However, larger businesses have many more costs that can be divided into two primary categories: direct and indirect costs:

• Purchased inventory
• Materials used to make inventory
• Direct labor costs for employees who make inventory
• Payroll for those who work in operations
• Manufacturing overhead, including rent, insurance and utilities costs
• Other overhead costs, including expenses that support the company but aren’t directly related to production, such as marketing and human resources

What is a cost driver?

A cost driver is a variable that affects business costs, such as the number of invoices issued, employee hours worked or units of electricity used. Unlike cost objects, such as units produced or departments, a cost driver reflects the reason for the incurred cost amounts. 

How to allocate costs

While cost objects vary by business type, the cost allocation process is the same regardless of what your company produces. Here are the steps involved.

1. Identify your business’s cost objects.

Determine the cost objects to which you want to allocate costs, such as units of production, number of employees or departments. Remember that anything within your business that generates an expense is a cost object. Review each product line, project and department to ensure you’ve gathered all cost objects for which you must allocate costs.

2. Create a cost pool.

Next, create a detailed list of all business costs. Categories should cover utilities, business insurance policies, rent and any other expenses your business incurs.

3. Choose the best cost allocation method for your needs.

After identifying your business’s cost objects and creating a cost pool, you must choose a cost allocation method. Several methods exist, including the following standard ones: 

• Direct materials cost method: This cost allocation method assumes all products have the same allocation base and variable rate.
• Direct labor cost method: This cost allocation method is most helpful if labor costs can be allocated to one product or if expenses vary directly with labor costs.
• High/low method. This cost allocation method is best if you have more than one cost driver and each driver has different fixed or variable rates.
• Step-up or step-down method: With this cost allocation method, departments are first ranked and then the cost of services is allocated from one service department to another in a series of steps. 
• Full absorption costing (FAC): This cost allocation method combines direct material and direct labor costs with a predetermined FAC rate based on company historical data or industry standards.
• Variable costing: Consider this cost allocation method if your business has many variable cost allocations (costs that vary by quantity) and uses significant direct labor.

4. Allocate costs.

Now that you’ve listed cost objects, created a cost pool and chosen a cost allocation method, you’re ready to allocate costs. 

Here’s a cost allocation example to help you visualize the process: 

Dave owns a business that manufactures eyeglasses. In January, Dave’s overhead costs totaled $5,000. In the same month, he produced 3,000 eyeglasses with $2 in direct labor per product. Direct materials for each pair of eyeglasses totaled $5. Here’s what cost allocation would look like for Dave: Direct costs: $5 direct materials + $2 direct labor = $7 direct costs per pair Indirect costs: Overhead allocation: $5,000 ÷ 3,000 pairs = $1.66 overhead costs per pair Direct costs: $7 per pair + Indirect costs: $1.66 per pair Total cost: $8.66 per pair

As you can see, cost allocation helps Dave determine how much he must charge wholesale for each pair of eyeglasses to make a profit. Larger companies would apply this same process to each department and product to ensure sufficient sales goals.

5. Review and adjust cost allocations.

Cost allocations are never static. To be meaningful, they must be monitored and adjusted constantly as circumstances change.

What are the benefits of cost allocation?

Accurate, regular cost allocation can bring your business the following benefits: 

• Helps you run your business: The information you glean from cost allocation reports helps you perform vital functions like preparing income tax returns and creating financial reports for investors, creditors and regulators. 
• Informs business decisions: Cost allocation is an excellent business decision tool that can help you monitor productivity and justify expenses. Cost allocation gives a detailed overview of how your business expenses are used. From this perspective, you can determine which products and services are profitable and which departments are most productive. 
• Helps produce accurate business reports: Tax accounting, financial accounting and management accounting all require some kind of cost allocation. This information is the foundation of accurate business reports. 
• Can reveal accurate production costs: Knowing what it costs to create a product, including all expenses allocated to it, is essential to making good pricing decisions and allocating resources efficiently.
• Helps you evaluate staff: Cost allocation can help you assess the performance of different departments and staff members. If a department is not profitable, staff productivity may need improvement. 

Common cost allocation mistakes

To get the most from cost allocation, avoid these common mistakes:

• Equal or inflexible allocation : Cost allocation is not as simple as allocating any given cost over different product lines or departments. Some cost objects require more time, expense or labor than others, for example.
• Missing costs: Costing is meaningless if it doesn’t include all expenses. Don’t forget costs, such as overhead, time spent and intangible expenses.
• Failing to adjust as needed: Costs and priorities in business are changing constantly. Be sure your cost allocations are monitored and adjusted to meet your information needs.
• Not considering fluctuating revenue with indirect costs: If your business is seasonal or fluctuates over time, it’s important to account for that when allocating costs. 

Cost allocation and your business

Even if you operate a very small business, it’s essential to properly allocate your expenses. Otherwise, you could make all-too-common mistakes, such as charging too little for your product or spending too much on overhead. Whether you choose to start allocating costs on your own with software or with the help of a professional small business accountant , cost allocation is a process no business owner can afford to overlook.

Dachondra Cason contributed to this article. 

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June 13, 2018

What is Cost Allocation? An Introduction to Cost Allocations

Michael shultz.

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• Cost Allocation Example & Definition

Cost allocation is the distribution of one cost across multiple entities, business units, or cost centers. An example is when health insurance premiums are paid by the main corporate office but allocated to different branches or departments.

When cost allocations are carried out, a basis for the allocation must be established, such as the headcount in each branch or department.

• Cost Allocation Methodology

A cost allocation methodology identifies what services are being provided and what these services cost. It also establishes a basis for allocating these costs to business units or cost centers based on their appropriate share of such cost.

The basis for allocating costs may include headcount, revenue, units produced, direct labor hours or dollars, machine hours, activity hours, and square footage.

Companies will often implement a cost allocation methodology as a means to control costs. Under an effective cost allocation methodology, business units become directly accountable for the services they consume. As a result, both the service provider and the respective consumers of that service become aware of service requirements and usage, and how such usage influences the costs incurred.

As business units begin seeing the cost of the services they consume, they can make more informed choices—such as trade-off decisions between service levels and costs, and benchmarking internal costs against outsourced providers.

• Process for Performing Cost Allocations

Using a basis for allocation, costs are spread to each business unit or cost center that incurred the cost based on their proportional share of the cost. For example, if headcount forms the basis of allocation for insurance costs, and there are 1000 total employees, then a department with 100 employees would be allocated 10% of the insurance costs.

While there are numerous ways cost allocations can be calculated, it is important to ensure the reasoning behind them is documented. This is often done by establishing allocation formulas or tables.

Once the calculation is established and cost distributions are calculated, journal entries are created to transfer costs from the providing or paying entity to the appropriate consuming entities. During each financial period, as periodic expenses are incurred, this calculation is repeated and allocating entries are made.

• What Does a Cost Allocation System Do?

A cost allocation system consists of a way to track which entity within an organization provides a product and/or service, the entity that consumes the products and/or services, and a means of distributing this cost from the provider to the consumer or consumers. Depending on the operating structure of the company, the cost allocation may be performed by internal invoice, through a chargeback module in the ERP system, or more commonly, through journal entries performed by accounting staff each financial period.

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Cost Allocation

The process of identifying a company’s costs and assigning those costs to cost objects

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds  asset management  firm with $20 billion under management, and as an investment banking analyst in  SunTrust Robinson Humphrey 's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Currently an investment analyst focused on the  TMT  sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a  BS  from The Tepper School of Business at Carnegie Mellon.

• What Is Cost Allocation?
• Types Of Costs
• How To Allocate Costs
• Why Do We Need To Allocate Costs?
• Examples Of Cost Allocation & Calculations

What is Cost Allocation?

Cost allocation is the process of identifying a company’s costs and assigning those costs to cost objects. Cost objects are the products, services, and activities of different departments of a company. 

This process of allocating costs helps a business determine which parts of the company are responsible for what costs. 

Sometimes it is difficult to draw the connection between allocated costs and their cost objects. When this happens, companies can use spreading costs. 

Spreading costs occur when businesses spread the responsibility for production expenses across various areas. 

When businesses can accurately allocate their costs, they are able to easily assess what particular cost objects are creating profits and losses for the company. On the other hand, if businesses are unable to allocate their costs correctly, their profit and loss calculations will be off. 

Also, businesses must charge a price for their goods and services that covers their expenses and allows them to make a profit.  

Intuitively, one can recognize the importance of cost allocation for the optimal performance of a company. Incorrect cost allocation calculations are extremely detrimental to any business and disrupt the ability to operate properly.

Cost allocation is necessary for any business, but as companies get larger and more complex, it becomes even more important to allocate costs accurately. 

Key Takeaways

Cost allocation is fundamental and necessary for any business, big or small. 

It helps with assessing profits and losses and the management of staffing. 

Cost allocation allows companies to explain the pricing of their goods and services to customers. 

Allocating costs is necessary for companies to maintain efficiency and financial accountability. 

Types of Costs

Companies have various types of costs, and it is important to be able to distinguish between the different types when allocating them. 

We can break them down into a few different categories.

• Direct costs:  direct costs are those that can be traced to a certain product or service offered by a company. Included in direct costs are materials and labor that go into the production of a good. 
• Indirect costs :  these expenses are those that go into the production of a good but do not have a connection to a specific cost object. Examples of indirect costs include rent, utilities, and office supplies.
• Fixed costs : these costs remain constant, regardless of a company’s production volume. (e.g., rent)
• Variable costs : these costs increase or decrease as a company’s volume of production changes (e.g., supplies). 
• A few examples of fixed overhead costs include rent, insurance, and workers’ salaries. Variable overhead costs include supplies and energy expenses, which both change as the  volume of production  increases or decreases. 

How to Allocate Costs

Now that we understand the different types of costs, we can better understand the processes involved in cost allocation. Regardless of what good or service a company produces, the process remains consistent across industries. 

• Identify  Cost Objects : anything within a business that creates an expense is considered a cost object. The first step for allocating costs is to note all the cost objects of your company. 

Electricity usage

Water usage

Fuel consumption

• Fixed cost allocation:  this method assigns particular direct costs with cost objects. Drawing direct connections between costs and cost objects makes this method one of the most simple.
• Proportional allocation:  proportional allocation deals with the distribution of indirect costs across associated cost objects. Sometimes proportional allocation divides costs equally across cost objects, while other times, it considers other factors (i.e., size) and divides costs accordingly. 
• Activity-based allocation:  this method is commonly considered the more accurate method of allocating costs. Activity-based allocation utilizes precise documentation to determine costs within departments and allocates the costs appropriately. 

Why Do We Need to Allocate Costs?

A company must allocate its costs in order to optimize its business activities.

Recognizing Profits And Losses

Understanding the distribution of expenses helps companies analyze which areas of their business may be profitable or which areas may be causing a loss. This allows companies to determine whether or not certain expenses can be justified or not. 

Companies do not know how much to charge the customer’s goods and services without cost allocation. Once non-profitable cost objects are identified, companies can cut expenses in those departments and focus their efforts on profitable cost objects. 

Management Decisions

Cost allocation is also important for a company to manage its staff. In areas where the company is not profitable, it can evaluate the staff performance of that department. Often, the losses incurred by part of a company are due to the underperformance of employees. 

Similarly, companies can analyze the allocation of their costs to determine where they are profitable and award the employees of that department. 

Using cost allocation to motivate employees offers the administration of a company an objective, quantitative justification for their management decisions. 

