cost assignment system

What is Cost Allocation?

Types of costs, cost allocation mechanism, what is a cost driver, benefits of cost allocation, additional resources, cost allocation.

The process of identifying, accumulating, and assigning costs to costs objects

Cost allocation is the process of identifying, accumulating, and assigning costs to costs objects such as departments, products, programs, or a branch of a company. It involves identifying the cost objects in a company, identifying the costs incurred by the cost objects, and then assigning the costs to the cost objects based on specific criteria.

When costs are allocated in the right way, the business is able to trace the specific cost objects that are making profits or losses for the company. If costs are allocated to the wrong cost objects, the company may be assigning resources to cost objects that do not yield as much profits as expected.

There are several types of costs that an organization must define before allocating costs to their specific cost objects. These costs include:

1. Direct costs

Direct costs are costs that can be attributed to a specific product or service, and they do not need to be allocated to the specific cost object. It is because the organization knows what expenses go to the specific departments that generate profits and the costs incurred in producing specific products or services . For example, the salaries paid to factory workers assigned to a specific division is known and does not need to be allocated again to that division.

2. Indirect costs

Indirect costs are costs that are not directly related to a specific cost object like a function, product, or department. They are costs that are needed for the sake of the company’s operations and health. Some common examples of indirect costs include security costs, administration costs, etc. The costs are first identified, pooled, and then allocated to specific cost objects within the organization.

Indirect costs can be divided into fixed and variable costs. Fixed costs are costs that are fixed for a specific product or department. An example of a fixed cost is the remuneration of a project supervisor assigned to a specific division. The other category of indirect cost is variable costs, which vary with the level of output. Indirect costs increase or decrease with changes in the level of output.

3. Overhead costs

Overhead costs are indirect costs that are not part of manufacturing costs. They are not related to the labor or material costs that are incurred in the production of goods or services. They support the production or selling processes of the goods or services. Overhead costs are charged to the expense account, and they must be continually paid regardless of whether the company is selling goods or not.

Some common examples of overhead costs are rental expenses, utilities, insurance, postage and printing, administrative and legal expenses , and research and development costs.

The following are the main steps involved when allocating costs to cost objects:

1. Identify cost objects

The first step when allocating costs is to identify the cost objects for which the organization needs to separately estimate the associated cost. Identifying specific cost objects is important because they are the drivers of the business, and decisions are made with them in mind.

The cost object can be a brand , project, product line, division/department, or a branch of the company. The company should also determine the cost allocation base, which is the basis that it uses to allocate the costs to cost objects.

2. Accumulate costs into a cost pool

After identifying the cost objects, the next step is to accumulate the costs into a cost pool, pending allocation to the cost objects. When accumulating costs, you can create several categories where the costs will be pooled based on the cost allocation base used. Some examples of cost pools include electricity usage, water usage, square footage, insurance, rent expenses , fuel consumption, and motor vehicle maintenance.

A cost driver causes a change in the cost associated with an activity. Some examples of cost drivers include the number of machine-hours, the number of direct labor hours worked, the number of payments processed, the number of purchase orders, and the number of invoices sent to customers.

The following are some of the reasons why cost allocation is important to an organization:

1. Assists in the decision-making process

Cost allocation provides the management with important data about cost utilization that they can use in making decisions. It shows the cost objects that take up most of the costs and helps determine if the departments or products are profitable enough to justify the costs allocated. For unprofitable cost objects, the company’s management can cut the costs allocated and divert the money to other more profitable cost objects.

2. Helps evaluate and motivate staff

Cost allocation helps determine if specific departments are profitable or not. If the cost object is not profitable, the company can evaluate the performance of the staff members to determine if a decline in productivity is the cause of the non-profitability of the cost objects.

On the other hand, if the company recognizes and rewards a specific department for achieving the highest profitability in the company, the employees assigned to that department will be motivated to work hard and continue with their good performance.

Thank you for reading CFI’s guide to Cost Allocation. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Break-Even Analysis
• Cost of Production
• Fixed Costs
• Fixed and Variable Costs
• Projecting Income Statement Line Items
• See all accounting resources
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Activity-Based Costing (ABC)

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on June 08, 2023

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Table of contents, activity-based costing (abc) - definition.

An activity-based costing system (also known as ABC System ) is a two-stage procedure for assigning overhead costs to products, which focuses on the major activities performed in the production process.

Activity-based costing is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each.

Moreover, Activity-Based Costing (ABC) has been developed as a more modern absorption costing method to overcome the problems of under-costing and over-costing and to produce more accurate product costs.

Explanation of Activity-Based Costing

Activity based Costing (ABC) is a systematic, cause & effect method of assigning the cost of activities to products, services, customers or any cost object.

ABC is based on the principle that “products consume activities”. Traditional cost systems allocate costs based on direct labor, material cost, revenue or other simplistic methods.

As a result, traditional systems tend to over-cost high volume products, services and customers and under-cost low volume.

Activity based costing should not be treated as an alternative to job costing or process costing but as one of the best tools for refining a costing system which provides a better measurement of the non-uniformity in the use of an organization’s overhead resources for job, products and services.

Activity-based costing incorporates in its costing system the basic and vital role of different activities. ABC System refined costing system by focusing on individual activities as the fundamental cost objects.

An activity is an event, task or unit of work with a specified purpose e.g., designing products, setting up machines, operating machines and distributing products.

In traditional absorption costing, overheads are first assigned or related to cost centers, (production and service centers) and then to cost objects i.e., products or services.

But in Activity-based costing system, overheads are related or assigned to activities or grouped into cost pools before they are related to cost objects i.e., products or services.

Thus, the activity based system system uses activities instead of functional departments (Cost Centers) for absorbing overheads.

The basic feature of functional departments is that they tend to include a series of different activities causing different costs that behave in different ways.

Further, the activities also tend to run across functions.

For example, the procurement or purchase of materials is made on the basis of a requisition note sent by a manufacturing department or stores.

The purchase requisition note is not raised in the purchasing department where most of the costs relating to procurement or purchase are incurred.

Activity costs tend to behave in a similar manner to each other i.e., they have the same cost driver or the factor causing a change in the cost of an activity.

Thus, it is believed that activity-based costing helps in presenting a more realistic picture of the behavior of costs.

