Allocation

Allocation is the process of assigning a cost that was incurred jointly, or that cannot be traced directly to a single cost object, out across the periods, departments, products, or activities that caused it or benefited from it. Almost every business incurs costs this way: rent on a shared factory floor, a corporate marketing budget, or the purchase price of a group of assets bought together all need to be divided up using some reasonable basis before they can be matched against the revenue or output they relate to.

Direct costs, such as the raw material in a specific product, need no allocation because they can be traced to one cost object without ambiguity. Indirect costs cannot be traced this precisely, yet ignoring them entirely would understate the true cost of running a department or producing a unit. Depreciation on a shared piece of equipment, for example, has to be allocated across every product line that uses the machine, or the profitability of each line would be distorted.

The basis chosen for an allocation is meant to approximate cause and effect as closely as possible. A heating bill might be allocated to departments based on square footage occupied; factory overhead is often allocated based on direct labor hours or machine hours; a joint cost incurred before several products split off from a common process is often allocated based on each product's relative sales value. No allocation basis is perfectly precise, since by definition the cost being allocated could not be traced directly in the first place, but a well-chosen basis produces results that are reasonable and defensible rather than arbitrary.

For external financial statements, absorption costing rules require fixed manufacturing overhead to be allocated into inventory and cost of goods sold, since GAAP treats it as a product cost rather than a period expense. For internal decision-making, however, allocated costs can sometimes mislead managers, since an allocated share of a shared cost would often continue to exist even if a single product line were discontinued. This is why management accountants frequently distinguish between a cost that has genuinely been allocated for reporting purposes and one that is actually avoidable, or relevant, to a specific decision.

Traditional allocation methods using a single basis such as labor hours can distort product costs badly when a company's product mix is diverse, since not every indirect cost actually varies with labor hours. Activity-based costing was developed specifically to improve on simple volume-based allocation by first allocating costs to the activities that drive them, then allocating the cost of those activities to the products or services that actually use them, producing allocations that more closely track the real cause of the cost.

Because allocation always involves judgment about which basis best represents cause and effect, two companies, or even two departments within the same company, can allocate an identical shared cost very differently and arrive at different reported product costs or departmental results. Auditors and analysts reviewing a company's internal reporting therefore look closely at whether its allocation methods are applied consistently from period to period, since an allocation basis changed without disclosure can shift reported profitability between products or divisions without any real change in the underlying business.