Transfer Pricing

Transfer pricing is the practice of charging for goods and services at an arm's length. The practice is used by departments the organization to charge for the goods and services exchanged within the same firm.

Cost allocation is vital for deriving transfer pricing, the exchange price of goods or services between two companies. 

Examples of Cost Allocation & Calculations

Now we understand cost allocation, the different types, and why we need it. Here are several examples of different ways a company might allocate its costs. 

Example 1: Square Footage

Christina’s business has an office and a manufacturing space. The square footage of the office is 1,000 square feet, and the manufacturing space is 1,500 square feet. The rent for the two spaces is $10,000 per month. The company will allocate the rent expense between the two spaces. 

$10,000 (rent) / 2,500 square feet = $4 per square foot

• Calculate the rental cost for the office

$4 x 1,000 = $4,000

This means that Christina will allocate $4,000 of the rent to the office.

• Calculate the rental cost for the manufacturing space

$4 x 1,500 = $6,000

This means that Christina will allocate $6,000 of the rent to the manufacturing space.

Example 2: Units Produced

Alex’s manufacturing company makes water bottles. In January, Alex produced 5,000 water bottles with direct material costs of $2.50 per water bottle and $3.00 in direct labor costs per water bottle. 

Alex also had $6,500 in overhead costs in January. Using the number of units produced as his allocation method, Alex can calculate his overhead costs using the overhead cost formula. 

• Calculate the overhead costs: 

$6,500 / 5,000 = $1.30 per water bottle

• Add the overhead costs to the direct costs to find the total costs:

$1.30 + $2.50 + $3.00 = $6.80 per backpack

So, Alex’s total costs in January were $6.80 per backpack. If Alex had not allocated the overhead costs, he would have most likely underpriced the backpacks, which would have resulted in a loss of income. 

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• Cost Classifications
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Cost allocation is the process by which the indirect costs are distributed among different cost objects such as a project, a department, a branch, a customer, etc. It involves identifying the cost object, identifying and accumulating the costs that are incurred and assigning them to the cost object on some reasonable basis.

Cost allocation is important for both pricing and planning and control decisions. If costs are not accurately calculated, a business might never know which products are making money and which ones are losing money. If cost are mis-allocated, a business may be charging wrong price to its customers and/or it might be wasting resources on products that are wrongly categorized as profitable.

Cost allocation is a sub-process of cost assignment , which is the overall process of finding total cost of a cost object. Cost assignment involves both cost tracing and cost allocation. Cost tracing encompasses finding direct costs of a cost object while the cost allocation is concerned with indirect cost charge.

Steps in cost allocation process

Typical cost allocation mechanism involves:

• Identifying the object to which the costs have to be assigned,
• Accumulating the costs in different pools,
• Identifying the most appropriate basis/method for allocating the cost.

Cost object

A cost object is an item for which a business need to separately estimate cost.

Examples of cost object include a branch, a product line, a service line, a customer, a department, a brand, a project, etc.

A cost pool is the account head in which costs are accumulated for further assignment to cost objects.

Examples of cost pools include factory rent, insurance, machine maintenance cost, factory fuel, etc. Selection of cost pool depends on the cost allocation base used. For example if a company uses just one allocation base say direct labor hours, it might use a broad cost pool such as fixed manufacturing overheads. However, if it uses more specific cost allocation bases, for example labor hours, machine hours, etc. it might define narrower cost pools.

Cost driver

A cost driver is any variable that ‘drives’ some cost. If increase or decrease in a variable causes an increase or decrease is a cost that variable is a cost driver for that cost.

Examples of cost driver include:

• Number of payments processed can be a good cost driver for salaries of Accounts Payable section of accounting department,
• Number of purchase orders can be a good cost driver for cost of purchasing department,
• Number of invoices sent can be a good cost driver for cost of billing department,
• Number of units shipped can be a good cost driver for cost of distribution department, etc.

While direct costs are easily traced to cost objects, indirect costs are allocated using some systematic approach.

Cost allocation base

Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools to different cost objects. A good cost allocation base is something which is an appropriate cost driver for a particular cost pool.

T2F is a university café owned an operated by a student. While it has plans for expansion it currently offers two products: (a) tea & coffee and (b) shakes. It employs 2 people: Mr. A, who looks after tea & coffee and Mr. B who prepares and serves shakes & desserts.

Its costs for the first quarter are as follows:

Total tea and coffee sales and shakes sales were $50,000 & $60,000 respectively. Number of customers who ordered tea or coffee were 10,000 while those ordering shakes were 8,000.

The owner is interested in finding out which product performed better.

Salaries of Mr. A & B and direct materials consumed are direct costs which do not need any allocation. They are traced directly to the products. The rest of the costs are indirect costs and need some basis for allocation.

Cost objects in this situation are the products: hot beverages (i.e. tea & coffee) & shakes. Cost pools include rent, electricity, music, internet and wi-fi subscription and magazines.

Appropriate cost drivers for the indirect costs are as follows:

Since number of customers is a good cost driver for almost all the costs, the costs can be accumulated together to form one cost pool called manufacturing overheads. This would simply the cost allocation.

Total manufacturing overheads for the first quarter are $19,700. Total number of customers who ordered either product are 18,000. This gives us a cost allocation base of $1.1 per customer ($19,700/18,000).

A detailed cost assignment is as follows:

Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000

Manufacturing overheads allocated to Shakes = $1.1×8,000

by Irfanullah Jan, ACCA and last modified on Jul 22, 2020

Related Topics

• Cost Behavior

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What is Cost Allocation? Definition & Process

Jul 16, 2020 Michael Whitmire

Working with the former accountants now working at FloQast, we decided to take a look at some of the pillars of the accounting professions.

The key to running a profitable enterprise of any kind is making sure that your prices are high enough to cover all your costs — and leave at least a bit for profit. For a really simple business — like the proverbial lemonade stand that almost every kid ran — that’s pretty simple. Your costs are what you (or your parents) paid for lemons and sugar. But what if it’s a more complex business? Then you might need to brush up on cost accounting, and learn about allocation accounting . Let’s walk through this using the hypothetical company, Lisa’s Luscious Lemonade. 

What is cost allocation ?

The cost allocation definition is best described as the process of assigning costs to the things that benefit from those costs or to cost centers . For Lisa’s Luscious Lemonade, a cost center can be as granular as each jug of lemonade that’s produced, or as broad as the manufacturing plant in Houston. 

Let’s assume that the owner, Lisa, needs to know the cost of a jug of lemonade. The total cost to create that jug of lemonade isn’t just the costs of the water, lemons, sugar and the jug itself, but also includes all the allocated costs to make it. 

Let’s start by defining some terms…

Direct costs are costs that can be traced directly to the product or service itself. For manufacturers, these consist of direct materials and direct labor. They appear in the financial statements as part of the cost of goods sold .

Direct materials are those that become an integral part of the finished product. This will be the costs of the water, sugar, lemons, the plastic jug, and the label. 

Direct labor includes the labor costs that can be easily traced to the production of those finished products. Direct labor for that jug will be the payroll for the workers on the production line. 

Indirect costs are the costs that can’t be easily traced to a product or service but are clearly required for making whatever an enterprise sells. This includes materials that are used in such insignificant quantities that it’s not worth tracing them to finished products, and labor for employees who work in the factory, but not on the production line. 

Overhead costs encompass all the costs that support the enterprise that can’t be directly linked to making the items that are sold. This includes indirect costs , as well as selling, marketing, administration, and facility costs. 

Manufacturing overhead includes the overhead costs that are directly related to making the products for sale. This includes the electricity, rent, and utilities for the factory and salaries of supervisors on the factory floor. 

Product costs are all the costs in making or acquiring the product for sale. These are also known as manufacturing costs or total costs . This includes direct labor, direct materials, and allocated manufacturing overhead. 

What is the process?

The first step in any cost allocation system is to identify the cost objects to which costs need to be allocated. Here, our cost objec t is a jug of lemonade. For a more complex organization, the cost object could be a product line, a department, or a branch. 

Direct costs are the simplest to allocate. Last month, Lisa’s Luscious Lemonades produced 50,000 gallons of lemonade and had the following direct costs:

                                    Total costs     Cost per gallon Direct materials        $142,500               $2.85 Direct labor                   $37,500                   $.75

How are costs allocated?

Allocating overhead costs is a bit more complex. First, the overhead costs are split between manufacturing costs and non-manufacturing costs. Some of this is pretty straightforward: the factory floor supervisor’s salary is clearly a manufacturing cost, and the sales manager’s salary is a non-manufacturing cost. But what about the cost of human resources or other service departments that serve all parts of the organization? Or facilities costs, which might include the rent for the building, insurance, utilities, janitorial services, and general building maintenance?

Human resources and other services costs might be logically split based on the headcount of the manufacturing versus non-manufacturing parts of the business. Facilities costs might be split based on the square footage of the manufacturing space versus the administrative offices. Electricity usage might be allocated on the basis of square footage or machine hours , depending on the situation. 

Let’s say that for Lisa’s Luscious Lemonades, after we split the overhead between manufacturing and non-manufacturing costs, we have the following annual manufacturing overhead costs : 

Supervisor salary                                  $84,000 Indirect costs                                         $95,000 Facility costs                                           $150,000 Human resources                                  $54,000 Depreciation                                          $65,000 Electricity                                                $74,000 Total manufacturing overhead             $522,000

In a perfect world, it would be possible to keep an accurate running total of all overhead costs so that management would have detailed and accurate cost information. However, in practice, a predetermined overhead rate is used to allocate overhead using an allocation base . 

This overhead rate is determined by dividing the total estimated manufacturing overhead by the estimated total units in the allocation base . At the end of the year or quarter, the allocated costs are reconciled to actual costs. 

Ideally, the allocation base should be a cost driver that causes those overhead costs . For manufacturers, direct labor hours or machine-hours are commonly used. Since Lisa only makes one product — gallon jugs of lemonade — the simplest cost driver is the number of jugs produced in a year. 

If we estimate that 600,000 gallons of lemonade are produced in a year, then the overhead rate will be $522,000 / 600,000 = $.87 per gallon.

Our final cost to produce a gallon of Lisa’s Luscious Lemonade is as follows:

Direct materials                             $2.85 Direct labor                                     $0.75 Manufacturing overhead               $0.87 Total cost                                         $4.47

What is cost allocation used for?

Cost allocation is used for both external reporting and internally for decision making. Under generally accepted accounting principles (GAAP), the matching principle requires that expenses be reported in the financial statements in the same period that the related revenue is earned. 

This means that manufacturing overhead costs cannot be expensed in the period incurred, but must be allocated to inventory items, where those costs remain until the inventory is sold, when overhead is finally expensed as part of the cost of goods sold. For Lisa’s Luscious Lemonade, that means that every time a jug of lemonade is produced, another $4.47 goes into inventory. When a jug is sold, $4.47 goes to the cost of goods sold. 

However, for internal decision-making, the cost allocation systems used for GAAP financials aren’t always helpful. Cost accountants often use activity-based costing , or ABC, in parallel with the cost allocation system used for external financial reporting . 

In ABC, products are assigned all of the overhead costs that they can reasonably be assumed to have caused. This may include some — but not all — of the manufacturing overhead costs , as well as operating expenses that aren’t typically assigned to products under the costing systems used for GAAP. 

AutoRec to keep you sane

Whatever cost accounting method you use, it’s going to require spreadsheets that you have to reconcile to the GL. Combine that with the other reconciliations you have to do to close out the books, and like Lisa’s controller, you might be ready to jump into a vat of lemonade to drown your sorrows. 