Difference Between Traditional Costing and Activity-Based Costing

The basic distinction between traditional cost accounting and ABC is as follows:

Traditional cost accounting techniques allocate costs to products based on attributes of a single unit.

Typical attributes include the number of direct labor hours required to manufacture a unit, purchase cost of merchandise resold or the number of days occupied.

Allocations, therefore, vary directly with the ‘volume of units produced, cost of merchandise sold or days occupied by the customer.

In contrast, Activity based costing (ABC) systems focus on activities required to produce each product or provide each service based on each product’s or service’s consumption of the activities.

Using ABC, overhead costs are traced to products and services by identifying the resources, activities and their costs and quantities to produce output.

A unit or output (a driver) is used to calculate the cost of each activity consumed during any given period of time.

An activity based costing system can be viewed in two different ways:

• The cost assignment view provides information about resources, activities and cost objects.
• The process view provides operational (often non-financial) information about cost drivers, activities and performance.

Factors Prompting the Development of Activity-Based Costing System

Activity based costing System has developed basically on account of the limitations of the traditional absorption costing system.

The basic factors which have prompted the development of Activity based costing (ABC System) may be summarized as follows:

• The traditional methods applied for absorbing overheads lay emphasis on the calculation and application of overhead recovery rates which are acceptable for the valuation of stocks for the purposes of routine financial reporting . The management is not able to find these different traditional methods of costing that may be helpful in making some hard decisions which may affect the product strategies.
• The rapid development of automated production has led to growing overhead costs. According to an estimate, the normal overhead rate which was 200% to 300% of direct costs about 15 years ago, has gone up to 500% to 800%.
• The ever increasing and severe market competition due to globalization has increased the necessity of more accurate product costs in order to avoid the disadvantages of under-costing and over-costing.
• There has been an increase in the tendency towards product diversification to secure economies of scope and increased market share requiring the ascertainment of more accurate product costs under the conditions of the fast-changing cost structure.

Importance/Advantages of Activity-Based Costing

Activity-based costing does not only apply to manufacture organizations: it is also appropriate for service organizations such as financial institutions , medical care providers and government units.

In fact, some banking companies have been applying the concept for years under another name - unit costing.

Unit costing is used to calculate the cost of banking services by determining the cost and consumption of each unit of output of functions required to deliver the service.

A major advantage of using Activity based costing (ABC) is that it avoids or minimizes distortions in product costing that result from arbitrary allocations of indirect costs.

Unlike more traditional line-item budgets which cannot be tied to specific outputs, ABC generates useful information on how money is being spent, if a department is being cost-effective, and how to benchmark (or compare oneself against others) for quality improvements.

Activity Based Costing also provides a clear metric for improvement. It encourages management to evaluate the efficiency and cost-effectiveness of program activities.

Some ABC systems rank activities by the degree to which they add value to the organization or its outputs.

This helps managers identify what activities are really value- added—those that will best accomplish a mission, deliver a service, or meet customer demand —thus improving decision-making through better information, and helping to eliminate waste by encouraging employees to look at all costs.

That is why an essential aspect of any ABC endeavor is to get a clear picture of the activities a business area performs.

When employees understand the activities they perform, they can better understand the costs involved.

Important Terms in Activity-Based Costing

The operation of the ABC System involves the use of the following terms:

• Cost Object: It indicates an item for which cost is calculated using the Activity-based costing System. For Example, a service, a customer or a product.
• Cost Driver: A cost driver is any factor or force that causes a change in the cost of an activity.

Cost driver may be divided into two parts:

(a) Resource Cost Driver and

(b) Activity Cost Driver.

The quantity measure of the resources used/consumed by an activity is called Resource Cost Driver. It is used to assign the cost of a resource to an activity or cost pool.

An activity cost driver is Really a measure of frequency and Strength of Demand, set on tasks by cost items.

It’s utilized to assign activity costs to cost objects. The price drivers for various company purposes i.e., manufacturing, promotion, research and development, etc., have been provided below:

Steps to Follow in Activity-Based Costing

Activity Based Costing requires accountants to follow these steps.

• Step 1: Identify the activities that consume resources.
• Step 2: Assign costs to activities.
• Step 3: Identify the cost driver associated with each activity. A cost driver is a factor that causes, or "drives" an activity's cost.
• Step 4: Compute a cost rate per cost driver unit.
• Step 5: Assign costs to products by multiplying the cost driver rate times the volume of cost drivers consumed by the product.

Need or Objects of Activities-Based Costing

ABC System is needed by an organization for the purpose of accurate product costing in cases where:

• Production overhead costs are high in comparison to the various direct costs;
• The product range of the organization is highly diverse;
• Overhead resources used by various products are very different in amounts;
• Volume or quantity of production is not a primary driving force for the consumption of overhead resources.

Limitations of ABC System

The ABC System suffers from the following limitations:

• This system is more time-consuming due to the fact that the number of activities to which the overhead resources of an organization have to be related, is very large.
• It involves a high cost of operation and can be used only by large organizations. It is not suitable for small scale units.
• In some cases, the establishment of cause and effect relationship between Cost Driver and Costs may not be a simple affair.

Jumbo Auto Ltd. produces three products ‘P’, ‘Q’ and ‘R’ for which the standard costs and quantities per unit are as follows:

Production overhead split by departments:

Department ‘A’ is labor intensive while Department ‘B’ is machine intensive. Total labor hours in Department A = 55,000 Total machine hours in Department B = 1,50,000 Production overhead split by activity:

You are required to:

(i). Prepare Product Cost Statement under traditional Absorption Costing and Activity-based Costing Method.

(ii). Compare the results under two methods:

Traditional Absorption Costing

Calculation of overhead absorption rates : Department ‘A’ = $5,50,000 / 55,000 Labor hours = $10 per labor hour.

Department ‘B’ = $7,50,000 / 1,50,000 Machine Hours = $5 per machine hour.

Activity-based Costing

Calculation of Cost Driver Rates:

(i). Receiving/Inspecting = $7,00,000 / 2,500 (No. of batches received/inspected) = $280 per requisition .

(ii). Production Scheduling/Machine Sets-up = $6,00,000 / 400 (No. of batches for scheduling) = $1,500 per set-up

Note: Calculation of Overhead per unit.

