Cost questions that need answers turn up in abundance when an organization engages in budgeting or planning. Accurate budgets and feasible plans are next to impossible without plausible cost figures for a wide range of cost objects. Trustworthy costing is equally essential for other core activities throughout the organization—measuring business performance, analyzing operations, managing the asset lifecycle, setting prices, validating the business model, and optimizing inventory flow, to name a few.
It is no overstatement to say that comprehensive, accurate costing is indispensable for running a successful business. In most businesses, responsibility for finding and assigning cost values falls primarily on the firm's cost accountants.
Mainstream costing methods include Cost allocation, a method for assigning values to certain cost objects, especially those that incur "indirect" costs. The method is a central component of traditional costing.
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 illustrate this process.
Costing examples below use cost objects familiar 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 and illustrate cost allocation and cost apportionmentin context with similar terms and concepts, focusing on four themes:
- Explaining cost allocation and cost apportionment principles.
- Showing how cost allocation works in assigning value to indirect costs.
- Examples showing how Activity Based Costing sometimes serves as an alternative to allocation approaches, essentially by turning direct costs into direct costs.
- What are cost allocation and cost apportionment?
- Allocation vs. apportionment: Is there a difference?
- What are the differences between direct and indirect costing?
- Example allocation: Indirect labor and materials.
- Example calculations: Allocations for the cost pool.
- How does Activity Based costing avoid allocation or apportionment by turning indirect costs into direct costs? Why do firms turn to Activity Based costing?
- Direct and Indirect Labor describes cost allocation for reporting indirect labor costs.
- See Overhead in Manufacturing, Administration, and Retail Selling for more on the role of cost allocation in financial reporting.
- Activity Based Costing explains how firms reduce the need for cost allocation by turning indirect costs into direct costs.
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 using somewhat arbitrary, or even subjective, rules.
- The other approach is more precise because it assigns cost portions using rules based on factors such as actual usage or consumption.
Unfortunately, there is no universal agreement on which term (allocation or apportionment) belongs to each of the points above. As a result, this article treats them as interchangeable terms.
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 arrangement is typical for IT departments, for instance, that provide support to other cost centers in the company.
- The IT department can measure some costs for individual cost centers directly. Measurable 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 merely reflect, for instance, the size of each cost center's user base.
Allocating Indirect Manufacturing Costs
Firms that manufacture products measure some of their costs for manufacturing labor and materials directly.
- 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. PVB allocates indirect costs as proportions of known direct cost items. The next section shows how PVB does this.
For example, consider a firm that manufactures mechanical assemblies from mechanical parts. The firm merely purchases some parts from suppliers, while it produces other parts from raw materials in its 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 of labor minutes or labor hours per product unit, for operating production equipment.
Indirect Manufacturing Charges
Some kinds of support costs are relatively easy to measure directly for specific 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 setup charges.
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 for each product unit.
- Purchase order costs for materials.
Companies typically order materials for entire batch runs, not for individual product units. They may also request materials sufficient for a given time span.
- Costs for packaging
Manufacturers sometimes package multiple product units in a single package. And, they sometimes fill numerous packages in a single packaging run.
- Equipment cleaning and maintenance costs.
These operations usually 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.
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|
|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|
|Setting up equipment||$375,000||26.4%|
|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.|
The simple cost allocation method appearing here uses only the indirect cost total from the Exhibit 3 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 (for example, 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 usually 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.
PVB allocation, however, can allocate the total indirect cos 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
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
- Product Beta:
Direct labor costs = $1,050,000.
Indirect cost allocation = 94.8% of $1,050,000
Allocating Indirect Costs to Product Units
Exhibit 4 shows how this allocation leads to indirect cost estimates per unit. Also, 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)
|10. Direct costs total |
(Exhibit 2, line 8)
|11. Total indirect costs |
(Allocation shown above)
|12. Revenues per unit |
(Exhibit 2, line 2)
|13. Direct costs per unit |
( = 10 / 9)
|14. Per unit Indirect cost |
( = 11 / 9 )
|15. Per unit Gross profit |
( = 12 − 13 − 14 )
|16. Gross profit margin |
( = 15 / 12 )
|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 equality 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 Activity 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.
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 problem is a particular concern when it is essential to know precisely 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 lifecycle 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 from the activities that go into it (for example, manufacturing machine set up and machinery 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.
Accountants then determine the total cost for each activity 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 provides more 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.