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What Does Allocation Mean In Accounting

What Does Allocation Mean In Accounting

Published: October 12, 2023

Learn the meaning of allocation in accounting and its importance in finance. Gain a clear understanding of how allocation impacts financial statements and decision-making processes.

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Table of Contents

Introduction, definition of allocation, purpose of allocation in accounting, types of allocation methods, direct and indirect costs, importance of allocation in financial reporting, challenges and limitations of allocation in accounting, examples of allocation in accounting.

In the world of accounting, allocation is a fundamental concept that plays a crucial role in accurately representing financial transactions and the overall financial health of an organization. Allocation refers to the process of distributing costs, expenses, or revenues among various departments, activities, or products. By allocating these resources, companies can measure performance, make informed decisions, and adhere to accounting principles.

Every financial transaction involves the utilization of resources, and allocation ensures that these resources are appropriately assigned to the relevant entities. Whether it’s allocating costs to different departments, assigning revenues to different product lines, or distributing expenses to different activities, the concept of allocation allows for a fair and equitable distribution and reporting of financial data.

Allocation is a crucial aspect of financial reporting as it helps organizations accurately reflect the usage and impact of resources across different areas of their operations. It allows for a more comprehensive assessment of profitability, efficiency, and effectiveness. Additionally, allocation is a fundamental component in budgeting, cost analysis, and decision-making processes.

In this article, we will explore the concept of allocation in accounting, its purpose, various methods used for allocation, and its importance in financial reporting. We will also discuss some challenges and limitations associated with allocation and provide examples to illustrate its practical application in accounting.

In the context of accounting, allocation refers to the systematic allocation of costs, expenses, or revenues to different entities, such as departments, activities, or products. It involves distributing these financial elements in a fair and reasonable manner, ensuring that each entity bears its appropriate share of the financial burden or benefits.

Allocation is necessary because resources, costs, and revenues within an organization are often shared or incurred collectively. For example, overhead costs, such as rent, utilities, or administrative expenses, are typically incurred for the entire business but need to be allocated to specific departments or products based on their proportional usage or benefit.

By allocating these costs, expenses, or revenues, companies can accurately track the financial impact of various entities within their operations. Allocation helps in measuring performance, evaluating profitability, and making informed decisions regarding resource allocation and pricing.

There are different methods of allocation, which we will explore in detail in the following section. These methods can include direct allocation, where costs are allocated based on a direct cause-and-effect relationship, or indirect allocation, where costs are allocated based on an allocation key, such as square footage, headcount, or revenue percentages.

Overall, allocation is a fundamental concept in accounting that ensures the proper distribution and reporting of financial data. It enables companies to have a clear understanding of how costs, expenses, and revenues are distributed throughout their operations, allowing for effective financial management and decision-making.

The purpose of allocation in accounting is multifaceted, serving various important functions within an organization. Let’s explore the key purposes of allocation in accounting:

  • Profitability Evaluation: Allocation helps in assessing the profitability of different departments, activities, or products. By allocating costs and revenues appropriately, companies can identify the true costs associated with each entity and determine their individual profitability. This information is crucial for decision-making, resource allocation, and identifying areas for improvement.
  • Cost Control and Analysis: Allocation allows companies to gain a better understanding of the costs associated with different aspects of their operations. By allocating costs to specific entities, management can analyze cost patterns, identify cost drivers, and implement strategies to control and manage expenses. This helps in improving cost efficiency, identifying areas of wastage, and optimizing resource allocation.
  • Performance Evaluation: Allocation helps in evaluating the performance of different departments or activities within an organization. By allocating costs and revenues, companies can measure the performance of each entity based on their contribution to the overall financial results. This information is valuable for performance appraisal, goal setting, and incentivizing employees based on their individual and collective performance.
  • Decision-Making: Allocation provides reliable financial data that is essential for making informed decisions. By accurately allocating costs and revenues, companies can determine the financial implications of different options, evaluate the profitability of potential investments, and assess the financial impact of strategic decisions. Allocation helps in aligning financial information with decision-making processes, ensuring that decision-makers have a complete and accurate picture of the financial consequences.
  • Compliance with Accounting Principles: Allocation is essential for adhering to accounting principles and standards. Proper allocation ensures that financial reporting reflects fair and accurate representation of transactions and events. It helps in complying with regulations, such as the matching principle, by allocating expenses to the appropriate period and recognizing revenues in the relevant accounting period.

In summary, the purpose of allocation in accounting is to evaluate profitability, control costs, assess performance, facilitate decision-making, and ensure compliance with accounting principles. By accurately allocating costs and revenues, companies can gain valuable insights into their financial performance, make informed decisions, and maintain transparency in their financial reporting.

There are several common methods used for allocation in accounting. The choice of allocation method depends on the nature of the costs or revenues being allocated and the available data for determining the allocation basis. Let’s explore some of the most commonly used allocation methods:

  • Direct Allocation: Direct allocation is used when costs or revenues can be traced directly to a specific department, activity, or product. For example, if a manufacturing department incurs direct labor costs, those costs can be directly allocated to the specific product being produced. Direct allocation is straightforward and based on a cause-and-effect relationship.
  • Step-Down Allocation: Step-down allocation, also known as sequential allocation, is used when costs need to be allocated from one department to another in a sequential manner. This method considers the hierarchical relationship among departments. The costs are allocated from one department to the next, and the final department receives the allocated costs from all preceding departments.
  • Allocation by Proportions: This method involves allocating costs or revenues based on predetermined proportions. For example, if two departments share a common cost, such as rent, the costs can be allocated based on the proportionate usage or square footage of each department. This method ensures a fair allocation based on the relative consumption or benefit of each entity.
  • Activity-Based Allocation: Activity-based allocation involves allocating costs based on the specific activities that drive those costs. This method takes into consideration the cost drivers or factors that directly influence the incurrence of costs. For example, if maintenance costs can be directly attributed to specific manufacturing activities, the costs can be allocated to those activities based on their usage or time spent.
  • Allocation by Revenue: This method involves allocating costs based on the revenue generated by each entity. It assumes that the revenue generated is a fair indicator of the benefit derived from the shared costs. For example, if overhead costs need to be allocated to different products, the costs can be allocated based on the proportion of revenue generated by each product.