Receiving: Product P = ($280 x 600) / 5,000 = $33.60 Product Q = ($280 x 900) / 15,000 = $16.80 Product R = ($280 x 1,000) / 22,500 = $12.44

Production Scheduling: Product P = ($1,500 x 140) / 5,000 = $42.00 Product Q = ($1,500 x 110) / 15,000 = $11.00 Product R = ($1,500 x 150) / 22,500 = $10.00

Comparison of Results Under Both Costing Methods

From the above analysis, it is clear that the Traditional Absorption Costing Method and Activity-based Costing Method show different cost results.

Under the traditional absorption costing method, Product ‘R’ is more expensive while under activity-based costing method, product ‘P’ is more expensive.

If we assume that Activity-Based Costing is more accurate (which may or may not be possible), under traditional absorption costing method, product ‘R’ would be over-priced while product ‘P’ would be underpriced as a result of which sales for product ‘R’ would be less and sales for product ‘P’ would be more leading to a loss to the company.

Activity-Based Costing (ABC) FAQs

What are the different types of cost drivers under abc.

Explicit cost driver- explicit cost drivers are those which are included in the accounting records of an organization at the time of preparing Financial Statements. These include items such as salaries, raw material consumption etc. Implicit cost drivers- Implicit cost drivers are not recorded in the accounting records of an organization during the preparation of Financial Statements. These include factors such as machine hours, labor hours etc.

What is a cost pool under ABC?

A cost pool consists of one or more similar activities that can't be identified easily with specific products, services, departments etc. Cost pools are used to account for the common costs of the organization.

What is a cost element under ABC?

A cost element refers to an account which receives and accumulates costs over a period of time. It also includes the revenue accounts that receive and accumulate revenues over a period of time.

What is a service level in ABC?

A service level measures the number of requests that are processed by an organization within a set time frame. Generally, the higher the number of services within the predetermined time period, the more efficient is the organization.

What is Activity-Based Costing (ABC)?

Activity-Based Costing (ABC) is a method of cost accounting that assigns costs to products and services based on the activities that produce them, rather than allocating overhead costs using traditional methods such as direct labor hours or machine hours.

About the Author

True Tamplin, BSc, CEPF®

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

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

Related Topics

• Activity-Based Costing (ABC) Principles, History & Steps
• Computation of Unit Cost Under Activity-Based Costing

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What is Cost Assignment?

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Cost assignment.

Cost assignment is the process of associating costs with cost objects, such as products, services, departments, or projects. It encompasses the identification, measurement, and allocation of both direct and indirect costs to ensure a comprehensive understanding of the resources consumed by various cost objects within an organization. Cost assignment is a crucial aspect of cost accounting and management accounting, as it helps organizations make informed decisions about pricing, resource allocation, budgeting, and performance evaluation.

There are two main components of cost assignment:

• Direct cost assignment: Direct costs are those costs that can be specifically traced or identified with a particular cost object. Examples of direct costs include direct materials, such as raw materials used in manufacturing a product, and direct labor, such as the wages paid to workers directly involved in producing a product or providing a service. Direct cost assignment involves linking these costs directly to the relevant cost objects, typically through invoices, timesheets, or other documentation.
• Indirect cost assignment (Cost allocation): Indirect costs, also known as overhead or shared costs, are those costs that cannot be directly traced to a specific cost object or are not economically feasible to trace directly. Examples of indirect costs include rent, utilities, depreciation, insurance, and administrative expenses. Since indirect costs cannot be assigned directly to cost objects, organizations use various cost allocation methods to distribute these costs in a systematic and rational manner. Some common cost allocation methods include direct allocation, step-down allocation, reciprocal allocation, and activity-based costing (ABC).

In summary, cost assignment is the process of associating both direct and indirect costs with cost objects, such as products, services, departments, or projects. It plays a critical role in cost accounting and management accounting by providing organizations with the necessary information to make informed decisions about pricing, resource allocation, budgeting, and performance evaluation.

Example of Cost Assignment

Let’s consider an example of cost assignment at a bakery called “BreadHeaven” that produces two types of bread: white bread and whole wheat bread.

BreadHeaven incurs various direct and indirect costs to produce the bread. Here’s how the company would assign these costs to the two types of bread:

• Direct cost assignment:

Direct costs can be specifically traced to each type of bread. In this case, the direct costs include:

• Direct materials: BreadHeaven purchases flour, yeast, salt, and other ingredients required to make the bread. The cost of these ingredients can be directly traced to each type of bread.
• Direct labor: BreadHeaven employs bakers who are directly involved in making the bread. The wages paid to these bakers can be directly traced to each type of bread based on the time spent working on each bread type.

For example, if BreadHeaven spent $2,000 on direct materials and $1,500 on direct labor for white bread, and $3,000 on direct materials and $2,500 on direct labor for whole wheat bread, these costs would be directly assigned to each bread type.

• Indirect cost assignment (Cost allocation):

Indirect costs, such as rent, utilities, equipment maintenance, and administrative expenses, cannot be directly traced to each type of bread. BreadHeaven uses a cost allocation method to assign these costs to the two types of bread.

Suppose the total indirect costs for the month are $6,000. BreadHeaven decides to use the number of loaves produced as the allocation base , as it believes that indirect costs are driven by the production volume. During the month, the bakery produces 3,000 loaves of white bread and 2,000 loaves of whole wheat bread, totaling 5,000 loaves.

The allocation rate per loaf is:

Allocation Rate = Total Indirect Costs / Total Loaves Allocation Rate = $6,000 / 5,000 loaves = $1.20 per loaf

BreadHeaven allocates the indirect costs to each type of bread using the allocation rate and the number of loaves produced:

• White bread: 3,000 loaves × $1.20 per loaf = $3,600
• Whole wheat bread: 2,000 loaves × $1.20 per loaf = $2,400

After completing the cost assignment, BreadHeaven can determine the total costs for each type of bread:

• White bread: $2,000 (direct materials) + $1,500 (direct labor) + $3,600 (indirect costs) = $7,100
• Whole wheat bread: $3,000 (direct materials) + $2,500 (direct labor) + $2,400 (indirect costs) = $7,900

By assigning both direct and indirect costs to each type of bread, BreadHeaven gains a better understanding of the full cost of producing each bread type, which can inform pricing decisions, resource allocation, and performance evaluation.