Enter FloQast AutoRec. Rather than spend hours every month reconciling accounts, AutoRec leverages AI to match one-to-one, one-to-many, or many-to-many transactions in minutes. Simple set up means you can start using it in minutes because you don’t need to create or maintain rules. Try it out, and see how much time you can save this month. 

Ready to find out more about how FloQast can help you tame the beast of the close?

Michael Whitmire

As CEO and Co-Founder, Mike leads FloQast’s corporate vision, strategy and execution. Prior to founding FloQast, he managed the accounting team at Cornerstone OnDemand, a SaaS company in Los Angeles. He began his career at Ernst & Young in Los Angeles where he performed public company audits, opening balance sheet audits, cash to GAAP restatements, compilation reviews, international reporting, merger and acquisition audits and SOX compliance testing. He holds a Bachelor’s degree in Accounting from Syracuse University.

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The Comprehensive Guide to Cost Allocation in Accounting

Accounting is a fascinating field, and cost allocation is one of the most important concepts in accounting. Whether you’re an accounting student or an accountant just starting out, it’s important to understand how to allocate costs.

In this comprehensive guide, we’ll cover everything from what it means to its pros and cons. 

How Can Costs Be Allocated Among Departments or Product Lines When There Is No Clear Source?

Allocation is distributing costs among different departments or product lines in an organization. Trying to accurately estimate the cost of producing a good or rendering a service is a common challenge for many businesses.

This is especially true when there is no apparent source of the costs, as it requires the use of various techniques and methods to distribute the expenses fairly and reasonably.

What Is the Concept of Allocation?

Allocation (also known as “cost allocation”) is a process used to distribute the costs of a shared resource or expense among different departments, product lines, or activities within an organization.

This process is necessary to accurately determine the cost of producing a product, providing a service, or running a business. Allocation allows firms to identify the expenses incurred by each department or product line and helps make informed decisions about allocating resources.

The allocation concept has existed for centuries and is a fundamental part of modern accounting and financial management. The cost allocation process involves assigning costs to specific departments or product lines based on objective criteria, such as resource use or the benefit received from the expense.

The objective criteria used in the allocation process may vary depending on the type of business, but the goal is always to distribute the costs fairly and reasonably.

One of the main challenges of allocation is that many expenses cannot be traced directly to a specific department or product line. For example, the cost of electricity used to run a manufacturing plant cannot be directly traced to one particular product line.

In such cases, the cost of electricity must be allocated to different departments or product lines based on objective criteria, such as the number of hours each department uses the electricity or the production output of each product line.

There are different methods of allocation, each with its strengths and weaknesses. Some of the most common ways include direct allocation, step-down allocation, sequential allocation, and activity-based allocation. Each mode uses a different approach to allocating costs, but the goal is always to ensure that the costs are distributed fairly and reasonably.

What Doesn’t the Term Allocation Mean?

The term allocation” is commonly used in various contexts, such as finance, economics, project management, and resource management. However, it’s essential to understand that allocation ” doesn’t mean “equal distribution” or “uniform distribution” of resources.

Allocation refers to assigning a portion of resources, such as time, money, or labor, to specific tasks or activities. The goal of allocation is to optimize the use of resources to achieve the desired outcomes.

One of the most common misunderstandings about allocation is that it means dividing resources equally among tasks or activities. However, this is only sometimes the case. Resources are often not distributed evenly because different tasks or activities have different requirements and priorities.

For example, in project management, some jobs may require more time, money, or labor than others. In such cases, the project manager must allocate more resources to these critical tasks to ensure the project’s success.

Another misunderstanding about allocation is that it means distributing resources inflexibly and rigidly. Allocation is a flexible process that can be adjusted based on priorities or changes in resource availability. For example, in a business setting, the budget allocation may change based on market conditions or changes in customer demand. In these situations, the business must be able to reallocate its resources to respond to these changes.

The allocation also doesn’t mean that the resources are assigned once and never adjusted. Allocation is an ongoing process requiring constant monitoring and adjustments to ensure that resources are used optimally.

For example, in finance, the allocation of investments must be reviewed regularly to ensure that the portfolio is aligned with the investor’s goals and objectives.

Another misconception about allocation is that it only applies to tangible resources, such as money or equipment. However, allocation also applies to intangible resources like time and labor. These intangible resources are often more critical and limited than tangible ones. For example, allocating time is crucial in project management to ensure that projects are completed on time and within budget.

As you can see, allocation is a complex and flexible process that requires careful consideration of multiple factors, such as resource availability, priorities, and goals. It’s essential to understand that allocation doesn’t mean equal distribution or limited distribution of resources.

Instead, it’s a dynamic process that requires ongoing monitoring and adjustments to ensure the optimal use of resources. By avoiding common misconceptions about allocation, individuals and organizations can more effectively allocate their resources and achieve their desired outcomes.

Where the Term Allocation Originated From?

The word “allocation” comes from the Latin word “allocare.” The word allocation ” refers to setting aside or assigning a particular portion, amount, or portion of something for a specific purpose or recipient.

The allocation comes from the Latin prefix ad- (meaning “to”) and the noun loci (meaning “place”). The combination of these two words implies the idea of assigning a place, or portion of something, for a specific purpose.

In finance and economics, “allocation” refers to distributing resources, such as money, to different projects or initiatives based on their perceived importance and likelihood of success.

The allocation concept is ancient and can be traced back to the earliest civilizations, where resources were allocated based on the community’s needs. In early societies, central planning or direct control by the ruling class were common methods of allocation.

However, with the advent of market-based economies, the allocation has become more decentralized and is now primarily done through the market mechanism of supply and demand.

In modern economies, allocation is crucial in ensuring that resources are used efficiently and effectively. For example, in capital allocation, investors allocate their funds to different projects and businesses based on the perceived potential return on investment. This helps direct investment toward the most promising and profitable opportunities, thereby increasing the economy’s overall efficiency.

Similarly, prices play a crucial role in allocating goods and services in directing resources to where they are most needed. In a market economy, the interaction of supply and demand determines prices. When demand for a particular good or service is high, the price will increase, directing more resources toward its production. On the other hand, when demand is low, the price will decrease, reducing the allocation of resources to its production.

Government policies and regulations can also have an impact on allocation in addition to the market mechanism. For example, the government may allocate resources to specific sectors through funding or subsidies, such as education or healthcare.

Similarly, government regulations and taxes can also impact the allocation of resources by affecting the incentives for businesses and individuals to allocate their resources in a particular way.

How Allocation Relates to Accounting?

In accounting, allocation determines the cost of producing a product or providing a service. This information is then used to create accurate financial statements and make informed decisions about allocating resources in the future.

For example, a company may allocate resources to a new product line based on the expected revenue it will generate or distribute costs to specific departments based on their usage of resources.

The allocation also plays a crucial role in cost accounting . Cost accounting involves analyzing the cost of production, including direct and indirect costs, and using this information to make decisions about pricing and resource allocation.

By accurately allocating costs, a company can determine the actual cost of production and make informed decisions about pricing , production volume, and resource allocation.

In addition, allocation is used to allocate the costs of long-term assets, such as property, plant, and equipment. This is done through the process of depreciation, which is a systematic allocation of the cost of an asset over its useful life. Depreciation is used to determine the value of an investment for financial reporting purposes and the amount of tax that a company must pay.

Finally, allocation is also used in the budgeting process. In budgeting, an organization allocates resources to various departments and activities based on their priorities and goals. By accurately allocating resources, a company can ensure that it has enough resources to meet its goals and objectives while staying within its budget.

3 Examples of Allocation Being Used in Accounting Practice

Example #1 of allocation being used in accounting practice.

Allocating the Cost of Goods Sold In accounting, “cost of goods sold” (COGS) refers to the direct costs associated with producing a product or providing a service. These costs include the raw materials, labor, and overhead expenses incurred to produce the goods. COGS is crucial in determining a company’s gross profit because it represents the cost of producing and selling a product.

One example of allocation in accounting practice is when a company allocates the cost of goods sold to each product. This is done to understand the cost of producing each product and identify the most profitable products. 

The allocation process involves dividing the total COGS by the number of units sold to arrive at an average cost per unit. This average cost per unit is then applied to each unit of product sold to determine the COGS for that specific product.

This allocation process is vital because it allows the company to accurately determine the cost of producing each product. This information is then used to make informed business decisions such as pricing strategies, production decisions, and cost control measures. 

For example, suppose a company realizes that the cost of producing one product is much higher than the cost of producing another. In that case, it may choose to discontinue the higher-cost product or find ways to reduce the cost of production.

Example #2 of Allocation Being Used in Accounting Practice

One example of allocation in accounting practice is allocating indirect costs to different departments or products within a company. Indirect costs, such as rent, utilities, and office supplies, cannot be directly traced to a specific product or department. These costs must be allocated among different departments or products to calculate the cost of each accurately.

For example, consider a manufacturing company with three departments: production, research and development, and administration. The company has a total indirect cost of $100,000 for the year, which includes rent, utilities, and office supplies.

The company might determine the proportion of space each department uses to allocate these costs. If production uses 40% of the total space, R&D uses 30%, and administration uses 30%, the company would allocate 40% of the indirect costs to production, 30% to R&D, and 30% to administration.

Next, the company might allocate indirect costs based on the number of employees in each department. If production has 20 employees, R&D has 15, and administration has 10, the company would allocate indirect costs based on the ratio of employees in each department.

In this example, production would receive 40% of the indirect costs, R&D would receive 30%, and administration would receive 30%.

Finally, the company might allocate indirect costs based on the number of products produced in each department. If production produces 1000 products, R&D produces 500, and administration produces none, the company would allocate indirect costs based on the ratio of products produced in each department.

In this example, production would receive 67% of the indirect costs, R&D would receive 25%, and administration would receive 8%.

Example #3 of Allocation Being Used in Accounting Practice

Suppose a manufacturing company produces two products: Product A and Product B. To determine the cost of each product, the company must allocate the factory overhead costs, including utilities, rent, maintenance, and supplies, among other expenses. The overhead costs must be assigned to each product based on the proportion of total machine hours used to produce each product.

For example, if the company uses 60% of the total machine hours to produce Product A and 40% to produce Product B, then 60% of the factory overhead costs would be allocated to Product A and 40% to Product B. The company would then use the allocated overhead costs and the direct costs of material and labor to calculate the total cost of each product.

The allocation of overhead costs to each product is critical for the company to accurately determine the cost of goods sold and price its products competitively. The company can use an allocation method to ensure a fair and accurate picture of the costs of producing each product.

How to Do Cost Allocation in Simple Steps?

Cost allocation can be complex, but it doesn’t have to be. Here are five simple steps for cost allocation:

Step 1: Identify the Costs That Need to Be Allocated

The first step in cost allocation is identifying the costs that need to be allocated. This includes both direct and indirect costs. Direct costs can be easily traced to specific products or services, while indirect costs, such as rent and utilities, cannot.

Step 2: Choose the Appropriate Method of Cost Allocation

Once you have identified the costs that need to be allocated, the next step is to choose the appropriate cost allocation method. The most common methods include direct cost allocation, step-down allocation, sequential allocation, and activity-based costing. The method chosen will depend on the nature of the costs and the objectives of the cost allocation process.

Step 3: Determine the Allocation Base

The allocation base is the basis on which the costs will be allocated. This can be the number of units produced, the number of employees, or any other relevant factor that can be used to determine the cost of goods or services.