It’s important to note that the choice of allocation method can have a significant impact on the outcome and interpretation of financial data. Companies should carefully consider the nature of the costs or revenues, the available data, and the objectives of the allocation process when selecting an appropriate method.

Additionally, it’s common for companies to use a combination of allocation methods to ensure a comprehensive and accurate representation of costs and revenues across different entities. The specific allocation methods chosen will vary based on the unique circumstances and requirements of each organization.

In the context of allocation, it is important to understand the distinction between direct costs and indirect costs. These terms refer to different types of costs and impact the allocation process in accounting.

Direct Costs: Direct costs are expenses that can be easily and specifically traced to a particular department, activity, or product. These costs have a direct cause-and-effect relationship with the entity being allocated. Examples of direct costs include direct labor costs, direct materials, and direct expenses that are incurred directly in the production or provision of a specific product or service. For instance, the cost of raw materials used to manufacture a product or the wages paid to workers involved in the production process are considered direct costs.

Indirect Costs: Indirect costs, also known as overhead costs, are expenses that cannot be directly attributed to a specific department, activity, or product. These costs are incurred for the overall benefit of the organization as a whole. Indirect costs are shared among multiple entities and require allocation based on an allocation key or basis. Examples of indirect costs include rent, utilities, administrative salaries, and depreciation of shared assets. These costs need to be allocated to different departments, activities, or products based on an appropriate allocation method, such as square footage, headcount, or revenue percentages.

The distinction between direct and indirect costs is essential for accurate financial reporting and cost analysis. Allocating direct costs ensures that the specific entities responsible for incurring those costs are properly accounted for. On the other hand, allocating indirect costs allows for a fair and equitable distribution of shared expenses across relevant entities based on their proportional usage or benefit.

It’s worth noting that some costs may have elements of both direct and indirect characteristics. In such cases, companies need to carefully analyze and determine the appropriate allocation approach to accurately represent the nature of the expenses.

Proper allocation of both direct and indirect costs is vital for measuring profitability, analyzing costs, and making informed business decisions. It enables companies to assess the true cost of their products or services, track performance at a departmental or product level, and optimize resource allocation for improved financial outcomes.

Allocation plays a crucial role in financial reporting as it ensures accurate and reliable representation of an organization’s financial data. Here are several key reasons why allocation is important in financial reporting:

  • Accurate Profitability Assessment: Allocation allows companies to assess the true profitability of their different entities, such as departments, product lines, or activities. By properly allocating costs and revenues, financial reports provide a clear picture of the financial performance of each entity. This information is essential for decision-making, resource allocation, and identifying areas for improvement.
  • Transparent Cost Analysis: Allocation enables companies to analyze and understand their cost structure in a transparent manner. By allocating costs to specific entities, financial reports provide insights into the cost drivers and resource consumption patterns. This information helps management analyze costs, identify inefficiencies, and implement strategies for cost control and cost reduction.
  • Effective Decision-Making: Accurate allocation of costs and revenues is critical for making informed business decisions. Financial reports provide decision-makers with reliable data on the financial impact of different options, investments, or strategies. By understanding the allocation of costs, management can evaluate the financial consequences and performance implications of various decisions.
  • Compliance with Accounting Standards: Proper allocation ensures organizations comply with accounting standards and principles. Financial reporting needs to reflect a fair and accurate representation of transactions and events. Allocation ensures that costs and revenues are allocated to the appropriate periods, in line with the matching principle , revenue recognition principles, and other relevant accounting regulations.
  • Investor and Stakeholder Confidence: Accurate allocation enhances the credibility and trustworthiness of financial reports. Investors and other stakeholders rely on financial information to make investment decisions, assess the company’s financial health, and evaluate its performance. Proper allocation provides stakeholders with a comprehensive and reliable view of the organization’s financial position.
  • Performance Evaluation and Benchmarking: Allocation facilitates the evaluation of the performance of different entities within an organization. Financial reports allow for benchmarking and comparison of performance metrics across departments, product lines, or activities. This information helps identify areas of excellence, set performance targets, and drive continuous improvement.

In summary, allocation is of utmost importance in financial reporting as it ensures accurate profitability assessment, transparent cost analysis, informed decision-making, accounting compliance, investor confidence, and performance evaluation. By correctly allocating costs and revenues, financial reports provide valuable insights that support effective financial management and decision-making.