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Cost Allocation

The process of identifying a company’s costs and assigning those costs to cost objects

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds  asset management  firm with $20 billion under management, and as an investment banking analyst in  SunTrust Robinson Humphrey 's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Currently an investment analyst focused on the  TMT  sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a  BS  from The Tepper School of Business at Carnegie Mellon.

• What Is Cost Allocation?
• Types Of Costs
• How To Allocate Costs
• Why Do We Need To Allocate Costs?
• Examples Of Cost Allocation & Calculations

What is Cost Allocation?

Cost allocation is the process of identifying a company’s costs and assigning those costs to cost objects. Cost objects are the products, services, and activities of different departments of a company. 

This process of allocating costs helps a business determine which parts of the company are responsible for what costs. 

Sometimes it is difficult to draw the connection between allocated costs and their cost objects. When this happens, companies can use spreading costs. 

Spreading costs occur when businesses spread the responsibility for production expenses across various areas. 

When businesses can accurately allocate their costs, they are able to easily assess what particular cost objects are creating profits and losses for the company. On the other hand, if businesses are unable to allocate their costs correctly, their profit and loss calculations will be off. 

Also, businesses must charge a price for their goods and services that covers their expenses and allows them to make a profit.  

Intuitively, one can recognize the importance of cost allocation for the optimal performance of a company. Incorrect cost allocation calculations are extremely detrimental to any business and disrupt the ability to operate properly.

Cost allocation is necessary for any business, but as companies get larger and more complex, it becomes even more important to allocate costs accurately. 

Key Takeaways

Cost allocation is fundamental and necessary for any business, big or small. 

It helps with assessing profits and losses and the management of staffing. 

Cost allocation allows companies to explain the pricing of their goods and services to customers. 

Allocating costs is necessary for companies to maintain efficiency and financial accountability. 

Types of Costs

Companies have various types of costs, and it is important to be able to distinguish between the different types when allocating them. 

We can break them down into a few different categories.

• Direct costs:  direct costs are those that can be traced to a certain product or service offered by a company. Included in direct costs are materials and labor that go into the production of a good. 
• Indirect costs :  these expenses are those that go into the production of a good but do not have a connection to a specific cost object. Examples of indirect costs include rent, utilities, and office supplies.
• Fixed costs : these costs remain constant, regardless of a company’s production volume. (e.g., rent)
• Variable costs : these costs increase or decrease as a company’s volume of production changes (e.g., supplies). 
• A few examples of fixed overhead costs include rent, insurance, and workers’ salaries. Variable overhead costs include supplies and energy expenses, which both change as the  volume of production  increases or decreases. 

How to Allocate Costs

Now that we understand the different types of costs, we can better understand the processes involved in cost allocation. Regardless of what good or service a company produces, the process remains consistent across industries. 

• Identify  Cost Objects : anything within a business that creates an expense is considered a cost object. The first step for allocating costs is to note all the cost objects of your company. 

Electricity usage

Water usage

Fuel consumption

• Fixed cost allocation:  this method assigns particular direct costs with cost objects. Drawing direct connections between costs and cost objects makes this method one of the most simple.
• Proportional allocation:  proportional allocation deals with the distribution of indirect costs across associated cost objects. Sometimes proportional allocation divides costs equally across cost objects, while other times, it considers other factors (i.e., size) and divides costs accordingly. 
• Activity-based allocation:  this method is commonly considered the more accurate method of allocating costs. Activity-based allocation utilizes precise documentation to determine costs within departments and allocates the costs appropriately. 

Why Do We Need to Allocate Costs?

A company must allocate its costs in order to optimize its business activities.

Recognizing Profits And Losses

Understanding the distribution of expenses helps companies analyze which areas of their business may be profitable or which areas may be causing a loss. This allows companies to determine whether or not certain expenses can be justified or not. 

Companies do not know how much to charge the customer’s goods and services without cost allocation. Once non-profitable cost objects are identified, companies can cut expenses in those departments and focus their efforts on profitable cost objects. 

Management Decisions

Cost allocation is also important for a company to manage its staff. In areas where the company is not profitable, it can evaluate the staff performance of that department. Often, the losses incurred by part of a company are due to the underperformance of employees. 

Similarly, companies can analyze the allocation of their costs to determine where they are profitable and award the employees of that department. 

Using cost allocation to motivate employees offers the administration of a company an objective, quantitative justification for their management decisions. 

Transfer Pricing

Transfer pricing is the practice of charging for goods and services at an arm's length. The practice is used by departments the organization to charge for the goods and services exchanged within the same firm.

Cost allocation is vital for deriving transfer pricing, the exchange price of goods or services between two companies. 

Examples of Cost Allocation & Calculations

Now we understand cost allocation, the different types, and why we need it. Here are several examples of different ways a company might allocate its costs. 

Example 1: Square Footage

Christina’s business has an office and a manufacturing space. The square footage of the office is 1,000 square feet, and the manufacturing space is 1,500 square feet. The rent for the two spaces is $10,000 per month. The company will allocate the rent expense between the two spaces. 

$10,000 (rent) / 2,500 square feet = $4 per square foot

• Calculate the rental cost for the office

$4 x 1,000 = $4,000

This means that Christina will allocate $4,000 of the rent to the office.

• Calculate the rental cost for the manufacturing space

$4 x 1,500 = $6,000

This means that Christina will allocate $6,000 of the rent to the manufacturing space.

Example 2: Units Produced

Alex’s manufacturing company makes water bottles. In January, Alex produced 5,000 water bottles with direct material costs of $2.50 per water bottle and $3.00 in direct labor costs per water bottle. 

Alex also had $6,500 in overhead costs in January. Using the number of units produced as his allocation method, Alex can calculate his overhead costs using the overhead cost formula. 

• Calculate the overhead costs: 

$6,500 / 5,000 = $1.30 per water bottle

• Add the overhead costs to the direct costs to find the total costs:

$1.30 + $2.50 + $3.00 = $6.80 per backpack

So, Alex’s total costs in January were $6.80 per backpack. If Alex had not allocated the overhead costs, he would have most likely underpriced the backpacks, which would have resulted in a loss of income. 

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Cost Allocation Methods

Published on :

21 Aug, 2024

Blog Author :

Edited by :

Reviewed by :

Dheeraj Vaidya

What Are Cost Allocation Methods?