Step 4: Allocate the Costs

Once you have determined the allocation base, the next step is to allocate the costs. This can be done by dividing the total cost by the number of units, employees, or another relevant factor and multiplying this by the number of units, employees, or another relevant factor for each product, service, or department.

Step 5: Review and Adjust the Cost Allocation

Once the costs have been allocated, the final step is to review and adjust the cost allocation as necessary. This may involve reallocating costs based on new information or changes in the business.

Which Industries Can Cost Allocation Be Applied?

With the proper guidance, cost allocation can be applied to almost any industry. It’s all about the data you have and how you use it.

Let’s take a look at some of the industries that could benefit from cost allocation:

The healthcare industry is one of the most expensive in the world. It is also one of the most heavily regulated. These factors make cost allocation a necessity for many healthcare providers.

Healthcare organizations have many different costs, but the most significant sources are labor and supplies. Labor costs can be very high in this industry because it requires highly skilled people to perform various tasks, including surgery, patient care, and patient education. Supplies like bandages and IV bags are also expensive because they have to be sterile and meet regulatory requirements.

A hospital’s supply department has much control over its budget, but it also has little control over what happens in other departments, such as surgery or patient care. This makes it difficult to allocate costs accurately when they don’t know how much they will spend on supplies or how many patients they’ll see each year.

Cost allocation helps solve these problems by allowing managers to see which departments are consuming the most resources. They can adjust accordingly without guessing what’s happening behind closed doors (or behind locked doors).

Manufacturing

The manufacturing industry is one of the most common places where cost allocation can be applied. In this industry, it is crucial to know how much it costs to make each product and how much it costs to produce goods (including materials and labor) for sale.

With this information, manufacturers can determine how much they need to charge for their products to cover all of their expenses, including overhead costs like rent or electricity bills.

Cost allocation can also help manufacturers determine which products are more profitable than others so that they can focus on those areas instead of wasting time and money on less popular lines of goods. For example, suppose a company produces clothing and electronics but finds its clothing line more popular among consumers than its electronics line.

In that case, it may want to stop producing electronics altogether because there would need to be more demand for these products for them to make any money off of them.

This is an industry that benefits from cost allocation. Energy companies have long been able to allocate costs to different projects and branches, but they often face challenges when assigning overhead expenses. That’s because overhead costs are shared among the company’s functions, making them difficult to track.

Cost allocation software can help energy companies assign overhead expenses in a way that makes sense for each project or branch. The software also allows them to better understand where their money is going and gives them more flexibility in budgeting and forecasting future expenses.

Retailers are a great example of an industry that can benefit from cost allocation.

Retailers are often sold on the idea of one-stop shopping: you go to a store and buy everything you need, from clothing to food to furniture. But in reality, there are many different types of retailers, such as grocery stores, department stores, clothing stores, etc. And each has its own distinct set of costs for running that type of business. So how do these retailers know how much each product line contributes to their overall profits? They use cost allocation.

Cost allocation is a technique for allocating overhead costs across product lines based on their relative importance to the company’s overall performance. This way, retailers can determine which products contribute most (or least) to their bottom line and make decisions accordingly.

Information Technology

Information technology (IT) is one of the most significant cost allocation areas. IT costs are often divided into two categories: direct costs and indirect costs. The former refers to those costs that can be directly attributed to a particular project or product, while the latter refers to those costs that cannot be directly attributed.

Cost allocation in IT has many benefits. It helps managers determine how much it costs to develop a new product or service and where inefficiencies lie in their IT departments.

It also allows them to understand better how much revenue they’re generating from each product or service line, which will help them make better decisions about future investments in the company’s infrastructure.

Construction

This is one of the most apparent industries to apply cost allocation. Construction projects are often massive and complex, with many different stakeholders involved in the planning, execution, and completion of a project. It’s common for construction projects to have hundreds or thousands of contracts with hundreds or thousands of different suppliers.

Cost allocation helps ensure that those involved in the project are paid what they’re owed without overpaying anyone else who participated. It’s also used to ensure that a company only spends a little money on a project by ensuring that every expense is only charged once.

Transportation

This is the industry that can benefit the most from cost allocation.

Transportation has many parts that must work in unison to transport goods or passengers. It can be difficult to determine which part of a vehicle’s operation should be allocated to specific parts, and it usually requires a lot of math.

Cost allocation can make it easier for companies in this industry to understand which parts are costing them more than they expected so that they can make changes accordingly.

Food and Beverage

Food and beverage companies can benefit significantly from cost allocation. These companies are typically comprised of many different departments that must be managed to ensure the entire business runs smoothly. Each department has specific costs that it incurs, so allocating those costs among all of the departments will help you understand where your money is going and how it can be used most effectively.

Cost allocation is also helpful when dealing with food or beverage products because it allows you to track the costs associated with each product line and make sure you profit on every product line. This way, you know what kinds of products are selling well, which ones aren’t selling as well, and how much money each product line has made for your company.

Real Estate

This is one of the most common industries to use cost allocation methods. Real estate developers often create multiple project phases, which must be accounted for separately. The costs of these phases are usually allocated to determine how much profit (or loss) will be made in each phase.

This lets developers decide which phases should be completed first and what incentives may be offered to convince buyers to purchase units from those phases.

Utilities are another excellent example of an industry where cost allocation can be used.

They must deal with various costs, including purchasing raw materials, paying for labor, and buying equipment. The type of utility and the sector it operates in determine the cost of each of these. For example, a water utility may have very high costs for purchasing raw materials but low costs for labor and employee benefits because they only need a few employees or benefit packages.

Cost allocation can help utilities determine how much money they should spend on each part of their business so that they’re not overspending on one part while underinvesting in another.

Pros of Cost Allocation

Cost allocation is a common business practice. Companies use it to help determine the profitability of individual products, services, and departments within a company. Here are the pros of cost allocation:

Improved Decision Making

Cost allocation helps businesses make informed decisions by accurately determining the cost of goods or services. Companies can make informed decisions on pricing, production, and marketing strategies with a better understanding of the costs associated with producing a product or offering a service.

Better Resource Allocation

Cost allocation helps businesses to determine the costs associated with different departments, products, or services. This information can then be used to allocate resources more efficiently and allocate more resources to more profitable areas.

Increased Profitability

By allocating costs accurately, businesses can identify less profitable areas and make changes to improve profitability. This could involve reducing costs, improving efficiency, or adjusting pricing.

Better Budget Planning

Cost allocation helps businesses to create more accurate budgets. Companies can plan their budgets more effectively as they understand the costs associated with each product, service, or department.

Improved Internal Control

Cost allocation helps businesses to maintain better internal control over their operations. By allocating costs accurately, companies can track expenses and identify improvement areas. This helps to prevent fraud and embezzlement and increases accountability within the company.

Better Understanding of Overhead Costs

Overhead costs can be challenging to understand and allocate accurately. Cost allocation helps businesses to understand these costs better and allocate them to the proper departments or products. This allows companies to make informed decisions on pricing and production.

Improved Cost Reporting

Cost allocation helps businesses to produce more accurate cost reports. This allows companies to make informed pricing, production, and marketing strategies decisions. Cost reports are also essential for tax purposes and to meet regulatory requirements.

Better Negotiations

Cost allocation helps businesses to understand their costs better, which can be used in negotiations with suppliers and customers. Companies can better understand costs and negotiate better prices, terms, and conditions with suppliers and customers. This helps businesses to maintain better relationships and increase profitability.

Cons of Cost Allocation

Cost allocation can be an excellent tool for helping you understand where your money is going and how to save it, but this method has some drawbacks.

Time-Consuming Process

Cost allocation can be time-consuming and requires significant effort from various departments within the company. This can divert resources from other important tasks and may slow down other processes.

Increased Complexity

Cost allocation can be complex, especially for large organizations with multiple departments and products. This complexity can result in errors and misunderstandings, negatively impacting the accuracy of cost reports and other important financial information.

Implementing a cost allocation system can be expensive and require a significant investment in technology, software, and training. This cost can be a barrier for smaller organizations or those with limited resources.

Unreliable Data

Cost allocation is only as accurate as the data used in the process. Poor quality data, errors in data entry, and outdated data can all result in inaccurate cost reports and inefficient resource allocation.

Resistance to Change

Some employees may resist implementing a cost allocation system, especially if they feel the process may negatively impact their department or lead to job loss.

Limited Flexibility

Cost allocation systems are often rigid and lack the flexibility to adapt to changes in business conditions. This can result in inefficiencies and limit the ability of the company to respond to new opportunities or challenges.

Potential for Misallocation

If not implemented correctly, cost allocation can misallocate costs, negatively impacting decision-making and profitability.

Dependence on Cost Allocation

Overreliance on cost allocation can lead to a lack of creativity and initiative within departments. Employees may become too focused on cost allocation and need to be more focused on driving innovation and growth for the company. This can limit the ability of the company to adapt to changing market conditions.

Frequently Asked Questions- Cost Allocation in Accounting

What are the main objectives of cost allocation.

The main objectives of cost allocation are to accurately determine the cost of goods or services, improve resource allocation, increase profitability, create more accurate budgets, improve internal control, and provide better cost reporting.

What Is Direct Cost Allocation?

Direct cost allocation refers to assigning costs directly to specific products or services. This method is used when the costs can be easily traced to specific business areas.

What Is Step-Down Allocation?

Step-down allocation refers to allocating costs from one department to another department or product. This method is used when costs cannot be directly traced to specific products or services.

What Is Sequential Allocation?

Sequential allocation refers to allocating costs based on the sequence in which they are incurred. This method is used when costs cannot be directly traced to specific products or services.

What Is Activity-Based Costing?

Activity-based costing refers to allocating costs based on the activities involved in producing a product or offering a service. This method is used when multiple activities are involved in creating a product or service.

Why Is Cost Allocation Important for Businesses?

Cost allocation is essential for businesses as it helps them understand the costs associated with each business area and make informed pricing, production, and resource allocation decisions. This leads to improved profitability and better resource allocation.

How Does Cost Allocation Impact Resource Allocation?

Cost allocation helps companies determine the costs associated with each department, product, or service, which are used to allocate resources more efficiently. By allocating resources based on accurate cost

How Does Cost Allocation Impact Pricing Decisions?

Cost allocation helps companies understand the costs associated with each product or service used to make informed pricing decisions. By accurately determining the cost of goods or services, companies can ensure that their pricing is based on a solid understanding of the costs involved.

The Comprehensive Guide to Cost Allocation in Accounting – Conclusion

Allocation of costs is a critical component of any business. By allocating costs, you can ensure that your company makes the best use of its resources and operates efficiently.

The ability to allocate costs allows you to make strategic decisions about your business’s operations and management and take appropriate actions regarding financial reporting.

The Comprehensive Guide to Cost Allocation in Accounting – Recommended Reading

Corporate Accountant: What Are the Responsibilities, Duties, & Salary of a Corporate Accountant?

How Can Business Intelligence Help with Budget Planning (in 2023)

Standard Costing- Common Problems (And How to Solve Them)

 Updated: 5/19/2023

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Cost Allocation Uncovered: Methods & Calculations

What was that invoice for and where does the other bill come from? Unfortunately for numerous service companies, these questions are posed way too often, resulting in tons of additional spendings appearing out of thin air. Fortunately, there is one way to prevent this situation from happening - it’s called cost allocation.

Arkadiusz Terpiłowski

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Cost allocation - key takeaways

After reading this article, you should be able to: 

• define cost allocation and factor that affect it,
• identify the cost objects that need to be taken into account in the process,
• use the cost allocation formula and cost allocation method to assign spendings to departments and projects with great accuracy. 

