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Cost Allocation and Cost Apportionment
Definitions, Meaning Explained, Example Calculations

 

Traditional cost accounting may assign certain cost figures by somewhat arbitrary allocation or apportionment rules. This contrasts with activity based costing, which tries to assign all costs based on actual resource usage.

Cost accountants use allocation rules to assign the so-called indirect costs.

What Are Cost Allocation and Cost Apportionment?

Allocation and apportionment are accounting methods for attributing cost to certain cost objects. (A cost object is simply any item associated with a cost figure of its own). Under these methods, cost assignments rely on rules or formulas instead of measuring resource usage directly. Allocation and apportionment are therefore examples of indirect costing.

Assigning cost figures to specific cost objects is a central task in budgeting, planning, and financial reporting. As a result, costing may involve both cost accountants and financial accountants who may use any of several different approaches.

In business, costing usually means:

  • Firstly, finding cost totals for using resources such as human labor, supplies, energy, raw materials, inventory, or support services.
  • Secondly, assigning appropriate portions of the totals to individual product units, organizations, or events.

Direct costing methods are preferred, of course, whenever possible. However, accountants resort to indirect methods such as allocation when they cannot measure resource usage directly. Examples in following sections show how this is done.

Costing examples below use cost objects common to manufacturing firms, but the principles apply to many other settings and their cost objects as well.

Explaining Allocation and Apportionment in Context

Sections below further define, explain, and illustrate cost allocation and cost apportionment. Note especially that these terms appear in context with other terms and concepts, including the following:

Cost Allocation
Cost Apportionment
Direct Cost
Indirect Cost
Traditional Costing
Activity Based Costing
Production Volume Based
Cost Base
Cost Pool

 

Contents

Related Topics


 

Allocation vs. Apportionment:
Is There a Difference?

Many business people use the terms allocation and apportionment more or less interchangeably. However, others differentiate these terms as follows:

  • One of these approaches assigns costs on the basis of rather arbitrary, or even subjective, rules.
  • The other approach is more precise because it assigns costs using rules based on factors such as actual usage or consumption.

Unfortunately, there is no common agreement on which term (allocation or apportionment) belongs to each of the points above. As a result, this article treats them as interchangeable terms.

Direct vs. Indirect Costing
What Are the Differences?

The difference between direct and indirect (overhead) costs has to do with the firm's ability to assign cost figures to individual product units, service deliveries, sale closings, or organizations.

Allocating Internal Cross Charge Costs for Support Services

Organizations that support other organizations throughout the business may have to cross-charge their internal clients for services. This is a typical situation for IT departments, for instance, that support other cost centers in the company.

  • The IT department can measure some costs for individual cost centers directly. Measureable direct costs might include the number of personal computers provided to each department, data storage volume, data transmission volume, and transaction volume.
  • Other IT department resources, however, are shared, more or less continuously, among all cost centers. Total costs are known, of course, for such things as IT staff salaries, IT maintenance, and server system operation. The amount due to each cost center, however, is not easy to measure directly. As a result, these are indirect costs.

For indirect costs, the IT department may instead create an allocation rule so that it can cross-charge each department its fair share of the total. Rules for this sometimes reflect other factors they can measure directly. Cross charges might simply reflect, for instance, the size of each cost center's user base.

Allocating Indirect Manufacturing Costs

In product manufacturing, firms measure directly some of their costs for manufacturing labor and materials. So-called direct costs are costs they can assign to specific product units.

  • In an automobile assembly line, for instance, the number of labor minutes for each windshield installation can be measured directly and accurately.
  • Each windshield's materials cost can also be known directly and accurately.

Income statement and budget figures for direct labor and direct materials expenses are direct because the labor time and materials for each product unit are known. However, the Income statement cost figures for other cost items cannot be measured directly for individual product units. For example:

  • Labor costs for a mechanic who sets up the automobile assembly line for a production run are known but not easily assigned to individual product units.
  • The monthly rental costs for factory floor space are also known but not measured directly for each product unit.

Instead, under traditional costing, firms typically assign indirect costs like these by allocation or apportionment. The intent is to assign figures for indirect cost items to individual product units. One method they may use for this purpose is production volume based (PVB) allocation. In PVB, indirect costs are allocated as proportions of known direct cost items. The next section shows how this is done.

Example: Allocating Indirect Labor and Materials Costs

For example, consider a firm that manufactures mechanical assemblies from mechanical parts. The firm simply purchase some parts from suppliers, while it manufactures other parts from raw materials in its own machine shop. In such settings, traditional cost accounting classifies production costs as either direct or indirect costs.