While allocation is an essential process in accounting, it is not without its challenges and limitations. Here are several key challenges and limitations associated with allocation:

  • Subjectivity: Allocation often requires subjective judgments and assumptions. Determining the appropriate allocation basis or key can be challenging and may vary among different organizations or individuals. Subjectivity in allocation can lead to differences in financial reporting, making it difficult to compare the financial performance of entities.
  • Data Availability and Accuracy: The accuracy and availability of data can pose challenges in the allocation process. Inaccurate or insufficient data can result in unreliable allocation outcomes, leading to distorted financial reporting. It is crucial for organizations to establish robust data collection and management systems to ensure the accuracy and completeness of data used for allocation.
  • Complex Cost Structures: Allocating costs in organizations with complex cost structures can be challenging. Entities with overlapping cost categories or shared resources may require intricate allocation methods. Determining the most appropriate allocation approach for such situations can be time-consuming and may require extensive analysis and consideration.
  • Allocation Bias: Allocation can be subject to biases that may distort the fairness and accuracy of the allocation process. Biases may arise due to management preferences, conflicts of interest, or personal agendas. It is essential to establish proper checks and balances to mitigate allocation biases and ensure fair and objective allocations.
  • Changing Business Models: Allocation may become more complex or less relevant when organizations undergo significant changes in their business models, such as mergers, acquisitions, or restructuring. New entities or activities may require the development of new allocation methods or the adjustment of existing methods to accommodate the changes in the organization’s structure, operations, or strategies.
  • Practicality of Allocation: Some costs or revenues may not lend themselves easily to allocation due to their nature or characteristics. For example, intangible assets or research and development costs may not have a straightforward allocation basis. In such cases, alternative approaches or estimation techniques may need to be utilized, which can introduce additional complexities and uncertainties.

It is important for organizations to be aware of these challenges and limitations when implementing allocation methods. Transparency, consistency, and robust internal controls are critical in addressing potential issues and ensuring the integrity of the allocation process.

Despite these challenges, allocation remains a valuable tool in financial reporting, helping companies assess profitability, analyze costs, and make informed decisions. By recognizing and addressing the limitations and challenges, organizations can enhance the accuracy and reliability of their financial reporting and use allocation as an effective tool for financial management and decision-making.

To better understand the concept of allocation in accounting, let’s explore some practical examples of how allocation is applied in various scenarios:

  • Departmental Allocation: In a manufacturing company, overhead costs such as rent, utilities, and administrative expenses need to be allocated to different departments. This allocation is typically based on an allocation key, such as square footage or headcount. The departments that occupy larger spaces or have more employees will bear a higher proportion of these shared costs.
  • Product Cost Allocation: A company that produces multiple products must allocate the costs incurred in the production process to each product. Direct costs like raw materials and direct labor can be easily allocated based on the specific usage for each product. Indirect costs, such as factory rent or maintenance expenses, need to be allocated based on an appropriate allocation basis, such as the direct labor hours or machine hours used for each product.
  • Activity-Based Allocation: In a service-oriented organization, such as a consulting firm, costs need to be allocated to different client projects. Activity-based allocation is used, where costs are assigned based on the specific activities performed for each client project. For example, the hours spent by consultants, the resources used, and the overhead costs are allocated based on the level of effort or time dedicated to each project.
  • Revenue-Based Allocation: Allocating costs based on revenue is commonly used in industries where revenue generation is a suitable basis for allocation. For instance, a software company that offers multiple software products may allocate shared costs, such as marketing expenses or technical support, based on the proportionate revenue generated by each product.
  • Shared Services Allocation: In large organizations with shared services, such as human resources or IT departments, the costs incurred by these shared services need to be allocated to the different operating units or departments they support. This ensures that each department bears its fair share of the costs based on its utilization of the shared services.

These examples illustrate how allocation is applied in various contexts to distribute costs, expenses, or revenues accurately. These allocation methods help organizations track performance, evaluate profitability, and make informed decisions based on a fair and comprehensive allocation of resources.

It’s important to note that specific allocation methods may vary depending on the nature of the organization, industry, and applicable accounting principles. Companies need to carefully analyze their unique circumstances and requirements to determine the most appropriate and accurate allocation methods.

Allocation is a fundamental process in accounting that plays a vital role in accurately representing the financial transactions and overall financial health of an organization. Through allocation, costs, expenses, and revenues are distributed among various departments, activities, or products in a fair and reasonable manner.

The purpose of allocation in accounting is multi-fold. It allows for the evaluation of profitability, cost control, performance assessment, and informed decision-making. Allocation helps comply with accounting principles, ensures transparency in financial reporting, and instills confidence in investors and stakeholders.

There are different types of allocation methods utilized, such as direct allocation, step-down allocation, allocation by proportions, activity-based allocation, and allocation by revenue. Companies choose the most appropriate method based on the nature of the costs or revenues being allocated.

Despite the benefits of allocation, there are challenges and limitations that need to be addressed. Subjectivity, data availability, complex cost structures, biases, changing business models, and practicality are some of the challenges faced in the allocation process. It is crucial for organizations to establish transparency, consistency, and robust internal controls to mitigate these limitations.

Practical examples of allocation include departmental allocation, product cost allocation, activity-based allocation, revenue-based allocation, and shared services allocation. These examples illustrate how different allocation methods are applied in various scenarios to ensure accurate allocation of costs, expenses, or revenues.

In conclusion, allocation is a critical component of financial reporting that enables companies to accurately reflect the utilization and impact of resources. It provides valuable insights into profitability, cost management, decision-making, and performance evaluation. By understanding and implementing allocation effectively, organizations can enhance financial management, adhere to accounting principles, and make informed decisions for sustained success.

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Allocations

Definition:.

Allocations divide costs between different departments or activities within a company. For instance, overhead costs such as the rent and utilities are often allocated to the company’s operating units. Determining accruals and allocations nearly always entails making assumptions and estimates.

Let’s use the rent and utilities as an example. If you take the amount of rent and utilities for a month, you could allocate that based on the square footage of each operating unit, or you could allocate it based on the number of employees in each operating unit.  There are many ways to allocate costs, pick a method that makes the most sense for your company that you can defend.