Cost allocation - definition

Cost allocation is the process of matching the cost objects with the departments or operations that generate them. It is mostly used for calculating the financial performance of a company or its parts, such as teams or projects and determining where given costs objects came from.

For example, in a typical service company, costs can be allocated to non-production departments (i.e. marketing, sales, administration), as well as project and teams. 

What is the cost allocation used for? 

Alright, but what is the point of calculating all of these things? 

Cost allocation is very helpful not only when it’s time to sum up the employee performance, results of particular project managers or finances that may interest the stakeholders. On a daily basis, it can also help you: 

• make sure that budgets are on track - applies to the budget of the entire company, as well as finances of particular departments or projects, 
• point to the fields of operation that generate excessive costs and act on the information, 
• check whether the money is really spent on the right endeavors.

In other words, cost allocation is the process of identifying the source of the costs and evaluating its importance.

Types of costs in cost allocation 

Cost allocation involves all the people and assets in the organization. Therefore, it includes dozens of different types of costs that project managers and executives need to take into consideration while managing project budgets and other finances. 

Let’s take a look at the types of costs in cost allocation. 

Basic costs in cost allocation

In the simplest classification possible, costs in cost allocation are divided into 3 categories: 

Direct costs 

Direct costs in cost allocation are the spendings that have already been attributed to certain departments, projects or teams and there are no doubts as to their origin. These costs contribute to the profit billable operations are supposed to generate as they are required in the production processes. 

For example, in a service company direct costs are usually included in the project budget, or even a project timeline in general. They usually refer to the wages and salaries, but they may also cover other resources required for the project. Therefore, allocating costs such as this is basically a piece of cake, as they are generated directly by the department, services or other costs objects they are related to.

Indirect costs 

The definition of indirect costs in cost allocation is a bit more complicated, especially for endeavors closely related to professional services. These are costs that are not associated with any organizational unit in particular; they are simply needed to keep the company running and growing. 

The indirect costs usually involve the spendings made by all the support staff that help the production department do its job, as well as their wages These include cost objects such as: marketing and sales specialists, administration employees, and any other support department. Indirect costs also often refer to internal projects. 

However, there is one more type of indirect costs in cost allocation that we need to consider - the overhead costs. 

Overhead costs

Overhead costs cover all the costs that need to be continually paid regardless of the company's business performance . 

Project overheads vs organizational overheads

Overhead costs are usually divided into 2 categories:

• project overheads, for example equipment, subscriptions and programs, 
• organizational overheads, such as utilities, bills, rent, etc.
• cost of services needed to keep the company running, i.e. security expenses, business management, etc.

Cost allocation method

At this point you may ask yourself “How can I allocate costs on my own?”. Fortunately, the answer to this question is not as complicated as it may seem - here’s a cost allocation method that can help you. 

Cost allocation method - example

Some organizations, particularly service companies, profit only from their projects and they do not need to allocate the costs for the entire business - they just need to share the costs between the profitable operations and departments, as well as other cost objects. Here’s how the process of identifying them looks like. 

• Define which costs you want to allocate

First, calculate the costs you want to allocate in the first place. For example, if you want to allocate the cost of utilities in your office, add them to get a bigger picture. But let's see how examples of cost shape the profitability of the operations.

For the sake of this cost allocation example, let’s assume that The Best Company is focused on allocating costs of their support departments to the project for the month (also known as a business overhead). The costs include:

• the costs of marketing department - 40 000$, 
• the costs of administration - 15 000%
• the costs of the sales department - 45 000$. 

Together all these departments account for 100 000$ of additional overhead or expenses that need to be allocated. 

• Determine the base for sharing the costs

Depending on the type of business, you can divide the costs based on different factors. The most popular ones include: 

• billable hours tracked in the services, 
• generated income, 
• generated profit. 

For this example, we will use the former of indicators - the billable hours . That method is considered to be the simplest way of allocating costs in a proportional manner.

The Best Company has 2 projects - Project A and Project B. To complete all the activities planned in Project A for the month, the project managers and their team members will need 1800 hours. For Project B, the number of hours needed is 1200. Both projects combined require 3000 hours to complete. Therefore, Project A accounts for 60% of all billable hours in the company, while Project B includes only 40% of them. These are the proportions we are going to use in the cost allocation in this method.

• Allocate the costs proportionally

If Project A includes 60% of all billable hours while project B only accounts for 40% of them, we can now use the numbers to share the costs between them. Let's focus on identifying how should they contribute to it.

According to the examples above, he total amount of costs to be shared between billable operations is 100 000$. Project B requires more hours, therefore it should pay for a larger chunk of the costs - exactly 60% of them. As a result, 60 000$ of costs are allocated to the project. 

Project B, on the other hand, only requires 40% of all the billable hours. Therefore, it should pay 40% of the costs - 40 000$. 

What if I have more operations on my hands? 

Admittedly, the example we have shown you above is very simple and it only reflects the reality for small companies. But what if you have a little (or much) more operations on your hands? 

In that case, project scheduling software can help you - and Primetric is one of them. Here’s how it handles the most common cases of 

Cost allocation in Primetric - project estimates

Let’s start with a simple example of project budgets. 

In Primetric, you can create a project budget right after you create a project itself. That’s because the system performs the cost allocations for direct cost in each estimated phase of the operation. As a result, the predicted costs of work are displayed right after you estimate the number of hours needed to complete the job. 

Financial report in Primetric 

But what if the project has already started and you see whether it stays in the budget? The easiest way to check that is to use the financial report for a project. 

Such a report is capable of combining numerous financial data, including: 

• project and company overheads, 
• costs of each hour of work completed in the project, 
• the comparison of costs and incomes. 

As a result, it can automatically calculate the final profit margin for the project and show how much costs in the company a given operation covers. 

Costs allocation in settlements

Information on the costs in a project can be found in the Budget tab. There, the costs are divided into 4 categories: 

• a dashboard with a general overview of the costs, 
• 3 separate tabs for scheduled, not settled and settled costs. 

There you can monitor all the incomes and expenses in your project and manage them accordingly. 

Overheads in Primetric 

In Primetric, you can also add both recurring and one-time overheads to the project - there is a special section dedicated just to these costs. These costs are later added or subtracted from the monthly invoice. 

Primetric also contains information on company overheads, such as bills, support department or office costs. They also affect the profits from the projects - in fact, each and every one of them has to pay for a part of them! 

Company overheads are included in the financial statements as Indirect costs - the costs that are not generated by any project directly. The information can be used for determining the third degree margin, an ultimate indicator for the profitability of your projects. 

Cost allocation in settlements reports 

Last but not least, cost allocation is clearly visible in the Settlements section. There you can find all the information on overheads, costs, incomes, and more. 

Benefits of cost allocation 

Fortunately, cost allocation is not only a burden, but also a huge business advantage. 

Just to name a few of its benefits, it can help you: 

• determine whether your projects are profitable, 
• what part the project play in covering the organizational costs, 
• check whether the rates are high enough to cover all the costs and generate profits, 
• determine whether the indirect costs are not eating up the majority of company’s profits,
• identify the actual cost of services you provide to your customers, 
• find out which departments are spending more or less money, and what they use it for, 
• assign the lost spendings to the people, teams or departments responsible for them, 
• calculate the real profitability of your business as a whole.

Want to know more about budgeting? 

Great - we have just what you need. 

Visit our blog and read more about: 

• Jira invoicing and the features you will need to do it right, 
• forecasting revenue before it becomes a problem, 
• project success factors that may take a toll on your budgeting, 
• professional service automation capable of taking the calculations off your hands, 
• project budget management software you can use to make the finances as simple as possible. 

And if you want to find out if our solutions have what you need to allocate costs, book a demo with our advisors or start a trial right now! 

Arkadiusz is Head of Growth and Co-founder at Primetric. Prior to that, Arkadiusz was at the helm of his own software development company where he oversaw operations. A great enthusiast of process improvements, his personal mission is to make software companies more profitable and efficient on their path to growth.

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Cost Allocation

This page provides detailed guidance to help local governments in Washington State allocate indirect (overhead) costs, including key questions to consider and sample cost allocation plans and procedures.

It is part of MRSC’s Financial Policies Tool Kit , created in partnership with the State Auditor’s Office Center for Government Innovation .

What Is Cost Allocation?

Cost allocation refers to a process of accounting and recording the full costs of a government service by including its indirect costs or "overhead" in addition to its direct costs.

Direct costs are those that clearly and directly benefit a specific fund or program, such as supplies, materials, staff salaries and benefits, or consultant fees that support a single department or project.

Indirect costs , commonly referred to as "overhead costs" or central services, are for support services that are shared by multiple departments, programs and/or funds, such as accounting, payroll, administrative, or human resource salaries and benefits; information technology (IT) services for the entire municipality; or operating and maintenance costs for city hall or other buildings shared by multiple departments.

For example, the full cost of the Public Works Department includes its direct costs (wages, benefits, maintenance, and operations) plus the indirect costs/"overhead" of support services received from central services (such as accounting, payroll, and IT).

A cost allocation plan distributes these indirect costs to ensure that the respective funds are fairly and accurately paying for the services they receive.

Why Do Local Governments Allocate Costs?

There are a number of reasons that a local government should develop a cost allocation plan or system. A formal cost allocation system can help a jurisdiction:

• Identify the actual cost of services being provided to the citizens.
• Equitably share the costs of shared facilities and support services between departments, programs, and funds throughout the organization.
• Ensure accuracy of cost-based user fees for public services such as utilities, development review, parks, or any other service where the user pays a fee for service.
• Relieve pressure on the general fund by allocating certain general fund costs to enterprise or other funds that receive a benefit from support services.
• Comply with state law and minimize audit issues. RCW 43.09.210 requires that all service rendered by one department to another shall be paid for at its true and full value by the department receiving the service, and that no department shall benefit in any financial manner whatever by an appropriation or fund made for the support of another.
• Get reimbursement for allowable overhead costs from federal and state grants, to the extent that this is allowed by the grant. This usually requires a formal cost allocation plan with internal controls to assure accuracy. Federal monies require strict adherence to OMB’s Uniform Guidance (2 CFR 200) .

Basic Steps of Cost Allocation

The key to successful cost allocation is to establish an allocation system that is fair, equitable, and supported by current data. In particular, a cost allocation system should:

• Identify shared facilities or support services
• Identify the costs to be allocated
• Determine the allocation factors/methodology to distribute the costs equitably
• Allocate the costs
• Update and monitor the data and methodology to ensure the allocation remains fair and equitable over time

Step 1: Identify Shared Facilities or Support Services

Your jurisdiction should allocate costs for any services, staff, facilities, or equipment that benefit other funds or departments. Identify within central services or internal service departments any specific services that support multiple funds or departments (such as payroll, accounts payable, utility billing, and facilities and grounds maintenance).

For the purposes of this cost allocation methodology, these costs are referred to as indirect costs or "overhead."