Direct Manufacturing Costs

In manufacturing settings, direct costs are known, with near certainty, for each product unit. Examples could include the direct costs of labor and materials for each product unit.

  • Direct materials costs.
    For example, costs per product unit for purchased parts, machined parts, fasteners, and lubricants. 
  • Direct labor costs.
    For example, the cost for labor minutes or labor hours per product unit, for operating production equipment.

Indirect Manufacturing Costs

Some kinds of support costs are relatively easy to measure directly for specific time periods, batches, or production runs. At the same time, however, they are not so easy to measure for individual product units. Such costs are therefore indirect manufacturing costs. These could include the following:

  • Equipment set up costs.
    Firms set up production machines for each production run, not for each product unit.
  • Machine testing and calibration costs.
    Manufacturing firms perform these operations regularly and often, but they do not do so each product unit.
  • Purchase order costs for materials
    Companies typically order materials for complete batch runs, not for individual product units. They may also order materials sufficient for a given time period.
  • Costs for packaging
    Manufacturers sometimes package multiple product units in a single package. And, they sometimes fill multiple packages in a single packaging run.
  • Equipment cleaning and maintenance costs.
    These operations normally occur only after manufacturing many product units. 

Product Specific Cost Sources

Now assume that the firm produces two product models, Alpha and Beta. Exhibit 1 compares several characteristics of these products. Differences between Alpha and Beta have different implications for each product's direct and indirect manufacturing costs.

Comparing Products Product Alpha Product Beta
   Purchasing Materials
More materials purchase orders,
small orders
Fewer materials purchase orders,
large orders
   Production Runs Many production runs, smaller runs Few production runs, larger runs
  Machine Set ups Many machine set ups Few machine set ups
  Product Packaging One Product unit per package Four Product units per package
  Required Direct labor More direct labor hours Fewer direct labor hours
  Direct  materials Direct materials cost: High Direct materials cost: Low
 Selling Price High price Low price
 Exhibit 1.  Comparing products Alpha and Beta.

Direct Manufacturing Costs for Products Alpha and Beta

In one fiscal year, the firm manufactures and sells the following:

  • Product Alpha: 1,800,000 units at $3.00 each
  • Product Beta: 2,100,000 units at $2.00 each.

 The revenues and direct costs for these sales appear in Exhibit 2.

Comparing Products Product Alpha Product Beta Total
1. Product units manufactured and sold 900,000 2,100,000 3,000,000
2. Selling price per unit $3.00 $2.00  
3. Direct labor cost per unit $0.50 $0.50
4. Direct materials cost per unit $0.75 $0.50
5. Sales revenues ( = 1 * 2 ) $2,700,000 $4,200,000 $6,900,000
Direct costs
6. Labor costs total ( = 1 * 3 ) $450,000 $1,050,000 $1,500,000
7. Materials costs total ( = 1 * 4 ) $675,000 $1,050,000 $1,725,000
8. Direct costs total ( = 6 + 7 ) $1,125,000 $2,100,000 $3,225,000
 Exhibit 2. Direct costs and direct revenues for products Alpha and Beta.

Indirect Manufacturing Cost Totals for Products Alpha and Beta

The so-called indirect or overhead costs for manufacturing products Alpha and Beta are the total costs for support activities (overhead). Exhibit 3, below, shows the indirect cost totals for the period's production. 

Sources of Indirect Costs Alpha +  Beta Indirect % of Total Indirect
Purchasing materials $180,000 12.6%
Setting up equipment $375,000 26.4%
Packaging products $280,000 19.7%
Testing & calibrating machines $300,000 21.1%
Maintaining and cleaning Equipment $287,000 20.2%
Indirect cost total      $1,422,500 100.0%
 Exhibit 3. Support costs for the period's Alpha and Beta production. These costs are also known as indirect costs and overhead.

Exmple Calculations: Allocating indirect Costs for the Cost Pool

The simple cost allocation method appearing here uses only the indirect cost total from Exhibit 3's bottom line. Here, the total indirect cost line is the cost pool for allocation later to individual product units. A more complex example could, of course, use single items (e.g. Purchasing materials) as cost pools and then allocate each pool's costs by its own rules.

For this example, however, putting all indirect costs into a single cost pool is appropriate because allocation percentages will derive from a single direct cost item. That direct cost item is known as a cost base.

Selecting a Cost Base for Allocation

In traditional cost accounting, firms normally allocate the indirect cost total (cost pool), based on proportional usage of a designated resource they can measure directly (the cost base). This approach is production volume based (PVB) cost allocation.