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(Excerpts from Financial Intelligence , Chapter 2 – Spotting Assumptions, Estimates, and Biases)

Accountants use accruals and allocations to try to create an accurate picture of the business for the month. After all, it doesn’t help anybody if the financial reports don’t tell us how much it cost us to produce the products and services we sold last month. That is what the controller’s staff is trying so hard to do, and that is one reason why it takes as long as it does to close the books.

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What is Cost Allocation? Definition & Process

Jul 16, 2020 Michael Whitmire

Working with the former accountants now working at FloQast, we decided to take a look at some of the pillars of the accounting professions.

The key to running a profitable enterprise of any kind is making sure that your prices are high enough to cover all your costs — and leave at least a bit for profit. For a really simple business — like the proverbial lemonade stand that almost every kid ran — that’s pretty simple. Your costs are what you (or your parents) paid for lemons and sugar. But what if it’s a more complex business? Then you might need to brush up on cost accounting, and learn about allocation accounting . Let’s walk through this using the hypothetical company, Lisa’s Luscious Lemonade. 

What is cost allocation ?

The cost allocation definition is best described as the process of assigning costs to the things that benefit from those costs or to cost centers . For Lisa’s Luscious Lemonade, a cost center can be as granular as each jug of lemonade that’s produced, or as broad as the manufacturing plant in Houston. 

Let’s assume that the owner, Lisa, needs to know the cost of a jug of lemonade. The total cost to create that jug of lemonade isn’t just the costs of the water, lemons, sugar and the jug itself, but also includes all the allocated costs to make it. 

Let’s start by defining some terms…

Direct costs are costs that can be traced directly to the product or service itself. For manufacturers, these consist of direct materials and direct labor. They appear in the financial statements as part of the cost of goods sold .

Direct materials are those that become an integral part of the finished product. This will be the costs of the water, sugar, lemons, the plastic jug, and the label. 

Direct labor includes the labor costs that can be easily traced to the production of those finished products. Direct labor for that jug will be the payroll for the workers on the production line. 

Indirect costs are the costs that can’t be easily traced to a product or service but are clearly required for making whatever an enterprise sells. This includes materials that are used in such insignificant quantities that it’s not worth tracing them to finished products, and labor for employees who work in the factory, but not on the production line. 

Overhead costs encompass all the costs that support the enterprise that can’t be directly linked to making the items that are sold. This includes indirect costs , as well as selling, marketing, administration, and facility costs. 

Manufacturing overhead includes the overhead costs that are directly related to making the products for sale. This includes the electricity, rent, and utilities for the factory and salaries of supervisors on the factory floor. 

Product costs are all the costs in making or acquiring the product for sale. These are also known as manufacturing costs or total costs . This includes direct labor, direct materials, and allocated manufacturing overhead. 

What is the process?

The first step in any cost allocation system is to identify the cost objects to which costs need to be allocated. Here, our cost objec t is a jug of lemonade. For a more complex organization, the cost object could be a product line, a department, or a branch. 

Direct costs are the simplest to allocate. Last month, Lisa’s Luscious Lemonades produced 50,000 gallons of lemonade and had the following direct costs:

                                    Total costs     Cost per gallon Direct materials        $142,500               $2.85 Direct labor                   $37,500                   $.75

How are costs allocated?

Allocating overhead costs is a bit more complex. First, the overhead costs are split between manufacturing costs and non-manufacturing costs. Some of this is pretty straightforward: the factory floor supervisor’s salary is clearly a manufacturing cost, and the sales manager’s salary is a non-manufacturing cost. But what about the cost of human resources or other service departments that serve all parts of the organization? Or facilities costs, which might include the rent for the building, insurance, utilities, janitorial services, and general building maintenance?

Human resources and other services costs might be logically split based on the headcount of the manufacturing versus non-manufacturing parts of the business. Facilities costs might be split based on the square footage of the manufacturing space versus the administrative offices. Electricity usage might be allocated on the basis of square footage or machine hours , depending on the situation. 

Let’s say that for Lisa’s Luscious Lemonades, after we split the overhead between manufacturing and non-manufacturing costs, we have the following annual manufacturing overhead costs : 

Supervisor salary                                  $84,000 Indirect costs                                         $95,000 Facility costs                                           $150,000 Human resources                                  $54,000 Depreciation                                          $65,000 Electricity                                                $74,000 Total manufacturing overhead             $522,000

In a perfect world, it would be possible to keep an accurate running total of all overhead costs so that management would have detailed and accurate cost information. However, in practice, a predetermined overhead rate is used to allocate overhead using an allocation base . 

This overhead rate is determined by dividing the total estimated manufacturing overhead by the estimated total units in the allocation base . At the end of the year or quarter, the allocated costs are reconciled to actual costs. 

Ideally, the allocation base should be a cost driver that causes those overhead costs . For manufacturers, direct labor hours or machine-hours are commonly used. Since Lisa only makes one product — gallon jugs of lemonade — the simplest cost driver is the number of jugs produced in a year. 

If we estimate that 600,000 gallons of lemonade are produced in a year, then the overhead rate will be $522,000 / 600,000 = $.87 per gallon.

Our final cost to produce a gallon of Lisa’s Luscious Lemonade is as follows:

Direct materials                             $2.85 Direct labor                                     $0.75 Manufacturing overhead               $0.87 Total cost                                         $4.47

What is cost allocation used for?

Cost allocation is used for both external reporting and internally for decision making. Under generally accepted accounting principles (GAAP), the matching principle requires that expenses be reported in the financial statements in the same period that the related revenue is earned. 

This means that manufacturing overhead costs cannot be expensed in the period incurred, but must be allocated to inventory items, where those costs remain until the inventory is sold, when overhead is finally expensed as part of the cost of goods sold. For Lisa’s Luscious Lemonade, that means that every time a jug of lemonade is produced, another $4.47 goes into inventory. When a jug is sold, $4.47 goes to the cost of goods sold. 