The cost allocation method is a process that facilitates identification and assignment of costs to products, departments, branches or programs based on certain criteria. When the allocation of costs is performed correctly, the business is able to account for its costs as well as trace them back to determine how they are making profits and losses.

Thus, it is a very useful technique that helps the business to distribute its expenses among various products, services, and cost centres. If the costs are accurately attributed, then it leads to better pricing strategy, production planning, resource allocation, cost control, and overall financial management, which leads to an increase in profitability.

Table of contents

Cost allocation methods explained, disadvantages, recommended articles.

The term cost allocation methods refer to the different techniques that a company may use in order to allocate or distribute its costs across its operations, products or cost centres, which leads to efficient and smooth running of the business, through maximum cost control.

The cost allocation method starts with the identification of cost drivers. The cost drivers tend to change the level of the cost incurred by the business for any aligned or identified activity. The cost drivers are generally composed of a number of machine-hours, the number of direct labour and the count of payment processed, the count of purchase orders, and the count of invoices that are dispatched to the customers.

The establishment of comprehensive joint cost allocation methods helps in fast decision making for the management as they tend to get access to the important data of cost allocation and utilization on periodic fronts. It additionally keeps labour staff motivated as the business tends to recognize the department or product line that is the most profitable department. Since the data on cost allocation becomes accessible to the management, it helps the management evaluate the department and the associated staff.

It is to be noted that the selection of overhead cost allocation methods will depend on the type and nature of business, the size of operation, the kind of resource used and future planning. It is not necessary that the business will use only one method. It can use multiple and combination of techniques which will not only give a proper understanding of the costing situation but also guide the business regarding the next step.

Given below are some important and widely used types of such joint cost allocation methods that exist in the corporate world.

#1 - Identification Of Cost Object

This is the starting step in the identification of costs, wherein the business attempts to find and classify the cost objects. The cost objects are required as it helps the business to determine effective costs on segregated levels. Additionally, such identification is also regarded as critical as the business or organization cannot go ahead with the process of cost allocation if the cost objects are not known and defined.

The cost objects could be a project in the pipeline, product line, department, division, or entirely a new segregated brand. In parallel to this activity of determining the cost objects, the business identifies and determines the basis of the costs. The cost basis is basically the fundamental aspect basis allocation of costs that are performed on the cost objects.

#2 - Accumulation of Costs into the Cost Pool

• Once the cost objects are identified and established, the next step involves the addition or accumulation of the cost into a defined cost pool and allocate the cost objects. The cost accumulation could result in the creation of multiple categories wherein the costs aligned would be pooled and segregated basis the cost allocation method employed. This could result in several methods. The cost pools aligned with the basis could be composed of electricity usage, square footage, water usage, insurance, fuel consumption, motor vehicle insurance, and rent expenses.
• Basis the identified costs the business tends to finally establish some levels of cost objects. Such cost objects can be identified as direct costs. The direct costs help in segregating costs that have a direct impact on business profitability and can be attributed to the distinct product line or service line. They are not required to be aligned with the defined cost objects as the business knows the type of expenses that could be incurred in the production of specific services and products.
• There could be some costs that are not direct; rather, they indirectly impact the aligned cost function, product line, or department. Such costs are required for the facilitation of business operations and further be divided into fixed or variable costs . Such costs would, therefore, be identified and then simultaneously allocated to the identified cost objects within the business unit or the organization.
• The fixed costs are basically the cost that is business or department has to bear to sustain itself. The variable costs, on the other hand, are costs that the business may or may not bear and depends on the level of output. Such variable costs can increase or decrease in magnitude, and such costs are generally controllable by the business if identified with the correct cost objects.
• There could be overhead cost allocation methods as well, which are indirect and are not identified with the process of production or manufacturing. Such costs are not related to the material costs and labour costs that the business has to incur in the generation of services and finished goods. However, overhead costs if identified correctly with the cost pools, help the business in terms of selling the finished goods or services, and it helps in the production process.
• The overhead costs are levied on the expense account, and they should be comprehensively compensated irrespective of the fact whether the business is making sales on the services or finished products. Such costs are aligned with the administrative expenses as well as such expenses can be aligned to the legal expenses.

The cost allocation methods basically focus in terms of accumulation of costs followed by the establishment of cost drivers and cost pools to establish cost objects further and then aligned such costs to the cost objects. Cost allocation is basically a critical task for the business as it helps the business in determining the effective profit and loss for themselves, and this attribute further helps the management to establish effective decision-making policy.

Let us assume a company ABC Ltd, which is looking into its cost allocation and analysing areas that need better control and strategy. It produces two kinds of products, A and B. Total quantity produced for A is around 20000 and B is produced by 50000 units. It management has calculated that the total cost of production comes to $150000. After identification it is seen that these include the cost or resource employment, usage of utility, purchase of various machinery, upgradation of software, procurement of raw materials, etc.

Now they need to allocate it among both products, then we can say that for products A and B, the total cost would be as follows:

Total cost = $150000,  Total production = 70000 units

Therefore for A = (150000/70000)* 20000 = $42,857

For B = (150000/70000)* 50000 = $107,143

Thus, the above is a very simple calculation of allocation. However, the components may change and calculation may be more complex, depending the type of product, the various cost breakups and the operational process.

The various methods explained above help in distributing the costs across the operations so that it enables the business to fairly align it across various outputs. But corporate cost allocation methods come with their own advantages and disadvantages. Let us look at the advantages first.

• Cost control – It is important for the business to have a proper control over its cost so that proper planning and revenue maximization can lead to profitability. The management of the business should take special care to select the correct common cost allocation methods of cost allocation so that the cost can be reduced.
• Decision making – A business needs proper decision making at every step. Correct strategy and planning are the key to success of operation. Cost control is the best way to cost management and revenue optimization. The methods help in not only doing so but also identify areas that need proper understanding and control so that wastage of resource is reduced.
• Fairness – A proper cost allocation leads to distribution of resources as per the usage and contribution of each resource.
• Reporting – This is the most important part, where financial details is reported in the statements that are widely viewed, used and analysed by investors, shareholders, and the management. Proper allocation of cost through corporate cost allocation methods reveals a clear and positive picture about the business, which not only make the company appear financially stable but also increase faith of stakeholders.

Here are some disadvantages of the common cost allocation methods .