Under PVB cost allocation, the total indirect cost could be allocated to each product based on factors such as the:

  • Production machine time for a product unit.
  • Direct labor time for a product unit.
  • Manufacturing floor space each product uses.

Other factors may also serve this purpose. For this example, however, the firm selects direct labor costs as the cost base for allocation. 

Using Direct Labor as a Basis for Allocation

Note that the indirect cost total from Exhibit 3 above is $1,422,500. And, the direct labor total (line 6 from Exhibit 1) is $1,500,000. From these figures, the firm allocates indirect labor cost to each product as a percentage of the product's own direct labor cost:

 Indirect labor cost / direct labor cost
        = $1,422,500 / $1,500,000 
        = 0.948
        = 94.8%

Direct labor costs for both products appear in line 6 of Exhibit 2. As a result, the indirect cost allocations are as follows:

  • Product Alpha:
          Direct labor costs = $450,00.
          Indirect cost allocation = 94.8% of $450,000
                                                    = $426,750.
  • Product Beta:
          Direct labor costs = $1,050,000. 
          Indirect cost allocation = 94.8% of $1,050,000
                                                    = $995,750.

Allocating Indirect Costs to Product Units

Exhibit 4 shows how this allocation leads to indirect cost estimates per unit. In addition, the Exhibit also shows the resulting gross profit and gross margin for each product unit.

Comparing products Product A Product B Total
9. Units manufactured and sold
(Exhibit 2, line 1)
900,000 2,100,000 3,000,000
10. Direct costs total
(Exhibit 2, line 8)
$1,125,000 $2,100,000 $3,225,000
11. Total indirect costs
(Allocation shown above)
$426,750 $995,750 $1,422,500
12. Revenues per unit
(Exhibit 2, line 2)
$3.00 $2.00  
13. Direct costs per unit
( = 10 / 9)
$1.25 $1.00
14. Per unit Indirect cost
( = 11 / 9 )
$0.47 $0.47
15. Per unit Gross profit
( = 12 − 13 − 14 )
$1.28 $0.53
16. Gross profit margin
( = 15 / 12 )
42.5% 26.3%
Exhibit 4. Indirect cost allocations per unit, along with the gross profit and gross margin result for each product.

Conclusions: Product Volume Based Allocation Example

  • Firstly, the estimated Indirect cost per unit is the same for both products, $0.47 (Exhibit 4, line 14). This must be the case because indirect costs for both products apply the same allocation rate ( 94.8%) to the same direct labor costs ($0.50 / unit).
  • Secondly, on a per unit basis, this costing method finds Product Alpha more profitable than product Beta. The Gross margin rate of 42.5% for Alpha compares with a Gross margin of 26.3% for Beta.

Note that this same example appears in the article "Activity Based Costing." That article compares costing results under Activitiy based costing to traditional costing results like those above. As a result, ABC finds different indirect costs and therefore different margins and profits for products Alpha and Beta.

Activity Based Costing Turns Indirect Costs Into Direct Costs

Cost accountants are well aware that allocated (or apportioned) costing methods can be problematic. The primary problem is that they do not always reflect actual resource usage accurately. This is is a special concern when it is important to know accurately the "true cost" of, say, manufacturing Product Alpha compared to the "true cost" of product Beta.

Accurate knowledge of these costs can be essential for the following:

  • Accurate financial accounting reports.
  • Effective product life cycle management.
  • Effective product portfolio management.

Nevertheless, there may be little assurance that cost allocation rules like those above accurately reflect real differences in product costs. 

Some Turn to Activity Based Costing

As a result, some organizations turn from allocation costing to activity based costing (ABC). ABC assumes the following:

  • Product production should be analyzed first in terms of the activities that go into it (for example, manufacturing machine set up and machine maintenance).
  • Then, the analyst measures the resources that go into each activity. Resources may include, for example, skilled labor hours, unskilled labor hours, electricity, fuel, replacement parts, and others.

The total cost for each activity is therefore determined by the very measurable costs of the resources it uses.

ABC then finds the cost of producing each product by referring to the product's usage of each activity. As a result, activity based costing essentially converts many of the indirect costs from traditional costing into direct costs.

  • The advantage to ABC is that it comes closer to accurate, direct measurement of some cost objects than does traditional cost allocation.
  • The disadvantage to ABC is that it is "accounting intensive," that is, it requires substantially more hours of analysis and accounting time than traditional methods.

For a complete introduction to ABC, see the article Activity Based costing.

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