There are two factors that are the biggest determiners of a business’s financial performance: revenue and costs.
To strike the balance between revenue and costs (and generate profit), businesses need to look at every dollar spent and ensure it’s generating value. But with businesses fielding multiple services, products, and projects, all with contributions from multiple departments, getting this level of insight is difficult.
If you want to understand the true costs of something, you need to look beyond the direct costs that are easily measured and attributed. Finance-savvy businesses use cost allocation to do exactly that.
What is cost allocation?
Cost allocation is a process businesses use to understand the “true” cost of a vertical, typically a product, service, project, or department. To find the true cost, all indirect costs are distributed (or allocated) to each vertical.
Each vertical has its direct costs—these are the costs that are only used by the one vertical and no others.
For example, products that are manufactured have the direct costs of the materials used in the production process. Or when looking at the departments of a business, the direct costs include the salary and wages, software, and equipment each team employs.
But only looking at the direct costs underestimates the true costs of a vertical. Maybe the factory rented also houses the offices of specific teams, machinery used in the production of multiple goods, or employees doing work that aids different departments.
Through cost allocation, portions of indirect costs (like overhead costs and operating expenses) are allocated to specific verticals to get a clearer measure of how much they really cost.
What is cost allocation used for?
Cost allocation is used to optimize prices, set budgets, and perform financial analysis. The true costs of something inform how the business must plan and operate to maximize profits.
The most common way businesses leverage cost allocations in their operations include:
- Setting prices: By understanding the true cost of a good or service through cost allocation, businesses can set prices that cover all costs and help generate profit consistently.
- Evaluating performance by vertical: When comparing products, services, or departments against each other, cost allocation gvies you a clearer picture of the true cost helping you determine if its proportional to the value created.
- Building budgets: Cost allocation helps bridge the gap between overhead costs and costs of operation. This helps businesses determine how much they’re able to spend while maintaining profitability.
If you want to understand your business’s finances at a granular level, you need to understand how to use cost allocation. The extra steps pay off by giving you the clearest picture of how costs are distributed across the business.
What are the components of cost allocation?
There are three main components of cost allocation you need to know about.
The first is cost objects—what you will be allocating costs to. The most common examples of cost objects are products, services, projects, and business departments.
The second is cost pools—the costs that you will be allocating. Cost pools are a way of grouping individual costs that are not associated with one specific business operation.
There are no set cost pools or specific amount of cost pools that you should be using. Ultimately, it’s up to you to determine how specific you want to get. The more cost pools you use, the more complex the process.
Some examples of cost pools are utilities, rent, labor, and administrative costs.
Finally, there’s the allocation base (or allocation rate)—the percentage you will use to allocate the costs. There are various ways to find an allocation base with the most common examples being:
- Percentage of total revenue generated by a product or service
- Total labor hours or number of full-time employees by department
- Total square footage used by department, production of a good or service, or project
- Machine hours used in the manufacturing of a product
Allocation bases are typically different for each cost pool. For example, you could use a square footage allocation base for rent and utilities and a labor hours allocation base for salary and wages.
It’s essential to understand cost objects, cost pools, and allocation bases. These three components are used in every cost allocation process.
Types of costs in cost allocation
There are three types of costs that are included in the cost allocation process.
Direct costs are the easiest as they are the costs that are unique to the cost object. For example, if you were to look at the costs of different departments, the labor and software that are used by only one department are the direct costs.
Indirect costs cannot be directly connected to a single cost object as they benefit multiple cost objects. Some examples include software used by multiple teams, machinery used in multiple production processes, or a vehicle that was used on multiple projects.
Overhead costs are a subcategory of indirect costs. These are costs that aren’t necessarily a benefit to any cost object, but are a necessary part of “keeping the lights on.” Common examples are rent and utilities.
In the cost allocation process, direct costs are accounted for first and added directly to the cost objects. Then indirect costs and overhead costs are put into cost pools before being divided into the cost objects based on the allocation rate.
What are the different methods of cost allocation?
There are multiple methods of cost allocation, each best suited for a different use case. These are the three most commonly used by SMBs and their specific uses.
Direct allocation method
The direct allocation skips cost pools and directly allocates any indirect and overhead costs to the cost objects.
In this method, the business determines the percentage of allocation using a predetermined allocation base. The allocation base could be based on an estimate or calculated using a factor like labor hours used or square footage used.
This is the simplest cost allocation method. The direct allocation method is best suited for simple businesses or someone who is trying cost allocation for the first time.
Step-down allocation method
The step-down allocation method (or sequential allocation method) is most commonly used when performing cost allocation at the department level. In this example, cost pools are support departments and cost objects are revenue-generating departments.
This method is a step-by-step process of allocating costs one support department at a time until there’s only revenue-generating departments left. It starts with the highest costing support department and works down towards the lowest costing support department.
Say a business has four departments: IT, administration, e-commerce operations, and retail operations. In this example, both operations teams are revenue-generating departments. We’ll also establish that administration is the highest costing department.
The first step would be to allocate the administration department's cost across all support and revenue-generating departments. Then the IT department’s total costs (including the allocated administration costs) are divided across the two operation departments.
At each step, the allocation base is recalculated based on the departments that are left to have the costs allocated across.
This method is best used by businesses with multiple service departments and revenue-producing departments. It only applies to cost allocation by department.
Activity-based costing method
The activity-based costing method is most commonly used when performing cost allocation at the product level. The process is intended to connect all indirect and overhead costs to specific goods or services.
First, the business defines what the cost objects are. The cost objects are what all other costs will be allocated toward.
Before doing any cost allocation, the direct costs (the costs of fulfillment) are added to each cost object.