However, for internal decision-making, the cost allocation systems used for GAAP financials aren’t always helpful. Cost accountants often use activity-based costing , or ABC, in parallel with the cost allocation system used for external financial reporting . 

In ABC, products are assigned all of the overhead costs that they can reasonably be assumed to have caused. This may include some — but not all — of the manufacturing overhead costs , as well as operating expenses that aren’t typically assigned to products under the costing systems used for GAAP. 

AutoRec to keep you sane

Whatever cost accounting method you use, it’s going to require spreadsheets that you have to reconcile to the GL. Combine that with the other reconciliations you have to do to close out the books, and like Lisa’s controller, you might be ready to jump into a vat of lemonade to drown your sorrows. 

Enter FloQast AutoRec. Rather than spend hours every month reconciling accounts, AutoRec leverages AI to match one-to-one, one-to-many, or many-to-many transactions in minutes. Simple set up means you can start using it in minutes because you don’t need to create or maintain rules. Try it out, and see how much time you can save this month. 

Ready to find out more about how FloQast can help you tame the beast of the close?

allocation meaning accounting

Michael Whitmire

As CEO and Co-Founder, Mike leads FloQast’s corporate vision, strategy and execution. Prior to founding FloQast, he managed the accounting team at Cornerstone OnDemand, a SaaS company in Los Angeles. He began his career at Ernst & Young in Los Angeles where he performed public company audits, opening balance sheet audits, cash to GAAP restatements, compilation reviews, international reporting, merger and acquisition audits and SOX compliance testing. He holds a Bachelor’s degree in Accounting from Syracuse University.

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Cost Allocation Base

allocation meaning accounting

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on February 27, 2023

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Table of Contents

Cost allocation base can be defined as a factor that is the common denominator for systematically linking a cost or group of costs to a cost object such as a department or an activity.

Where cost object is a product, the narrower term cost application base is often used.

Cost Allocation Base FAQs

What is a cost allocation base.

A cost allocation base is the unit, activity, or item that allocates costs in an organization. It can be used to measure and assign expenses to departments and activities accurately.

How does a cost allocation base work?

Costs are assigned to the appropriate department or activity based on the number of units of a resource consumed by each respective department or activity, such as labor hours or machine hours. The total amount of expenses for the period is then divided among the various departments and activities based on their usage patterns.

What types of costs can be allocated using a cost allocation base?

Most variable costs associated with production processes can be allocated using a cost allocation base, such as direct materials, wages and salaries, utilities, machinery, and equipment rental costs.

What are the benefits of using a cost allocation base?

Using a cost allocation base enables organizations to identify areas where costs can be reduced or controlled more efficiently. It also helps allocate accurate costs for each department or activity and provides the necessary data for pricing products and services accurately.

How often should a cost allocation base be updated?

Organizations should review their cost allocation bases regularly to ensure accuracy in allocating expenses. The frequency will depend on the size of the organization and how quickly resource consumption patterns change within that organization. Generally speaking, it is recommended to update your cost allocation base at least once a year.

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True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

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allocation meaning accounting

Reporting and Operations

Expenses are allocated to show the total cost of activities, services, and projects.  It is very important for the board and management to know the total costs of activities, services, and projects so both can see how the nonprofit’s resources are used.

Expenses that benefit an activity, service, or project should be charged to the activity, service, or project according to the relative benefit received by the activity, service, or project.

  • Salaries are allocated through using timesheets to record the actual effort (typically the number of hours) for each employee per activity, service, or project.
  • Timesheets should be reviewed and signed by both the employee and their supervisor.  This dual review helps ensure the accuracy of the timesheet
  • Fringe benefits expenses for each staff typically are allocated based on salary allocations.
  • Expenses for facilities are typically allocated based upon the staffing effort for each activity, service, or project.  Two frequently used measures of staffing effort are full time equivalents and salaries.
  • General and administrative expenses should be shared by all activities, services, or projects.  Again staffing effort could be used as the allocation basis.  Total costs for each activity, service, or project could also be used.

The basis used for allocation of expenses also needs to be consistent.  If the allocation basis is frequently changed:

  • Management of the financial results of the activities, services, and projects becomes more difficult since the resources available for the activities, services, or projects may change because the allocated expenses change.
  • Budgeting for individual activities, services, or projects and the nonprofit as a whole is more difficult since each new activity, service, or project could have a different allocation basis.
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Definition of allocate

transitive verb

Examples of allocate in a Sentence

These examples are programmatically compiled from various online sources to illustrate current usage of the word 'allocate.' Any opinions expressed in the examples do not represent those of Merriam-Webster or its editors. Send us feedback about these examples.

Word History

borrowed from Medieval Latin allocātus, past participle of allocāre "to place, stow, hire out, place on hire, allow, admit, credit," from Latin ad- ad- + locāre "to place, situate" — more at locate

1616, in the meaning defined at sense 1

Phrases Containing allocate

  • sub - allocate

Dictionary Entries Near allocate

Cite this entry.

“Allocate.” Merriam-Webster.com Dictionary , Merriam-Webster, https://www.merriam-webster.com/dictionary/allocate. Accessed 20 Feb. 2024.

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Allocation Method: Cost Allocation Methods Explained

  • by Covenant
  • July 23, 2022
  • 7 minute read

Allocation Method: Cost Allocation Methods Explained

Table of Contents Hide

What is cost allocation method, how does it work, direct costs, direct labor, direct materials, indirect costs, manufacturing overhead, overheads costs, product costs, what is the direct allocation method, how to determine cost allocation, what is allocation method for direct deposit, define cost objects., create a cost pool., allocation method faqs, what is cost allocation, how does cost allocation work, what is cost allocation used for, how do you calculate a company’s external report.

