Cost allocation

Allocating Indirect Costs

Cost allocation is the process of assigning indirect costs to cost objects.

Cost objects include products, activities, sub-units of the organization, customers, suppliers, and time periods.

For example, cost objects in a hospital could include a patient, the pediatrics department, or the first quarter of the fiscal year.

Each of these objects has direct and indirect costs associated with it.

Direct costs occur when resources are used for only one cost object.

For example, raw materials used by a specific product are considered direct costs of the product, while the product is the cost object.

Indirect costs, however, result from the use of resources by multiple cost objects. A machine that is used by many products is an indirect cost to those products.

The tracing of indirect product costs for planning purposes was performed using activity-based costing (ABC) Opens in new window.

Indirect product costs are part of the cost of providing a product and must be traced or allocated to the different products through the use of cost drivers.

The cost drivers are chosen to reflect the cause of the indirect costs. If the product uses the cost driver, indirect costs are traced to the product.

Ideally, the tracing of indirect costs through cost drivers will reflect the cost of using indirect resources.

Choosing cost drivers to trace indirect costs is appropriate, if the purpose is to make a planning decision with respect to the cost object. However, organizations allocate indirect costs to cost objects for other reasons besides planning decisions.

Allocating indirect costs through cost drivers is not necessarily best for the organization when control and external reporting issues are considered.

While ABC Opens in new window can be worthwhile, other indirect costs allocation mechanisms often prove more beneficial in motivating managers or influencing users of external accounting reports.

The choice of the cost allocation method is subjective, and ethical considerations must be taken into account.

Cost allocations for control purposes can adversely affect certain managers and benefit others. Cost allocation methods for external reporting are often chosen to minimize the organization’s tax liability.

The subjective nature of indirect cost allocations makes the process one of the most controversial in accounting. Inappropriate cost allocation mechanisms can lead to poor planning decisions, demoralized managers, and unhappy customers.

In spite of the potential drawbacks associated with cost allocation, the practice is ubiquitous in organizations.

For example, the costs of the human resources department are an indirect cost to other departments, and are commonly allocated to those departments.

For example, Enbridge Inc., an international energy transportation and distribution company, allocates the cost of its centralized services to its business operations based on budgeted costs established during the budget process.

These allocations allow management to assess the overall financial performance of each line of business. Business operations know in advance the allocated costs that they will receive in the upcoming budget year.

While allocated and budgeted costs might differ, the budget process acts as a mechanism to control costs. However, conflicts over cost allocations could arise between the different user groups and between the users and the centralized services due to the greater ambiguity of these costs.

In a similar fashion, the University of Pennsylvania allocates centralized services based on resources used in academic units. For example, library services are allocated to faculties based on student headcount, course units, and faculty headcount.

The university’s cost allocation system aligns with its internal budgeting and financial reporting framework of responsibility center management. This alignment promotes disciplined decision making, transparency, and creates incentives for accountability, stewardship, and revenue generation.

Indirect costs, such as IT and human resources departments and university libraries, arise because it is less expensive for the organization to have once centrally provided service that is then shared among many users than to have each user purchase its own service. In other words, economies of scale Opens in new window usually motivate the acquisition of the shared resource.

By analogy, it is usually cheaper for three people to share one larger pizza than for each person to buy her own smaller pizza, assuming they can agree on which pizza to share.

But once the larger pizza is purchased, the three must decide how to split the cost. The pizza cost can be shared equally, by amount consumed, or one person buys it.

The widespread use of cost allocation implies that many benefits also result from the practice. However, an organization should clearly identify why costs are being allocated and the effect of those cost allocations on management behavior.

Each cost allocation has planning, control, and external reporting implications. An organization must often make trade-offs among these considerations in choosing an allocation method.