From there, equations can be created using the base to properly distribute funds. With such a complex and comprehensive process, the individual overseeing the cost allocation process should have extensive experience organizing and working with numbers. Because cost allocation focuses on how an organization charges its funding sources, it provides managers with more visibility into their organization than simply which department is spending what on a particular service.
Cost allocation can be used to analyze performance across different business units, providing insight into the true value drivers within an organization. Management can utilize this information to make decisions about products, investments, and operations simply by having a clearer understanding of how expenditures are broken down. Cost allocation can also help improve forecast accuracy and adds a layer of detail to financial reporting.
Not only does cost allocation provide insight into how services are used within an organization, but the information also helps financial analysts and others interpret financial data to determine profitability. It can also demonstrate which products or services are proving to be a good financial investment, and which should be more closely evaluated. Shared costs encompass a wide variety of expenses. For clarification, they can be broken down into a few specific groups:.
There are three primary cost allocation methods used by organizations based on how the expenditures are generated. The step method is best when all costs are internal. For this method, one department within an organization provides a service directly to another. This allocation process ensures the department utilizing the service gets charged for the work of the other department.
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Your foundation for continued accounting and finance excellence. Rich learning resources for every stage of your BlackLine journey. Industry, technology, and business process expertise tailored to your needs. Cost allocation is the distribution of one cost across multiple entities, business units, or cost centers. An example is when health insurance premiums are paid by the main corporate office but allocated to different branches or departments.
When cost allocations are carried out, a basis for the allocation must be established, such as the headcount in each branch or department.
A cost allocation methodology identifies what services are being provided and what these services cost. It also establishes a basis for allocating these costs to business units or cost centers based on their appropriate share of such cost.
The basis for allocating costs may include headcount, revenue, units produced, direct labor hours or dollars, machine hours, activity hours, and square footage. Companies will often implement a cost allocation methodology as a means to control costs. Since high sales volume does not necessarily equate to high profits , this approach can result in a low-profit entity being burdened with a substantial corporate allocation. Costs are allocated based on the profits generated by each subsidiary.
A problem is that high-profit entities will be charged with the bulk of all corporate expenses, so their inherent profitability will not be overly apparent when their results are viewed on a fully-burdened basis.
This is the most specious basis of allocation, for some entities can generate sales and profits with few staff, while others require massive numbers of employees.
Also, a large number of low-paid employees might attract a large cost allocation, while another subsidiary with a much smaller number of higher-paid employees would attract a comparatively smaller charge. When deciding upon which cost allocation method to use, keep in mind that none of these methods will achieve a close relationship between the allocated costs and the cost objects to which they have been applied.
Consequently, it is best to use the simplest method available, and not worry about a high level of allocation precision. Accounting Books. Finance Books. In such a situation, the entity simply includes the unallocated cost in the company's entire cost of doing business. Any profit generated by the departments contributes toward paying for the unallocated cost. Accounting Books.
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