Key questions to consider:

• What staff members or departments support multiple funds or programs? Common examples for smaller jurisdictions include finance directors, clerks/treasurers, payroll clerks, and facility maintenance staff. For larger jurisdictions, this may also include categories like city administrators, attorneys, human resources, and IT.
• What contracted services support multiple funds or departments? For instance, do you contract with a technology firm to provide IT services to your entire jurisdiction? Have you hired a company to maintain shared facilities or grounds?
• What facilities and equipment are used by multiple departments or programs? Are all of your departments and programs located in one central services or public works facility? Did you purchase a piece of equipment (such as a vehicle or a copier) that will be used by multiple departments?
• How should costs be allocated to your enterprise (utility) funds? Utility funds and other funds with restricted revenue sources should only reimburse for the actual benefit received from the services provided by other funds such as the general fund, internal service funds, motor pools, IT services, and others.
• Should you allocate costs associated with your elected officials? When considering whether to allocate these costs to restricted funds such as utilities, use extreme caution. The SAO will require documentation to support the fairness of these charges. Do the elected officials devote time every meeting to those enterprise activities? Consider using agenda items as the basis for allocating these costs.

Step 2: Identify Costs

Once you have identified these shared "overhead" functions, compile their total costs using timesheet data or other accounting of actual expenditures associated with this activity.

You can also allocate shared costs using budget projections, although in that case you should include a monitoring component at the end of the year to make sure the budget and the actual costs are within an acceptable range. If you are using projections, the cost allocation plan should define what the "acceptable range" is. For instance, the plan might state that the actual costs must be within 1% of the budgeted costs, or 5%, or somewhere in between.

For instance, below are two simple, fictional examples of cost allocation processes for payroll and facility maintenance.

Example A: Calculating Payroll Costs

The payroll department conducts payroll for all departments, so payroll costs can and should be allocated. To calculate the total cost of providing payroll services, you must calculate the number of hours that each staff member spends on payroll. The most accurate method of calculating this is to use timesheet data. Record the hours each staff member spent on the payroll function, along with their hourly pay rates and the prorated costs of benefits for those employees. Only include payroll hours - if the staff members providing payroll services also perform other duties, do not include the other duties.

If you do not have this level of timesheet data, it will be important to establish a process for hourly timesheet reporting over multiple pay periods to ensure accurate data collection. Conduct a periodic timesheet analysis to determine how the payroll staff spend their time over the course of a typical period (such as a quarter) and update this analysis at least once or twice a year.

Example B: Calculating Facility Maintenance Costs

Use the same method to calculate the maintenance costs for facilities that are shared by multiple departments. This example is for a hypothetical City Hall. Be sure to include the costs of materials and any contractors that provide janitorial or other facility maintenance services.

Step 3: Determine Allocation Factors

Next, determine a fair and equitable way to spread those costs among the various departments, funds, or programs that benefit from the shared services. Use numbers that are easy to gather or estimate and that can be easily updated in the future to keep the cost allocation plan current.

Remove any costs that should not be allocated, costs that can be assigned directly, and any other agreed upon revisions that do not diminish the "cost-basis" of the plan.

• Payroll and personnel: Number of full-time equivalents (FTEs) or number of hours worked within each department or fund.
• Accounts payable/purchasing: Number of transactions for each department or fund.
• Financial reporting and budgeting: Budget appropriation levels or year-end fiscal totals.
• Facility operations and maintenance: Square footage or number of employees in the building for each department or fund.
• Information technology: Number of computers, servers, databases, etc. for each department or fund
• How will you document the cost estimates? For instance, when allocating wages, salaries, and benefit costs for services such as payroll, budget development, or financial reporting, conduct a periodic timesheet analysis.

Example A (Continued): Determining Payroll Allocation Factor

Payroll costs largely depend on the number of employees your jurisdiction has, so the allocation factor is typically full-time equivalent (FTE) positions. This means that the cost of the payroll function is allocated to the different departments based on the number of FTEs within each department.

Example B (Continued): Determining Facility Maintenance Allocation Factor

Facility maintenance costs depend in large part on the size of the facility, so the allocation factor for facilities maintenance is typically square footage (SF). This means that the facility maintenance costs for City Hall are allocated based on the number of square feet that each department occupies.

Step 4: Allocate Costs

Next, allocate the costs by applying the allocation factors to each department, program, or fund based on their proportionate share (a "one-step" methodology). Again, be sure to thoroughly and consistently document your calculations.

Larger or more complex organizations would typically use either a "two-step" methodology (allocating overhead costs to direct users and to those departments that use the services of the direct users) or reciprocal allocation methodology (allowing for overhead to be allocated back and forth between departments).

Example A (Continued): Allocating Payroll Costs

The payroll overhead costs are being allocated on the basis of FTEs per department. The following chart shows what that might look like based on the size of the departments in this example.

Note that the Finance and Payroll Department cannot allocate all of the payroll costs to other departments and must retain some of those costs internally, because some of the time is spent on payroll for employees within the department.

In this example, Finance and Payroll would retain $1,270 of the payroll costs and allocate the remaining costs to the other departments.

Example B (Continued): Allocating Facility Maintenance Costs

The facility maintenance costs for City Hall are being allocated on the basis of square footage per department. The following chart shows what that might look like based on the how much space each department occupies within City Hall.

Step 5: Update and Monitor the Data and Methodology

You should periodically review your cost allocation formulas and data to make sure they continue to accurately reflect costs. Incorporating an annual review as a pre-budget development step will help enhance your budget forecasting numbers and update your cost methodology.

Key Questions to Consider:

• What are your internal controls to ensure data accuracy and reviews? Incorporating internal control measures into the cost allocation plan demonstrates a commitment to accurate and reliable data.
• Did you use estimates or budget projections (as opposed to actual costs) in your allocation process? If so, you should include a monitoring component at the end of the year to make sure that the estimated and actual costs are within the acceptable range as defined by your cost allocation plan. Any variances outside of the acceptable range will require adjustment.
• How often will you update your calculations? You should review and update your data at least once a year, and perhaps more frequently for some figures such as public works timesheet information.

Examples of Cost Allocation Plans and Documents

Below are examples of cost allocation plans, studies, and related documents that may be useful, focusing in particular on small to mid-size jurisdictions.

Cost Allocation Plans, Policies, and Studies

• Arlington Cost Allocation Policy (2017) - on pages 31-32 of the comprehensive financial policies
• Bainbridge Island Cost Allocation Manual (2017) - Detailed goals, background, and methodology for the city’s cost allocation plan.
• Bremerton Overhead Cost Allocation Memo (2012) - Recommendations from the city auditor on how to improve the city's cost allocation process
• Monroe Cost Allocation Plan (2014) - Short, three-page cost allocation plan, changes city’s cost allocation method from estimated costs to a two-year "look back" method. Includes adopting resolution.
• Napavine  Draft Central Services Cost Allocation Plan (2016) - Includes descriptions of central services and cost allocation methodology.
• Poulsbo Indirect Cost Allocation Plan  (2012) - Easy-to-understand cost allocation methodology for all city departments and functions
• Skagit County Central Services Cost Allocation Plan (2021) - Includes summary and detail components, financial information for internal funds, and reconciliation of net position.
• Stevenson Cost Allocation Plan (2016) - Short, four-page cost allocation plan.

Cost Allocation RFPs

• Kennewick RFP for cost allocation plan/comprehensive rate study (2010) - RFP for the development of a full cost allocation plan and a comprehensive fee and rate study for development-related services

Recommended Resources

Below are some useful resources from the State Auditor's Office (SAO) and Government Finance Officers Association (GFOA) to help you create an effective cost allocation system.

• SAO Resources Database: Cost Allocation - Simple, three-page overview, including common cost allocation mistakes
• SAO BARS GAAP Manual:  3.9.5 Overhead Cost Allocation
• SAO BARS Cash Basis Manual:  3.9.5 Overhead Cost Allocation
• GFOA:  Indirect Cost Allocation  (2014) - GFOA best practices
• GFOA: Pricing Internal Services (2013) - GFOA best practices for cost allocation for internal services such as IT, payroll, legal, and HR
• GFOA: Cost Analysis and Activity-Based Costing for Government (2004) - For-purchase publication

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Cost Allocation Base

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on April 01, 2024

Fact Checked

Why Trust Finance Strategists?

Table of Contents

Cost allocation base can be defined as a factor that is the common denominator for systematically linking a cost or group of costs to a cost object such as a department or an activity.

Where cost object is a product, the narrower term cost application base is often used.

Cost Allocation Base FAQs

What is a cost allocation base.

A cost allocation base is the unit, activity, or item that allocates costs in an organization. It can be used to measure and assign expenses to departments and activities accurately.

How does a cost allocation base work?

Costs are assigned to the appropriate department or activity based on the number of units of a resource consumed by each respective department or activity, such as labor hours or machine hours. The total amount of expenses for the period is then divided among the various departments and activities based on their usage patterns.

What types of costs can be allocated using a cost allocation base?

Most variable costs associated with production processes can be allocated using a cost allocation base, such as direct materials, wages and salaries, utilities, machinery, and equipment rental costs.

What are the benefits of using a cost allocation base?

Using a cost allocation base enables organizations to identify areas where costs can be reduced or controlled more efficiently. It also helps allocate accurate costs for each department or activity and provides the necessary data for pricing products and services accurately.

How often should a cost allocation base be updated?

Organizations should review their cost allocation bases regularly to ensure accuracy in allocating expenses. The frequency will depend on the size of the organization and how quickly resource consumption patterns change within that organization. Generally speaking, it is recommended to update your cost allocation base at least once a year.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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Create and manage Azure cost allocation rules

• 3 contributors

Large enterprises often centrally manage Azure services or resources. However, different internal departments or business units use them. Typically, the centrally managing team wants to reallocate the cost of the shared services back out to the internal departments or organizational business units who are actively using the services. This article helps you understand and use cost allocation in Cost Management.

With cost allocation, you can reassign or distribute the costs of shared services. Costs from subscriptions, resource groups, or tags get assigned to other subscriptions, resource groups or tags in your organization. Cost allocation shifts costs of the shared services to another subscription, resource groups, or tags owned by the consuming internal departments or business units. In other words, cost allocation helps to manage and show cost accountability from one place to another.

Cost allocation doesn't support purchases, including reservations and savings plans.

Cost allocation doesn't affect your billing invoice. Billing responsibilities don't change. The primary purpose of cost allocation is to help you charge back costs to others. All chargeback processes happen in your organization outside of Azure. Cost allocation helps you charge back costs by showing them as the get reassigned or distributed.

Allocated costs appear in cost analysis. They appear as other items associated with the targeted subscriptions, resource groups, or tags that you specify when you create a cost allocation rule.

Prerequisites

• A Microsoft Customer Agreement (MCA) in the Enterprise motion where you buy Azure services through a Microsoft representative. Also called an MCA enterprise agreement.
• A Microsoft Customer Agreement that you bought through the Azure website. Also called an MCA individual agreement.
• An Enterprise Agreement (EA) .
• To create or manage a cost allocation rule, you must use an Enterprise Administrator account for Enterprise Agreements . Or you must be a Billing account owner for Microsoft Customer Agreements.

Create a cost allocation rule

• Sign in to the Azure portal at https://portal.azure.com .
• Navigate to Cost Management + Billing > Cost Management .
• Under Settings > Configuration , select Cost allocation .
• Ensure that you select the correct EA enrollment or billing account.
• Select +Add .
• Enter descriptive text for the cost allocation rule name.

The rule's evaluation start date generates the cost allocation percentages and prefills them.

• Select Add sources and then select either subscriptions, resource groups, or tags to choose costs to distribute.
• Select Add targets and then select either subscriptions, resource groups, or tags to receive the allocated costs.
• If you need to create more cost allocation rules, repeat this process.

Configure the allocation percentage

Configure the allocation percentage to define how costs proportionally divide between the specified targets. You can manually define whole number percentages to create an allocation rule. Or you can split the costs proportionally based on the current usage of the compute, storage, or network across the specified targets.