Then, the business bunches indirect and overhead costs into cost pools. Some examples of cost pools include labor costs, machine costs, rent or real estate costs, and utility costs.
An allocation base is then calculated for each cost pool. For rent or real estate costs, the allocation base could be calculated based on the square footage required for production of the good or service.
One-by–one, the business distributes the cost in each cost pool to each cost object using the allocation base until there are no more cost pools left. What they’re left with is the true cost of each cost object.
Main steps in cost allocation methodology
While there are different approaches to conducting cost allocation, there are five steps to the process.
1. Identify the cost objects
Cost objects are what the costs will be allocated to. The most common examples of cost objects are specific products, services, projects, and business departments.
For example, a clothing manufacturer could use the products they produce as cost objects. In this case, they might use t-shirts, sweatshirts, and pants as the cost objects.
Alternatively, you may want to look to understand the costs of each department. In this case, you could use marketing, human resources, operations, sales, and finance as cost objects.
The cost objects you use should reflect the type of analysis you’re trying to conduct.
2. Calculate all associated costs
Gather all costs that you’re looking to allocate into cost pools.
Cost pools are a way of grouping all direct and indirect costs before allocating them to cost objects. Common examples include labor costs, rent or real estate costs, machine costs, utilities, and administrative costs.
3. Choose a cost allocation method
Once you have the cost objects and cost pools, it’s time to choose your cost allocation method.
As covered above, the cost allocation method plays a big role in how the calculation is done. As a general rule of thumb:
- A simple cost allocation process uses the direct allocation method
- Cost allocation by department uses the step-down allocation method
- Cost allocation by product (or other revenue generator) typically use the activity-based costing method
If you’re doing cost allocation for anything else, choose the method that you think best applies to your situation.
4. Choose an allocation base
An allocation base needs to be chosen for each cost pool. What you use to determine the allocation base should reflect the costs that will be distributed.
For example, you may want to use hours worked as an allocation base for the labor cost pool.
Say you have $100,000 in labor costs and you’re looking to allocate it to two cost objects: product A and product B. The production of product A accounted for 60% of hours worked and the production of product B accounted for 40% of hours worked. Those percentages would be used as the allocation base.
In this example, $60,000 of the labor costs would be allocated to the cost object of product A and $40,000 would be allocated to the cost object of product B.
5. Allocate all cost pools to cost objects
Step-by-step, each cost pool is allocated to cost objects until there are no cost pools left. Once all cost pools are distributed, you’ve completed the cost allocation process.
With a more accurate representation of the cost behind each cost object, you can start to analyze the profitability and performance of each. Analyze these numbers to start making data-informed decisions.
Benefits of cost allocation
Cost allocation helps businesses understand the true cost of a department, product, project, or other cost object. This is crucial information used in decision-making throughout the organization.
The biggest impact is on your financial reporting. By understanding your business through vertical slices, you get granular detail on what’s driving costs and whether they’re proportional to the value generated.
Getting this level of insight guides budgeting decisions. You have more information to set spend levels, cut costs, and optimize expenses with a smaller focus. Instead of looking at the organization as a whole, you can optimize for each department or project on the go.
It’s also essential information for setting prices. By looking beyond the direct costs, you can set prices that cover all costs and ensure profit is being generated.
Cost allocation should absolutely be used by any business that’s looking to compare costs across different aspects of their business. The process will uncover tidbits on what the true costs are and help guide the strategic decision-making that maximizes profits.
Challenges of cost allocation
Cost allocation is a complex process that requires a high level of stats to be done properly. A business’s current setup might not have the metrics needed immediately handy and may need to change its reporting to accommodate the practice.
The main complexity comes from defining the allocation base. Say you want to use labor hours to determine the allocation base, would you have accurate hours worked per cost base readily available? What about hours of machinery used in production?
You can still perform a rudimentary cost allocation calculation using rough estimates, but then the output won’t be as accurate and the conclusions will be less definitive.
The cost allocation process can also take a lot of time. Reporting needs to be compiled from multiple sources before the process actually begins.
To combat these pain points, it’s best to set time aside to lay the groundwork needed to streamline each repeated instance of the process. Make tracking the needed stats part of the workflow, centralize reporting with spreadsheets or software, and use templated reporting to cut down on both work and errors.
Cost allocation example
A bike manufacturer makes kids', road, and mountain bikes. They’ve manufactured 1,000 units of road and mountain bikes and 500 units of kids’ bikes. Throughout the process, they tracked the labor hours and machine hours used in the manufacturing process, the direct costs, and the total amount of square footage used in the storage of each model (seen below).
Next, they start to tally up their indirect costs and assign them to a cost pool.tt
With their cost pools set up, they need to determine their allocation base. To do so, they use percentage of total labor hours, percentage of storage (by square feet), and percentage of machine hours.
Now that the cost objects, cost pools, and allocation rate are defined, they can complete the cost allocation calculation. They sum up the costs for each cost pool and multiply it by the allocation base for each cost object (model of bike).
Using the cost allocation process, the manufacturer gets clarity into the true cost of each model and can use this information for setting prices.
Understanding and optimizing your expenses
The practice of cost allocation is dedicated to providing finance teams the information they need to manage expenses and budgets to optimize a business’s financial health. Every insight is valuable and some insights can come with no extra work.
With BILL Spend & Expense, expense and budget management is streamlined to save time on the execution and free up time for analysis. Set spend controls and policies that guarantee everyone is sticking to the spend plan so profits are protected.
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*Based on a survey of 127 BILL Spend & Expense users conducted by UserEvidence in March 2022.