Different cost allocation method (s) are used to allocate factory overhead costs to units of production.  Allocations are made to create financial statements that conform to the applicable accounting system. 

The most common distribution methods are listed in the following paragraphs along with comments on their advantages and disadvantages.

The cost allocation methodology determines which services are provided and how much these services cost.  It also establishes a basis for apportioning these costs among divisions or cost centers based on their respective shares of such costs.

A cost allocation basis may include headcount, revenue, units produced, direct labor hours or dollars, machine hours, activity hours, and square footage.

Companies often implement a cost allocation methodology as a means of controlling costs.  Under an efficient cost allocation methodology, business units are directly responsible for the services they consume. 

As a result, both the service provider and the respective consumers of the service become aware of the requirements for the services and their usage, as well as how such usage affects the costs incurred.

When business units begin to see the value of the services they consume, they can make more informed choices, such as making trade-offs between service level and cost, and comparing internal costs with external providers.

ALSO CHECK: Cost Object: Definition, Types, Examples & Benefits

Using an allocation basis, costs are allocated to each business unit or cost centre that incurred the costs based on their proportionate share of the costs. 

For example, if headcount is the basis for allocating insurance costs and the total number of employees is 1,000, then a department with 100 employees will be allocated 10% of the insurance costs.

Although there are many ways to calculate cost allocations, it is important to ensure that the reasoning behind them is documented.  This is often done by establishing formulas or distribution tables.

Once the calculation is established and the cost allocation is calculated, journal entries are created to transfer the costs from the supplier entity or the payer entity to the corresponding consumer entities. 

During each financial period, as recurring expenses arise, this calculation is repeated and allocation entries are made.

ALSO CHECK: SALES BUDGET: Step-by-step Guide To Preparing A Sales Budget

What Are The Types of Cost Allocation?

Cost allocation is based on different types of costs, which generally fall into one of three categories.

These costs are directly related to the product or service.  In your company’s financial statements, these costs can be linked to goods sold.  For a small clothing store, this may include the cost of inventory.

This cost category includes costs directly related to the production of the items or services your company sells.  Direct labor costs include the wages of workers involved in making the goods your company sells.

As the name suggests, this category includes costs associated with resources used to produce a finished product.  Direct materials include fabric used to make clothes or glass used to make tables.

These costs are not directly related to the product or service, but are necessary to create the product or service.  Indirect costs include the wages of those who work in the operational area.  It also lists the costs of materials you use in such small quantities that their cost is easily overlooked.

This category includes warehousing costs and any other costs directly related to the production of the products sold.  Manufacturing overhead includes wages for warehouse managers as well as warehouse costs such as rent and utilities.

These include expenses that support the company as a whole but are not directly related to production.  Some examples of overhead costs are marketing, operations, and utilities for a storefront.

This category is also called “production costs” or “overhead costs”.  This category includes the cost of making or purchasing the product you are selling.  All manufacturing overhead costs are also listed in this category.

ALSO CHECK: INDIRECT LABOR: Definition, Examples and Costs

The direct allocation method is a technique of allocating departmental maintenance costs to other parts of the business.  This concept is used to fully load operations departments with the overhead they are responsible for. 

For example, a cleaner provides cleaning services for all company premises, while the maintenance department is responsible for the company’s equipment and the IT department maintains the information technology systems.  These are all service departments.

ALSO CHECK: WAREHOUSE LOGISTICS: Guide To Improve The Processes

Cost allocation is not an exact science when it comes to cost objects.  Some cost allocation methods are based on units produced, square footage, hours, staff, or usage.

Let’s say you have a building with a photo studio on the first floor and a salon on the second floor;  you will use square meters as the cost object.  The area of ​​the salon is 2,000 square meters, and the studio is 1,000 square meters. 

The total cost of renting the building is $6,000 per month.  To split the rent between two units, you must first divide the total rent by the total floor area of ​​the building:

$6,000 (overall rent) ÷ 3,000 sq. ft. (total space) = $2 per sq. ft.

Second, you’ll want to calculate your photography studio rental fee:

$2 (price per sq. ft.) x 1,000 (studio sq. ft.) = $2,000

Thirdly, you can calculate the salon rent:

$2 (price per sq. ft.) x 2,000 (salon sq. ft.) = $4,000

Your space rent should be $2,000 for studio overhead and $4,000 for salon overhead.

Other scenarios might include allocating payroll costs based on employee cost centers or allocating payment processing costs based on transactions per location or franchise.

ALSO CHECK: VARIANCE REPORT: Detailed Guide To Variance Reporting

Direct deposit distribution is the automatic distribution of regular, recurring electronic deposits to one or more eligible accounts.  To set up a direct deposit allocation, please use the attached form to indicate which accounts you wish to fund and the amount to be applied to each account. 

Your direct deposits will be automatically distributed according to your instructions.  Direct deposits can be transferred to almost any account.  Transfer funds to money markets or club accounts for taxes, holidays, vacations, and more. 

Create family savings by transferring funds to your spouse’s or children’s accounts.  Get tax benefits with deductions for depository accounts.  You can even speed up your loan repayments by setting aside funds to supplement your regular monthly payments.

ALSO CHECK: ACCUMULATED AMORTIZATION: How To Calculate It On The Balance Sheet

How Do I Allocate Costs?

Cost objects differ depending on the type of business.  However, the cost allocation process consists of the same steps regardless of what your company produces.