When you distribute costs by compute cost, storage cost, or network cost, the proportional percentage is derived by evaluating the selected target's costs. The costs are associated with the resource type for the current billing month.

When you distribute costs proportional to total cost, the proportional percentage allocates by the sum or total cost of the selected targets for the current billing month.

Once set, the prefilled percentages defined don't change. All ongoing allocations use them. The percentages change only when you manually update the rule.

• Distribute evenly – Each of the targets receives an even percentage proportion of the total cost.
• Total cost – Creates a ratio proportional to the targets based on their total cost. It uses the ratio to distribute costs from the selected sources.
• Compute cost - Creates a ratio proportional to the targets based on their Azure compute cost (resource types in the Microsoft.Compute namespace. It uses the ratio to distribute costs from the selected sources.
• Storage cost - Creates a ratio proportional to the targets based on their Azure storage cost (resource types in the Microsoft.Storage namespace). It uses the ratio to distribute costs from the selected sources.
• Network cost - Creates a ratio proportional to the targets based on their Azure network cost (resource types in the Microsoft.Network namespace). It uses the ratio to distribute costs from the selected sources.
• Custom – Allows you to manually specify a whole number percentage. The specified total must equal 100%.
• When done, select Create .

The allocation rule starts processing. When the rule is active, all the selected source's costs allocate to the specified targets.

Here's a video that demonstrates how to create a cost allocation rule.

Rules processing

Rules are processed in the order in which they're created and can take up to 24 hours to take effect.

Let's look at an example. Assume that an active rule, Rule CA-1 , allocates costs from subscription A (the source) to subscription B (the target).

Later, a new rule, Rule CA-2 gets created. Its source is subscription A and its target is subscription C. So, the rule has no effect because costs for subscription A are zero. The costs are zero because Rule CA-1 is active. It already allocated all the costs from subscription A to subscription B.

Verify the cost allocation rule

When the cost allocation rule is active, costs from the selected sources distribute to the specified allocation targets. Use the following information to verify proper cost allocation to targets.

View cost allocation for a subscription

You view the effect of the allocation rule in cost analysis. In the Azure portal, go to Subscriptions . Select a subscription in the list that is the target of an active cost allocation rule. Then select Cost analysis in the menu. In Cost analysis, select Group by and then select Cost allocation . The resulting view shows a quick cost breakdown generated by the subscription. Costs allocated to the subscription appear, similar to the following image.

View cost allocation for a resource group

Use a similar process to assess the effect of a cost allocation rule for a resource group. In the Azure portal, go to Resource groups . Select a resource group in the list that an active cost allocation rule targets. Then select Cost analysis in the menu. In Cost analysis, select Group by and then select Cost allocation . The view shows you a quick cost breakdown generated by the resource group. It also shows cost allocated to the resource group.

View cost allocation for tags

In the Azure portal, navigate to Cost Management + Billing > Cost Management > Cost analysis . In Cost analysis, select Add filter . Select Tag , choose the tag key, and tag values with allocated costs.

View cost allocation in the downloaded Usage Details and in Exports CSV files

Cost allocation rules are also available in the downloaded Usage Details file and in the exported data. The data files have the column name costAllocationRuleName . If a Cost allocation rule is applicable to an entry in Usage Details or Exports file, it populates the row with the Cost allocation rule name. The following example image shows a negative charge with an entry for the source subscription. It's the charge getting allocated cost from. There's also a positive charge for the Cost allocation rule's target.

Azure invoice reconciliation

Azure invoice reconciliation also uses the Usage Details file. Showing any internal allocated costs during reconciliation could be confusing. To reduce any potential confusion and to align to the data shown on the invoice, you can filter out any Cost allocation rules. After you remove the cost allocation rules, your Usage Details file should match the cost shown by the billed subscription invoice.

Edit an existing cost allocation rule

You can edit a cost allocation rule to change the source or the target or if you want to update the prefilled percentage for either compute, storage, or network options. Edit the rules in the same way you create them. Modifying existing rules can take up to two hours to reprocess.

Current limitations

Currently, Cost Management supports cost allocation in Cost analysis, budgets, and forecast views. Allocated costs appear in the subscriptions list and on the Subscriptions overview page.

The following items are currently unsupported by cost allocation:

• Billing subscriptions area
• Cost Management Power BI App
• Power BI Desktop connector

The Usage Details API version 2021-10-01 and later supports cost allocation data.

However, cost allocation data results might be empty if you're using an unsupported API or if you don't have any cost allocation rules.

If you have cost allocation rules enabled, the UnitPrice field in your usage details file is 0. We recommend that you use price sheet data to get unit price information until it's available in the usage details file.

Cost allocation to a target doesn't happen if that target doesn't have any costs associated with it.

• Read the Cost Management + Billing FAQ for questions and answers about cost allocation.
• Create or update allocation rules using the Cost allocation REST API
• Learn more about How to optimize your cloud investment with Cost Management

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Additional resources

Fact Sheet | Building for the Future Through Electric Regional Transmission Planning and Cost Allocation

FERC’s new transmission and cost allocation rule, Order No. 1920, continues the essential work of the Commission – ensuring a reliable grid – by requiring the nation’s transmission providers to plan for the transmission we know we will need in the future. 

This rule adopts specific requirements addressing how transmission providers must conduct long-term planning for regional transmission facilities and determine how to pay for them, so needed transmission is built. The final rule reflects more than 15,000 pages of comments from nearly 200 stakeholders representing all sectors of the electric power industry; environmental, consumer and other advocacy groups; and state and other government entities. 

The grid rule contains these major elements:

• Requirement to conduct and periodically update long-term transmission planning to anticipate future needs.
• Requirement to consider a broad set of benefits when planning new facilities.
• Requirement to identify opportunities to modify in-kind replacement of existing transmission facilities to increase their transfer capability, known as “right-sizing.”
• Customers pay only for projects from which they benefit.
• Expands states’ pivotal role throughout the process of planning, selecting, and determining how to pay for transmission facilities.

Long-Term Regional Transmission Planning

More specifically, the rule requires each transmission operator to:

• Produce a regional transmission plan of at least 20 years to identify long-term needs and the facilities to meet them.
• Conduct this long-term planning at least once every five years using a plausible and diverse set of at least three scenarios that incorporate specific factors and use best available data.
• Apply seven specific benefits to determine whether any identified regional proposals will efficiently and cost-effectively address long-term transmission needs.
• Include an evaluation process to identify long-term regional transmission facilities for potential selection in the regional plan.
• Include a process giving states and interconnection customers the opportunity to fund all, or a portion, of the cost of a long-term regional transmission facilities that otherwise would not meet the transmission provider’s selection criteria.
• In the event of delays or cost overruns, reevaluate long-term regional transmission facilities that previously were selected in a regional transmission plan.
• Consider transmission facilities that address interconnection-related needs identified multiple times in existing generator interconnection processes, but that have not been built.
• Consider the use of Grid Enhancing Technologies such as dynamic line ratings, advanced power flow control devices, advanced conductors and transmission switching.

How to Pay for Transmission

The grid rule contains these cost-allocation provisions:

• Before applicants submit compliance filings, they must open a six-month engagement period with relevant state entities.
• Applicants must propose a default method of cost allocation to pay for selected long-term regional transmission facilities.
• Applicants may propose, a state agreement process that lasts for up to six months after a project is selected for participants to determine, and transmission providers to file, a cost allocation method for the selected facilities.

Enhanced Transparency, “Right-Sizing” and Interregional Transmission Coordination

The grid rule requires transmission providers to:

• Be transparent regarding local transmission planning information and conduct stakeholder meetings during the regional transmission planning cycle about the local process.
• Identify opportunities to modify in-kind replacement of existing transmission facilities to increase their transfer capability, known as “right-sizing,” when needed.
• Give incumbent transmission owners a right of first refusal to develop these “right-sized” replacement facilities.
• Revise existing interregional transmission coordination processes to reflect the new long-term regional transmission planning reforms. 

Order No. 1920 takes effect 60 days after publication in the Federal Register .   Compliance filings with respect to most of the rule’s requirements are due within 10 months of the effective date, while filings to comply with the interregional transmission coordination requirements are due within 12 months of the effective date.

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Innovations and efficiencies in generator interconnection workshop, staff presentation | building for the future through electric regional transmission planning and cost allocation, ferc takes on long-term planning with historic transmission rule.

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IT Cost Allocation

• 1 What is IT Cost Allocation
• 2 IT Cost Allocation Framework [3]
• 3 Strategies for IT Cost Allocation [4]
• 5 References
• 6 Further Reading

What is IT Cost Allocation

Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you want to separately measure costs. Examples of cost objects are a product, a research project, a customer, a sales region, and a department.

Cost allocation is used for financial reporting purposes, to spread costs among departments or inventory items. Cost allocation is also used in the calculation of profitability at the department or subsidiary level, which in turn may be used as the basis for bonuses or the funding of additional activities. Cost allocations can also be used in the derivation of transfer prices between subsidiaries. [1]

A central question in management accounting is the allocation of support department costs. Support departments provide services to operating departments that directly add value to a product or service in the firm. The increasing use of information technology (IT) has resulted in the creation of another important cost category that contributes to overhead costs. Although increases in IT spending are expected to increase productivity and profitability, the results were typically mixed. This phenomenon has historically been labeled “the productivity paradox.” Recently, IT has more rapidly increased productivity and profitability in various organizations, but the productivity increase has been erratic and inconsistent. To remain competitive, managers have had to respond to these technological changes by investing heavily in IT. Hence, justifying IT expenses has been an increasing conundrum for CIOs of most organizations. The paper provides insight into cost allocation methods that can be used to distribute IT costs. [2]

IT Cost Allocation Framework [3]

If there is no cost associated with the usage of IT resources by different business unit, than each unit will utilize the the IT resources to maximize its potential benefit to the detriment of the corporate as a whole. Thus, to ensure effective use of the IT resources there must be some association of cost or allocation between the internal demand and consumption by each business unit. A best practice allocation approach enables business transparency of IT cost and business drivers of IT usage so that thoughtful business decisions for the company as a whole can be made with the minimum of allocation overhead and effort. A well-designed allocations framework will ensure this effective association as well as:

• provide transparency to IT costs and the particular business unit costs and profitability,
• avoid wasteful demand and alter overconsumption behaviors
• minimize pet projects and technology ‘hobbies’

To implement an effective allocations framework there are several foundation steps. 1. Ensure the corporate and business unit CFOs’ support and the finance team resources to implement and run the allocations process. Generally, CFOs look for greater clarity on what drives costs within the corporation. Allocations allow significant clarity on IT costs which are usually a good-sized chunk of the corporation’s costs. CFOs are usually highly supportive of a well-thought out allocations approach. 2. Have a reasonably well-defined set of services and an adequately accurate IT asset inventory. If these are not in place, you must first set about defining your services (e.g. and end user laptop service that includes laptop, OS, productivity software, and remote access or a storage service of high performance Tier 1 storage by Terabyte) and ensuring your inventory of IT assets is minimally accurate (70 to 80 %). If there are some gaps, they can be addressed by leveraging a trial allocation period where numbers and assets are published, no monies are actually charged, but every business unit reviews its allocated assets with IT and ensures it is correctly aligned. The IT services defined should be as readily understandable as possible. The descriptions and missions should not be esoteric except where absolutely necessary. They should be easily associated with business drivers and volumes (such as number of employees, or branches, etc) wherever possible. In essence, all major categories of IT expenditure should have an associated service or set of services and the services should be granular enough so that each service or component can be easily understood and each one’s drivers should be easily distinguished and identified. Below are some examples of IT services and their consumption units. Note that you should orient your IT components and associated services into either ‘direct’ services, those easily identified as consumable by the business or by applications and those that are indirect services, which would then be billed through other direct services (a good example of an indirect service would be data center, which is then billed through servers, storage, etc).

