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What is Cost Allocation? Definition & Process - YouTube
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- Today's video is all
about cost allocation.
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We're going to define cost allocation,
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explain the process, and provide examples
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to help you understand why
cost allocation is useful.
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(whip cracking and bell dinging)
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What is cost allocation?
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Basically a cost allocation system
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is a process for assigning costs
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to the different businesses, departments,
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or products that benefit from those costs.
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Also known as cost drivers.
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Throughout this video
we're going to illustrate
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cost allocation methods
using a fictional business,
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a chain of lemonade stands
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known as Lisa's Luscious Lemonade.
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If Lisa wants to know what it costs
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to produce a jug of lemonade,
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she needs to allocate several
different types of costs,
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or a cost pool, to each jug she produces.
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What types of costs are allocated?
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Now let's talk about the types of costs
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a business might allocate.
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There are three broad categories
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of costs used in cost counting.
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Direct costs.
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You can trace direct costs
right to the product or service.
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Lisa's Luscious Lemonade
has direct materials,
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such as lemons, sugar, and water.
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She also has direct labor for the wages
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she pays to employees
who make the lemonade.
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Indirect costs.
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Indirect costs can't be traced directly
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to a product or service,
but they are necessary.
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Indirect costs may be fixed or variable.
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Fixed costs stay the
same from month to month,
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no matter how the company's production
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or sales volume fluctuates.
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A few common examples of fixed costs
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include renting manufacturing equipment
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or a supervisor's salary.
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Variable costs increase when sales
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or production volume goes up.
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One example of a variable
cost is equipment maintenance,
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because a heavily used piece of equipment
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needs more frequent maintenance.
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Overhead costs aren't part of
producing a good or service,
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but they benefit the business as a whole.
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Some examples include
advertising, insurance,
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human resources, and wages
paid to the sales team.
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What are the four purposes
of cost allocation?
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So why bother with cost allocation?
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Because it provides several benefits.
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The first benefit is to justify costs
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for pricing or reimbursement.
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Cost allocation helps a business
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know how much to charge for
its products or services.
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For example, suppose Lisa bases the price
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of a glass of lemonade
on direct costs alone
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without allocating overhead costs.
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She would lose money on every
glass of lemonade she sells
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and eventually have to close up shop.
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Two, to measure the costs of inventory
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and cost of goods sold.
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Businesses also use cost
allocation for financial reporting.
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Generally Accepted Accounting Principles,
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otherwise known as GAAP,
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requires companies to match expenses
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with related revenues.
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For Lisa's Luscious Lemonade,
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this means Lisa can't expense the cost
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of lemons and sugar when
she buys ingredients.
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Instead she allocates
those costs to inventory
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where they remain until
she sells the lemonade.
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Once Lisa makes the sale she
can finally expense those costs
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as a part of cost of goods sold.
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Number three, to provide
information for decisions.
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Cost allocation gives
business owners and managers
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the information they need to make
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financial and economic decisions.
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A company might use GAAP
for its financial reporting,
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but GAAP isn't always helpful
for internal decision making.
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That's why many businesses
use activity-based costing
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in addition to the cost allocation
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used for financial reporting.
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In activity-based costing
a business assigns products
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to all of the overhead costs they can
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reasonably be assumed to have caused.
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This usually includes some, but not all,
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manufacturing overhead costs
and some operating expenses
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they don't assign to
products under GAAP rules.
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Say Lisa is considering
selling freshly baked muffins
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in addition to lemonade.
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Lisa needs to know the cost
of producing those muffins.
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Using activity-based costing,
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she can assign costs to each activity
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in the production process,
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allowing her to more accurately adjust
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her pricing methodology to
set a price that accounts
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for how much it costs
to create each muffin.
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Then she can compare
that cost to the price
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her customers are willing to pay
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and decide whether it's worth the effort
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and expense of producing and selling them.
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Number four, to motivate
managers and employees.
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Cost allocation can also help
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motivate managers and employees.
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For example, say Lisa has two shifts
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of employees making the lemonade.
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One shift uses more lemons and sugar
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but makes fewer jugs
of lemonade per shift.
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Maybe untrained employees
are making mistakes.
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Maybe someone is stealing products.
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Either way, allocating costs
to the different shifts
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has uncovered a problem
Lisa needs to look into.
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What is the process?
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Now that you know what cost allocation is
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and why it's important,
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let's dive into the process
for allocating costs.
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Step one, identify the direct costs
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that need to be allocated.
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For Lisa's Luscious Lemonade,
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the cost object is a jug of lemonade.
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For a larger, more complex business
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cost objects can be a product line,
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a department, or a branch.
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Allocating direct costs
is usually pretty simple.
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For example, if Lisa's Luscious Lemonade
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produced 50,000 jugs of lemonade,
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it should be easy to figure
out how much was spent
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on direct materials and direct labor costs
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and divide those numbers
by 50,000 to come up
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with a direct cost per jug.
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Step two, allocate overhead costs.
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Allocating overhead is
a bit more complicated
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because they're usually split
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between manufacturing and
non-manufacturing costs.
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Some overhead costs clearly
fall on one side or the other.
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For example, a factory
floor supervisor's salary
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is clearly a manufacturing cost,
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but what about costs that serve
all parts of an organization
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such as human resources?
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Or facilities costs which might include
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rent for the building,
insurance, janitorial services,
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and building maintenance.
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Different businesses allocate
these costs in different ways.
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For example, a manufacturer might allocate
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human resources based on the
headcount of the manufacturing
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versus non-manufacturing
parts of the business.
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Facilities costs might be allocated
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based on the square footage
of the manufacturing area
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versus sales and
administrative square footage.
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Electricity might be
based on machine hours.
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In a perfect world, a business
could keep a running total
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of total costs and allocate
them every month or quarter.
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But in reality businesses usually set
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a predetermined overhead rate
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and allocate that rate
using an allocation base.
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Ideally, the allocation
base should be a cost driver
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that causes those overhead costs.
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For a manufacturer that
might be direct labor hours,
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machine hours, or simply
the number of products
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produced in a given period.
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Let's recap.
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Now let's review what we
learned about cost allocation.
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Number one, cost allocation
allows a business
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to assign all of the different costs
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that go into creating a product or service
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to the appropriate cost center
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and adjust their budgeting accordingly.
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Number two, cost allocation
helps a business set prices,
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appropriately record inventory
and costs of goods sold
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in its financial statements
and journal entries,
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make better business decisions,
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and hold managers and
employees accountable.
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Number three, there are different methods
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for allocating indirect
costs and overhead,
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such as basing it on
headcount, square footage,
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machine hours, the
depreciation of various assets,
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or the number of products produced.
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Number four, and finally,
when allocating overhead
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most businesses calculate a
predetermined overhead rate
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and apply it to different products,
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departments, or projects.
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Hey, if you found this video
useful, hit that like button,
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and don't forget to subscribe.
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That's all for today.
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Good luck with your cost allocation.
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