To begin allocating costs, you need to make a list of the cost objects of your business.  Remember that anything in your business that creates costs is a cost object.  Review each product line, project, and department to ensure you have collected all cost objects.

Next, make a detailed list of all business expenses.  It is appropriate to categorize expenses based on the reason for each amount.  Categories should cover utilities, insurance, square footage, and any other expenses your business incurs.

Now that you have listed the cost objects and created the cost pool, you are ready to allocate costs.  As shown in the example above, add up the costs of each cost object. 

At first glance, your report should justify all the expenses related to your business.  If expenses aren’t adding up properly, use the list to identify where you can make adjustments to get back on track.

The cost allocation method is a method used by business owners to calculate profitability for financial reporting purposes.  To ensure that the company’s finances are on track, costs are separated or divided into different categories depending on the area of ​​the business they affect.

For example, a cost allocation for a small clothing boutique would include costs for materials, shipping, and marketing.  Consistently calculating these costs will help the store owner ensure that the profit from sales will be higher than the costs of owning and operating the store.  If not, the owner could easily determine where to raise prices or cut costs.

For a larger company, this process will be applied to each department or individual location.  Many companies use cost allocation to determine which areas receive bonuses each year.

This is a method used to estimate costs associated with cost objects in specific categories within an enterprise.  Cost objects can include a product or service you sell, a specific department of your company, or the cost of working with a supplier.

Cost allocation essentially works by assigning costs to smaller areas within the overall business so that you can view profits or losses at a more detailed level.  When you use cost allocation, you may find that your actual manufacturing cost per unit is higher than expected.

Cost allocation is used for many reasons, both external and internal.  The reports generated by this process are excellent resources for business decision making, performance monitoring and cost justification.

External reports are generally calculated based on Generally Accepted Accounting Principles (GAAP).  According to GAAP, expenses can be reflected in the financial statements only during the period during which the corresponding income is received.  For this reason, general production costs are divided and allocated to separate commodity and material values.  When inventory is sold, overhead is expensed as part of cost of goods sold (COGS).

  • blackline.com – What is Cost Allocation? An Introduction to Cost Allocations
  • thebalance.com – What Is Cost Allocation?
  • businessnewsdaily.com – What Is Cost Allocation?

Editor’s Recommendation

  • Cost Object: Definition, Types, Examples & Benefits
  • SALES BUDGET: Step-by-step Guide To Preparing A Sales Budget
  • INDIRECT LABOR: Definition, Examples and Costs
  • WAREHOUSE LOGISTICS: Guide To Improve The Processes
  • VARIANCE REPORT: Detailed Guide To Variance Reporting
  • ACCUMULATED AMORTIZATION: How To Calculate It On The Balance Sheet

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Module 5: Job Order Costing

Over and under-allocated overhead, learning outcomes.

  • Adjust for over and under-allocated overhead

At the end of the month, Jackie notices that her Factory Overhead account looks like this:

She used a standard rate to allocate Factory Overhead to jobs during the month that assigned $3,000 of overhead based on $3 per direct labor dollars:

Actual overhead was $2,800 ($2,500 rent and $300 materials).

Therefore, the Factory Overhead account shows a credit balance of $200, which means it was over-allocated. In order to reconcile that account, the financial accountants would make the following journal entry:

A journal entry dated July 31 shows a debit of $200 to Factory Overhead and a credit of $200 to Cost of Goods Sold with the note “To adjust under-allocated factory overhead”. Each line item in the journal entry points to the corresponding debit or credit on its respective t-account.

Finally, Jackie will run a trial balance to make sure all debits equal credits and to summarize the accounts as follows:

A t-account for Checking Account shows a debit of $150,000 beginning balance, credits of $2,500, $400, $50, $600, and $100, a debit of $2,000, and a debit of $148,350 ending balance. A t-account of Raw Materials - Direct shows a debit of $3,000 beginning balance, credits of $100, $100, and $100, and a debit of $2,700 ending balance. A t-account for Work in Process shows a debit of $100 beginning balance, debits of $450, $100, $700, $100, and $3,000, a debit of $4,350, and a debit of $100 ending balance. A t-account for Raw Materials - indirect shows a debit of $1,000 beginning balance, a credit of $300, and a debit of $700 ending balance. A t-account for finished goods shows a debit of $4,350 beginning balance, a credit of $1,750, and a debit of $2,600 ending balance. A t-account for Owner’s Capital shows a credit of $150,000 beginning and ending balance.

We can see that after accounting for the overhead, which was over-allocated to Jobs 1 and 2, by recording it as an adjustment to Cost of Goods Sold, it improves MaBoards’ financial gross profit by $200. As long as those final adjustments are not material to the financial statements taken as a whole, managerial accountants feel that the additional benefit of having real-time information makes up for the lack of precision that comes with estimating Factory Overhead by using a standard rate during the month.

Instead of plugging under- or over-allocated overhead into cost of goods sold as an unassigned (to any job) amount, we could re-allocate factory overhead to jobs based on the actual amount of overhead incurred, but that would be of more interest to financial accountants, who are focused on historical data.

Obviously, the managerial accountants will adjust the rate based on historical and projected information.

Watch this video to see how to dispose of overallocated or under-allocated overhead.

You can view the transcript for “Underapplied or Overapplied Manufacturing Overhead (how to dispose of it)” here (opens in new window) .

Now, let’s check your understanding of adjusting Factory Overhead at the end of the month.

Practice Question

  • Introduction to Month-end Reporting. Authored by : Joseph Cooke. Provided by : Lumen Learning. License : CC BY: Attribution

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COMMENTS

  1. What Is Allocation in Accounting?

    It's an accounting process referred to as "allocation." Learn more about the meaning of allocation in accounting with our simple guide. Understanding allocations Allocations, also referred to as cost allocations, split costs between different activities, products, or departments (a more technical term for this is "cost objects") within a company.