3. Finance team must identify which costs are associated with which services once the service has been defined, the assets inventoried and consumption unit identified. They should work closely with your management team to identify a ‘cost pool’ for each service or asset component. Again, these costs pools should be at least reasonably accurate but do not need to be perfect to begin a successful allocation process. The structure of the financial allocation framework should allow you to drive to both holistic unit costs for each defined service (e.g., cost per Terabyte for Storage) as well as accommodate indirect services and overhead costs. Below is a diagram demonstrating how this financial framework could be defined:

4. The allocations framework must have an overall IT owner and a senior Finance sponsor (preferably the CFO). CFOs want to implement systems that encourage effective corporate use of resources so they are a natural advocate for a sensible allocation framework. There should also be a council to oversee the allocation effort and provide feedback and direction where majors users and the CFO or designate are on the council. This will ensure both adequate feedback as well as buy-in and support for successful implementation and appropriate methodology revisions as the program grows. As the allocations process and systems mature, ensure that any significant methodology changes are reviewed and approved by the allocation council with sufficient advance notice to the Business Unit CFOs. 5. Once the allocations are started, even if during a pilot or trial period, make sure there is transparent reporting. The leads team and leads should have a monthly meeting with each business area with good clear reports. The finance lead and the business unit finance lead must be included in the meeting to ensure everyone is on the same financial page. Remember, a key outcome is to enable the business users to understand their overall costs, what the cost is for each services and, what business drivers impact which services and thus what costs they will bear. By establishing this linkage clearly the business users will then look to modify business demand so as to optimize their costs. Further, most business leaders will also use this allocations data and new found linkage to correct poor over-consumption behavior (such as users with two or three PCs or phones) within their organizations. However, for them to do this they must be provided usable reporting with accurate inventories. The best option is to enable managers to peruse their costs through an intranet interface for such end-user services such as mobile phones, PCs, etc . There should be readily accessible usage and cost reports to enable them to understand their team’s demand and how much each unit costs. They should have the option right on the same screens to discontinue, update or start services.

Strategies for IT Cost Allocation [4]

Increasingly, IT managers need to communicate the value of IT and reduce costs while maintaining quality. As a result, they need more visibility into the full costs of IT services to understand the cost burden placed on IT by specific business units. There are many methods for determining this "cost allocation" -- the trick is finding the best approach to provide the most accurate data. Allocation strategies fall into six main categories:

• Even Spread - Dividing IT costs evenly among business units is the easiest way to perform cost allocation. With this approach, IT cost data is simply split into equal parts. For example, a company might spend $1M on server maintenance each year. If the company has 1,000 servers, that means they spend $1,000 annually per server. The Even Spread method makes good sense for a company that is in the early days of scrutinizing IT spending and wants to quickly establish a starting point.
• Manually Assigned Percentage – This method provides more accurate cost assignment than the Even Spread methodology. With this allocation model, someone in the company who can provide an educated guess of how costs should flow will assign percentages to various categories. For example, if the server maintenance team spent half of their time working on five troublesome servers, each of those servers could get 10 percent of the maintenance costs, or 50 percent of the total maintenance cost budget. This method recognizes there are generally some services consuming a greater share of IT resources than others. In many instances, the data in this method already exists in a spreadsheet-based financial model.
• Manually Weighted - With this allocation system, percentages are no longer important. Instead of adding up expense columns to total 100 percent, a model owner would plug in whole numbers, representing consumption or activity. The manual weightings have an advantage over percentages because they are rooted in solid numbers. With this approach, each asset (i.e. a server) is assigned its weighted share of the total expense and when totaled together, the named asset is linked to the cost of the particular application being supported (i.e. CRM).
• Direct Spend Weighting of Shared Expenses – This allocation strategy typically weighs shared expenses as a portion of overall spend. For example, an entire company may share a help desk or an email database, but dividing those expenses evenly across departments may neither be fair or accurate. To determine how much each department should pay, the cost-based method leverages other IT spending. Suppose a company has $10 million of shared IT expenses and $100 million of IT spending attributed to individual departments. The legal department spends $50 million on IT expenses, or half of the company's IT spending. Therefore, we can then assign half of the $10 million of shared IT expenses, or $5 million, to this department. Grand total for Legal: $50M + $5M = $55M. This strategy is advantageous because it requires no new data. The weighting of attributed dollars is the data.
• Activity Based Costing (ABC) – This method is even more accurate and tracks IT activity that actually happened -- as captured in a system of record -- and then uses those numbers to distribute shared costs. For example, helpdesk costs get allocated according to per-ticket costs that were driven by the helpdesk users. In IT, ABC is most popular where the usage data exists in a readily consumable format, so helpdesks and asset management systems are good sources of activity data. With ABC, each business division can be assured costs are being fairly allocated, not estimated. When a business unit can see they are being charged based on actual usage, they're less likely to object to the charge and more likely to be cognizant of how they're consuming IT services.
• Multi-dimensional – This strategy is a mix of strategies described above, in order to produce a new weighting. The multi-dimensional strategy consists of using two or more dimensions of data at once, in order to produce a single weighting for use in cost allocation. Picture a model with a cost pool of network charges, and above that, a pool of application charges. The goal is to allocate from network costs to the various applications. A multi-dimensional approach might say, "Take the web applications and multiply, for each one, (a) the number of logins, times (b) the number of critical network-related tickets." So, each web application gets a weighting that splits up a subset of network charges across the web applications.

Cost allocations are a core component of any IT financial model that aims to express cost in a manner that makes sense to business consumers. It is common to find several strategies in play at once, with strategies evolving over time and becoming more sophisticated when better data becomes available.

• IT Financial Management (ITFM)
• Technology Business Management (TBM)
• IT Chargeback
• IT Cost Optimization
• Federal IT Acquisition Reform Act (FITARA)
• Total Cost of Ownership (TCO)
• Activity-Based Management (ABM)
• Absorption Costing
• Cost Accounting Standards (CAS)
• Management Accounting
• ↑ Defining Cost Allocation -Accounting Tools
• ↑ Cost Allocation and Information Technology -Jamshed Jal Mistry
• ↑ A Framework for IT Cost Allocation -Recipe for IT
• ↑ Six Strategies for IT Cost Allocation -Spend Matters

Further Reading

• Control of Information Technology Costs by Allocating Costs to Users Louise Kloot
• IT Cost Allocation: The Gateway to Business Alignment and Mature Service Management...if done correctly Deloitte

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FERC shakes up power industry with landmark grid rule

By Zach Bright | 05/13/2024 01:44 PM EDT

The Federal Energy Regulatory Commission in a 2-1 vote approved the rule aimed at facilitating a massive build-out of the U.S. electric system.

Federal Energy Regulatory Commission headquarters in Washington. Francis Chung/E&E News

Federal energy regulators on Monday directed U.S. electricity grid operators to plan new transmission infrastructure that can deliver more renewable energy and defend against extreme weather.

A   divided Federal Energy Regulatory Commission said grid planners and transmission owners must look 20 years ahead to expected shifts in how electricity is produced and consider a range of long-term benefits to building and upgrading power lines. The vote for the rule, Order 1920, was 2-1.

FERC established new requirements for how the costs of building high-voltage power lines should be allocated among customers, pulling states deeper into issues around regional infrastructure.

Also Monday, FERC unanimously passed a separate rule, Order 1977, that gives it the authority to grant permits to electric transmission lines in certain instances where states do not act first.

The development of long-distance power lines that cross multiple states is increasingly dividing red and blue states. Many led by Democrats are adopting clean energy and climate goals that will require a larger grid, while some Republicans wary of a transition away from fossil fuels have questioned the costs of projects that may cross into their borders.

Monday’s FERC decision seeks to change federal and state approaches to regional planning that has made it harder to shift the nation to low-carbon technology. In areas where grid planning isn’t well coordinated among states, projections for rapidly expanding demand from data centers and the electrification of homes and vehicles is raising concern about grid reliability.

FERC Chair Willie Phillips called both new rules “giant steps” and said the transmission planning and cost allocation rule “cannot come fast enough.”

“Combined, these two new rules make the first significant FERC action on transmission policy in more than a decade,” Phillips said during Monday’s meeting.

New transmission projects spanning hundreds of miles are crucial if more renewable energy is to move from prime wind- and solar-producing areas of the Great Plains and Southwest to urban centers.

Seeking to expand the economic and political argument for a bigger and more resilient power grid, the Department of Energy has stressed the crucial role transmission lines can play in preventing or recovering from grid emergencies caused by weather assaults like Winter Storm Uri that rocked the Texas system in 2021.

Biden administration officials have said the existing regional transmission capacity needs to double to achieve a goal of cutting carbon pollution from the power sector by 2035. And electric utilities have been ratcheting down their use of coal. But power generation still accounts for nearly a quarter of U.S. greenhouse gas emissions.

Senate Majority Leader Chuck Schumer (D-N.Y.), who pushed FERC on the rulemaking, welcomed the final standards as talks on grid legislation languish in Congress.

“These new rules together with the Inflation Reduction Act will deliver lower costs for American families, cleaner air for our communities and a brighter future for the youngest generation and beyond,” Schumer said.

Beyond legal authority?

At FERC, the transmission policy debate has reflected a divide over clean energy and climate change. The two Democrats that form the commission’s current majority voted to pass the rule, with Phillips saying the rule presents strong opportunities for states to have a role in divvying up costs.

Commissioner Allison Clements, the other Democrat, called the rule “as common sense as it is historic.”

Commissioner Mark Christie, the lone Republican, voiced strong opposition to the rule, arguing that it “goes far beyond FERC’s legal authority and fails to perform our consumer protection function and the Federal Power Act.”

“This final rule is not a compromise,” he said during Monday’s meeting. “I was perfectly prepared to vote for this final rule, if it were a bipartisan compromise, if it preserved the state role that everybody sitting up here voted for two years ago.”

Clements diverged in her concurring statement from Christie’s view, saying “In reading the stridently worded dissent that I believe misrepresents the final rule and strains in its legal rationale, I can only surmise that ‘thou doth protest too much.'”

FERC has for months been under pressure to advance a final rule on transmission planning and cost allocation. More than 100 lawmakers and tech giants and private companies have sent letters with that message.

Now, attention turns to how states respond to FERC’s latest attempt at grid planning policy.

FERC’s new policy directs planners to seek agreement among state energy officials in setting cost-allocation formulas for multistate power lines. The FERC rule applies to grid planning organizations in the lower 48 states. The rule does not affect the Electric Reliability Council of Texas, the grid operator in most of the Lone Star state that is largely isolated from the rest of the U.S. power system.

FERC, as expected, did not act on a policy proposal that could have expanded planning requirements to interregional power line projects, which could advance development of the longest lines.

The nation’s major regional transmission organizations have only begun strengthening their interconnections in recent years. FERC has sought industry and advocacy group comment on an interregional planning policy and invited experts to weigh in on a possible rule that would require a minimum of transfer capacity between regions.

“Not everybody is going to get everything that they want. I don’t even get everything that I want,” Phillips said. “But that is the nature of these large proceedings and these large rules here at FERC.”

Reporter Peter Behr contributed.

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