• Subjective - The entire process is very subjective in the sense that the methods are selected based on past experiences and historical results. This may lead to disagreements or misallocation and disputes.
• Complex process – There are multiple types of cost allocation methods, which are difficult to select, based on company operations and strategies. Moreover, even after selecting a method, using it is not very easy because it involves a number of assumptions, calculations, and analysis.
• Assumptions – It is quite obvious that there are a number of assumptions that are used in the process which may not be very realistic or related to actual usage of resource contribution.
• Inaccuracy – Due to complexity and assumptions used the ultimate result may not always be accurate. There may be deviations from expectation which may later lead to cost increase and requirement of new strategy to conduct the business.
• Cost involved – Any new method implementation requires some amount of cost. This is extra cost that the company has to bear and above all the management may not be sure of its positive result. Therefore, the skill and expertise employed for achievement of the objective involves cost.

Thus, the above are some important advantages and disadvantages that should be kept in mind while selecting and implementing the different cost allocation methods.

This has been a guide to What are Cost Allocation Methods & its Definition. Here we discuss the two broad cost allocation methods, i.e. explain them in detail. You can learn more about from the following articles -

• Contract Costing
• Semi-Fixed Cost
• Factory Cost

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What Is Cost Allocation?

Cost allocation is a process businesses use to identify costs. Here's everything you need to know.

Table of Contents

Entrepreneurs, small business owners and managers need accurate, timely financial data to run their operations. Specifically, understanding and connecting costs to items or departments helps them create budgets, develop strategies and make the best business decisions for their organizations. This is where cost allocation comes in. Detailed cost allocation reports help businesses ensure they’re charging enough to cover expenses and make a profit. 

While a detailed cost allocation report may not be vital for extremely small businesses, more complex businesses require cost allocation to optimize profitability and productivity.

What is cost allocation?

Cost allocation is the process of identifying and assigning costs to business objects, such as products, projects, departments or individual company branches. Business owners use cost allocation to calculate profitability. Costs are separated or allocated, into different categories based on the business area they impact. These amounts are then used in accounting reports . 

For example, say you’re a small clothing manufacturer. Your product line’s cost allocation would include materials, shipping and labor costs. It would also include a portion of the operation’s overhead costs. Calculating these costs consistently helps business leaders determine if profits from sales are higher than the costs of producing the product line. If not, it can help the owner pinpoint where to raise prices or cut expenses .

For a larger company, cost allocation is applied to each department or business location . Many companies also use cost allocation to determine annual bonuses for each area.

Types of costs

If you’re starting a business , the cost allocation process is relatively straightforward. However, larger businesses have many more costs that can be divided into two primary categories: direct and indirect costs:

• Purchased inventory
• Materials used to make inventory
• Direct labor costs for employees who make inventory
• Payroll for those who work in operations
• Manufacturing overhead, including rent, insurance and utilities costs
• Other overhead costs, including expenses that support the company but aren’t directly related to production, such as marketing and human resources

What is a cost driver?

A cost driver is a variable that affects business costs, such as the number of invoices issued, employee hours worked or units of electricity used. Unlike cost objects, such as units produced or departments, a cost driver reflects the reason for the incurred cost amounts. 

How to allocate costs

While cost objects vary by business type, the cost allocation process is the same regardless of what your company produces. Here are the steps involved.

1. Identify your business’s cost objects.

Determine the cost objects to which you want to allocate costs, such as units of production, number of employees or departments. Remember that anything within your business that generates an expense is a cost object. Review each product line, project and department to ensure you’ve gathered all cost objects for which you must allocate costs.

2. Create a cost pool.

Next, create a detailed list of all business costs. Categories should cover utilities, business insurance policies, rent and any other expenses your business incurs.

3. Choose the best cost allocation method for your needs.

After identifying your business’s cost objects and creating a cost pool, you must choose a cost allocation method. Several methods exist, including the following standard ones: 

• Direct materials cost method: This cost allocation method assumes all products have the same allocation base and variable rate.
• Direct labor cost method: This cost allocation method is most helpful if labor costs can be allocated to one product or if expenses vary directly with labor costs.
• High/low method. This cost allocation method is best if you have more than one cost driver and each driver has different fixed or variable rates.
• Step-up or step-down method: With this cost allocation method, departments are first ranked and then the cost of services is allocated from one service department to another in a series of steps. 
• Full absorption costing (FAC): This cost allocation method combines direct material and direct labor costs with a predetermined FAC rate based on company historical data or industry standards.
• Variable costing: Consider this cost allocation method if your business has many variable cost allocations (costs that vary by quantity) and uses significant direct labor.

4. Allocate costs.

Now that you’ve listed cost objects, created a cost pool and chosen a cost allocation method, you’re ready to allocate costs. 

Here’s a cost allocation example to help you visualize the process: 

Dave owns a business that manufactures eyeglasses. In January, Dave’s overhead costs totaled $5,000. In the same month, he produced 3,000 eyeglasses with $2 in direct labor per product. Direct materials for each pair of eyeglasses totaled $5. Here’s what cost allocation would look like for Dave: Direct costs: $5 direct materials + $2 direct labor = $7 direct costs per pair Indirect costs: Overhead allocation: $5,000 ÷ 3,000 pairs = $1.66 overhead costs per pair Direct costs: $7 per pair + Indirect costs: $1.66 per pair Total cost: $8.66 per pair

As you can see, cost allocation helps Dave determine how much he must charge wholesale for each pair of eyeglasses to make a profit. Larger companies would apply this same process to each department and product to ensure sufficient sales goals.

5. Review and adjust cost allocations.

Cost allocations are never static. To be meaningful, they must be monitored and adjusted constantly as circumstances change.

What are the benefits of cost allocation?

Accurate, regular cost allocation can bring your business the following benefits: 

• Helps you run your business: The information you glean from cost allocation reports helps you perform vital functions like preparing income tax returns and creating financial reports for investors, creditors and regulators. 
• Informs business decisions: Cost allocation is an excellent business decision tool that can help you monitor productivity and justify expenses. Cost allocation gives a detailed overview of how your business expenses are used. From this perspective, you can determine which products and services are profitable and which departments are most productive. 
• Helps produce accurate business reports: Tax accounting, financial accounting and management accounting all require some kind of cost allocation. This information is the foundation of accurate business reports. 
• Can reveal accurate production costs: Knowing what it costs to create a product, including all expenses allocated to it, is essential to making good pricing decisions and allocating resources efficiently.
• Helps you evaluate staff: Cost allocation can help you assess the performance of different departments and staff members. If a department is not profitable, staff productivity may need improvement. 