  2. Allocation definition

    An allocation is the process of shifting overhead costs to cost objects, using a rational basis of allotment. Allocations are most commonly used to assign costs to produced goods, which then appear in the financial statements of a business in either the cost of goods sold or the inventory asset.

  3. What Does Allocation Mean In Accounting

    Allocation refers to the process of distributing costs, expenses, or revenues among various departments, activities, or products. By allocating these resources, companies can measure performance, make informed decisions, and adhere to accounting principles.

  4. Cost allocation definition

    Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you want to separately measure costs. Examples of cost objects are a product, a research project, a customer, a sales region, and a department.

  5. Cost Allocation

    Home › Resources › Accounting › Cost Allocation Cost Allocation The process of identifying, accumulating, and assigning costs to costs objects Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more.

  6. Expense allocation definition

    Expense allocations are required by several accounting frameworks in order to report the full cost of inventory in the financial statements. A cost object is anything for which a cost is compiled. Examples of cost objects are products, product lines, customers, sales regions, and subsidiaries.

  7. allocation definition and meaning

    allocation definition The assigning or dividing up of amounts. For example, depreciation is an allocation process because it assigns an asset's cost to expense in each of the years the asset is expected to be used.

  8. Allocations in Financial Accounting

    Definition: Allocations divide costs between different departments or activities within a company. For instance, overhead costs such as the rent and utilities are often allocated to the company's operating units. Determining accruals and allocations nearly always entails making assumptions and estimates. Example:

  9. Cost Allocation in Accounting: An In-Depth Look

    The cost allocation definition is best described as the process of assigning costs to the things that benefit from those costs or to cost centers. For Lisa's Luscious Lemonade, a cost center can be as granular as each jug of lemonade that's produced, or as broad as the manufacturing plant in Houston. Let's assume that the owner, Lisa ...

  10. allocated definition and meaning

    allocated definition Costs that have been divided up and assigned to periods, departments, products, etc. In depreciation it is the asset's cost that is assigned to each of the years that the asset is in use.

  11. What Is Cost Allocation? (+ Types of Costs & Examples)

    Cost allocation example 1. Ken owns a small manufacturing plant, with administrative offices housed on the second floor. The square footage of the plant is 5,000 square feet, while the ...

  12. What is cost allocation?

    Cost allocation is the assigning of a cost to several cost objects such as products or departments. The cost allocation is needed because the cost is not directly traceable to a specific object. Since the cost is not directly traceable, the resulting allocation is somewhat arbitrary.

  13. Accounting Allocation the Easy Way (#119)

    Overhead allocation means that we apportion expenditures among the cost of goods sold and inventory, which means that we're delaying some expense recognition until a later period. We do this because we have to.

  14. Cost Allocation Base

    Table of Contents. Cost allocation base can be defined as a factor that is the common denominator for systematically linking a cost or group of costs to a cost object such as a department or an activity. Where cost object is a product, the narrower term cost application base is often used.

  15. Allocating Expenses

    Medium. Expenses are allocated to show the total cost of activities, services, and projects. It is very important for the board and management to know the total costs of activities, services, and projects so both can see how the nonprofit's resources are used. Expenses that benefit an activity, service, or project should be charged to the ...

  16. Allocation Definition & Meaning

    1 : to apportion for a specific purpose or to particular persons or things : distribute allocate tasks among human and automated components 2 : to set apart or earmark : designate allocate a section of the building for special research purposes allocatable ˈa-lə-ˌkā-tə-bəl adjective allocation ˌa-lə-ˈkā-shən noun allocator ˈa-lə-ˌkā-tər noun

  17. What is the meaning of systematic and rational allocation?

    Definition of Systematic and Rational Allocation. Systematic and rational allocation is typically included in the definition of depreciation. In this context, it means that a company's annual depreciation expense reported on its financial statements should be based on a formula that is: Logical. Consistently applied.

  18. Allocation Base

    Allocation base is the measuring system by which the overhead cost of the business or the department is decided and can be measured in terms of hours worked, systems used, operational, square feet, etc. Step 1: Determine the total reach of the support department. Step 2: Find the Allocation Base. Step 3: Allocating Overhead to the individual ...

  19. Overhead allocation definition

    Overhead allocation is the apportionment of indirect costs to produced goods. This is done in order to more accurately state the total cost of producing goods or providing services. Overhead allocation is required under the rules of various accounting frameworks.

  20. Allocation Method: Cost Allocation Methods Explained

    The cost allocation methodology determines which services are provided and how much these services cost. It also establishes a basis for apportioning these costs among divisions or cost centers based on their respective shares of such costs. A cost allocation basis may include headcount, revenue, units produced, direct labor hours or dollars ...

  21. Allocation base definition

    December 28, 2023 What is an Allocation Base? An allocation base is the basis upon which an entity allocates its overhead costs. An allocation base takes the form of a quantity, such as machine hours used, kilowatt hours consumed, or square footage occupied.

  22. Over and Under-allocated Overhead

    Instead of plugging under- or over-allocated overhead into cost of goods sold as an unassigned (to any job) amount, we could re-allocate factory overhead to jobs based on the actual amount of overhead incurred, but that would be of more interest to financial accountants, who are focused on historical data. Obviously, the managerial accountants ...

  23. Allocation rate definition

    An allocation rate is the standard amount of overhead applied to a unit of production or other measure of activity. This is done when shifting costs to a cost object, which may be required under one of the accounting frameworks to ensure that a full cost is applied to inventory.