Common cost allocation mistakes

To get the most from cost allocation, avoid these common mistakes:

• Equal or inflexible allocation : Cost allocation is not as simple as allocating any given cost over different product lines or departments. Some cost objects require more time, expense or labor than others, for example.
• Missing costs: Costing is meaningless if it doesn’t include all expenses. Don’t forget costs, such as overhead, time spent and intangible expenses.
• Failing to adjust as needed: Costs and priorities in business are changing constantly. Be sure your cost allocations are monitored and adjusted to meet your information needs.
• Not considering fluctuating revenue with indirect costs: If your business is seasonal or fluctuates over time, it’s important to account for that when allocating costs. 

Cost allocation and your business

Even if you operate a very small business, it’s essential to properly allocate your expenses. Otherwise, you could make all-too-common mistakes, such as charging too little for your product or spending too much on overhead. Whether you choose to start allocating costs on your own with software or with the help of a professional small business accountant , cost allocation is a process no business owner can afford to overlook.

Dachondra Cason contributed to this article. 

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• Cost Classifications
• Relevant Cost of Material
• Manufacturing Overhead Costs
• Conversion Costs
• Quality Costs
• Revenue Expenditure
• Product Cost vs Period Cost
• Direct Costs and Indirect Costs
• Prime Costs and Conversion Costs
• Relevant vs Irrelevant Costs
• Avoidable and Unavoidable Costs
• Cost Allocation
• Joint Products
• Accounting for Joint Costs
• Service Department Cost Allocation
• Repeated Distribution Method
• Simultaneous Equation Method
• Specific Order of Closing Method
• Direct Allocation Method

Cost allocation is the process by which the indirect costs are distributed among different cost objects such as a project, a department, a branch, a customer, etc. It involves identifying the cost object, identifying and accumulating the costs that are incurred and assigning them to the cost object on some reasonable basis.

Cost allocation is important for both pricing and planning and control decisions. If costs are not accurately calculated, a business might never know which products are making money and which ones are losing money. If cost are mis-allocated, a business may be charging wrong price to its customers and/or it might be wasting resources on products that are wrongly categorized as profitable.

Cost allocation is a sub-process of cost assignment , which is the overall process of finding total cost of a cost object. Cost assignment involves both cost tracing and cost allocation. Cost tracing encompasses finding direct costs of a cost object while the cost allocation is concerned with indirect cost charge.

Steps in cost allocation process

Typical cost allocation mechanism involves:

• Identifying the object to which the costs have to be assigned,
• Accumulating the costs in different pools,
• Identifying the most appropriate basis/method for allocating the cost.

Cost object

A cost object is an item for which a business need to separately estimate cost.

Examples of cost object include a branch, a product line, a service line, a customer, a department, a brand, a project, etc.

A cost pool is the account head in which costs are accumulated for further assignment to cost objects.

Examples of cost pools include factory rent, insurance, machine maintenance cost, factory fuel, etc. Selection of cost pool depends on the cost allocation base used. For example if a company uses just one allocation base say direct labor hours, it might use a broad cost pool such as fixed manufacturing overheads. However, if it uses more specific cost allocation bases, for example labor hours, machine hours, etc. it might define narrower cost pools.

Cost driver

A cost driver is any variable that ‘drives’ some cost. If increase or decrease in a variable causes an increase or decrease is a cost that variable is a cost driver for that cost.

Examples of cost driver include:

• Number of payments processed can be a good cost driver for salaries of Accounts Payable section of accounting department,
• Number of purchase orders can be a good cost driver for cost of purchasing department,
• Number of invoices sent can be a good cost driver for cost of billing department,
• Number of units shipped can be a good cost driver for cost of distribution department, etc.

While direct costs are easily traced to cost objects, indirect costs are allocated using some systematic approach.

Cost allocation base

Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools to different cost objects. A good cost allocation base is something which is an appropriate cost driver for a particular cost pool.

T2F is a university café owned an operated by a student. While it has plans for expansion it currently offers two products: (a) tea & coffee and (b) shakes. It employs 2 people: Mr. A, who looks after tea & coffee and Mr. B who prepares and serves shakes & desserts.

Its costs for the first quarter are as follows:

Total tea and coffee sales and shakes sales were $50,000 & $60,000 respectively. Number of customers who ordered tea or coffee were 10,000 while those ordering shakes were 8,000.

The owner is interested in finding out which product performed better.

Salaries of Mr. A & B and direct materials consumed are direct costs which do not need any allocation. They are traced directly to the products. The rest of the costs are indirect costs and need some basis for allocation.

Cost objects in this situation are the products: hot beverages (i.e. tea & coffee) & shakes. Cost pools include rent, electricity, music, internet and wi-fi subscription and magazines.

Appropriate cost drivers for the indirect costs are as follows:

Since number of customers is a good cost driver for almost all the costs, the costs can be accumulated together to form one cost pool called manufacturing overheads. This would simply the cost allocation.

Total manufacturing overheads for the first quarter are $19,700. Total number of customers who ordered either product are 18,000. This gives us a cost allocation base of $1.1 per customer ($19,700/18,000).

A detailed cost assignment is as follows:

Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000

Manufacturing overheads allocated to Shakes = $1.1×8,000

by Irfanullah Jan, ACCA and last modified on Jul 22, 2020

Related Topics

• Cost Behavior

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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?

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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TWO-STAGE ALLOCATION PROCESS

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Conventional , two-stage allocation in product cost accounting systems that assign indirect costs to jobs or products typically follow a two-stage allocation process. In the first stage, the system identifies indirect costs incurred by support departments (e.g., purchasing, personnel, maintenance, and quality control departments), then allocates these support (i.e., indirect) costs to production departments. In the second stage, the system combines the accumulated indirect costs with production department costs, and using direct labor hours or machine hours as the basis, creates predetermined department overhead application rates (sometimes called burden rates). Overhead costs are allocated to products using the predetermined burden rates.

Activity-based costing (ABC) systems also assign costs to jobs or products in two stages. In the first stage, the ABC system identifies essential activities within the organization and assigns costs to these activities to form activity cost pools....

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(2000). TWO-STAGE ALLOCATION PROCESS . In: Swamidass, P.M. (eds) Encyclopedia of Production and Manufacturing Management. Springer, Boston, MA . https://doi.org/10.1007/1-4020-0612-8_1010

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What Is Cost Accounting?

Understanding cost accounting.

• Cost vs. Financial Accounting
• Cost Accounting FAQs

The Bottom Line

• Corporate Finance

Cost Accounting: Definition and Types With Examples

Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.

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Cost accounting is a form of managerial accounting that aims to capture a company's total cost of production by assessing all of its variable and fixed costs.

Cost accounting is not compliant with generally accepted accounting principles (GAAP); this accounting method is only used by businesses for internal purposes.

Key Takeaways

• Cost accounting is a form of managerial accounting that aims to capture a company's total cost of production by assessing both its variable and fixed costs.
• There are different types of cost accounting, including standard costing, activity-based costing (ABC), lean accounting, and marginal costing.
• Cost accounting is not compliant with generally accepted accounting principles (GAAP); therefore, it is only used internally to help companies make fully informed business decisions.
• Unlike financial accounting, which provides information to external financial statement users, cost accounting is not shared externally, so its methods can be tailored to meet the particular needs of a company.

Investopedia / Theresa Chiechi

Cost accounting is used by a company's internal management team to identify all variable and fixed costs associated with its production processes. Once all input costs are measured and recorded individually, a company can compare all of these costs to its output results. This is one way for a company to measure its financial performance and make future business decisions.

Types of Costs

Cost accounting attempts to capture all of a company's costs, both variable and fixed. While the exact costs used in cost accounting vary from industry to industry—and business to business—these cost categories will typically be included: direct costs, indirect costs, variable costs, fixed costs, and operating costs.

• Fixed costs are costs that don't vary depending on the level of production. These are usually things like the mortgage or lease payment on a building (or a piece of equipment) that's depreciated at a fixed monthly rate. An increase or decrease in production levels would cause no change in these costs.
• Variable costs are costs tied to a company's level of production. For example, a floral shop ramping up its floral arrangement inventory for Valentine's Day will incur higher costs when it purchases an increased number of flowers from a local nursery.
• Operating costs are costs associated with the day-to-day operations of a business. These costs can be either fixed or variable, depending on the unique situation of the business.
• Direct costs are costs related to producing a specific product. If a coffee roaster spends five hours roasting coffee, the direct cost of the finished product includes the labor hours of the roaster and the cost of the coffee beans.
• Indirect costs are costs that cannot be directly linked to a product. In the previous coffee roaster example, the energy cost to heat the coffee roaster is an indirect cost because it is inexact and difficult to trace to any individual products.

Cost Accounting vs. Financial Accounting

Financial accounting presents a company's financial position and performance to outside investors and creditors through financial statements , which include information about its revenues , expenses , assets , and liabilities .

While financial accounting presents information for external sources to review, cost accounting is often used by management within a company to aid in decision-making. Cost accounting can be beneficial as a tool to help management with budgeting. It can also be used to set up cost-control programs, with the goal of improving net margins for the company in the future.

Another key difference between cost accounting and financial accounting is that, while in financial accounting the cost is classified depending on the type of transaction, cost accounting classifies costs according to the information needs of the management. 

Cost accounting, because it is used as an internal tool by management, does not have to meet the standards set forth by  generally accepted accounting principles (GAAP) and, as a result, varies in use from company to company.

Cost accounting methods are typically not used to determine tax liabilities.

Types of Cost Accounting

Standard costing.

Standard costing assigns "standard" costs—rather than actual costs—to its cost of goods sold (COGS) and inventory. These standard costs are based on the most efficient use of labor and materials to produce the good or service under standard operating conditions; these standard costs are basically the budgeted amount. (Even though standard costs are assigned to the goods, the company still has to pay actual costs.)

Assessing the difference between the standard—most efficient—cost and the actual cost incurred is called variance analysis. If the variance analysis determines that actual costs are higher than expected, the variance is unfavorable. If it determines the actual costs are lower than expected, the variance is favorable.

Two factors can contribute to a favorable or unfavorable variance: the cost of the input and the efficiency (or quantity) of the input. The cost of the input is the cost of labor and materials. This is considered to be a rate variance.

The efficiency or quantity of the input used is considered a volume variance. For example, if XYZ company expected to produce 400 widgets in a period but ended up producing 500 widgets, the cost of materials would be higher due to the total quantity (volume) produced.

Activity-Based Costing (ABC)

Activity-based costing (ABC) identifies overhead costs from each department and assigns them to specific cost objects, such as goods or services. ABC cost accounting is based on activities, which refer to any event, unit of work, or task with a specific goal—such as setting up machines for production, designing products, distributing finished goods, or operating machines. These activities are also considered to be cost drivers , and they are the measures used as the basis for allocating overhead costs .

Traditionally, overhead costs are assigned based on one generic measure, such as machine hours. Under ABC, an activity analysis is performed where appropriate measures are identified as the true cost drivers. As a result, ABC cost accounting tends to be much more accurate and helpful when reviewing the cost and profitability of a company's specific services or products.

For example, suppose there is a company that produces both trinkets and widgets. The trinkets are very labor-intensive and require quite a bit of hands-on effort from the production staff. The production of widgets is automated; it mostly consists of putting raw material in a machine and waiting many hours for the finished goods. It would not make sense to use machine hours to allocate overhead to both items because the trinkets hardly use any machine hours. Under ABC, the trinkets are assigned more overhead costs related to labor and the widgets are assigned more overhead costs related to machine use.

Lean Accounting

The goal of lean accounting is to improve financial management practices within an organization. Lean accounting is related to lean manufacturing and production, which has the stated goal of minimizing waste while optimizing productivity. For example, if an accounting department is able to cut down on wasted time, employees can focus that saved time more productively on value-added tasks.

When using lean accounting, traditional costing methods are replaced by value-based pricing  and lean-focused performance measurements. Financial decision-making is based on the impact on the company's total value stream profitability. Value streams are the profit centers of a company; a profit center is any branch or division that directly adds to a company's bottom-line profitability.

Marginal Costing

Marginal costing (sometimes called cost-volume-profit analysis ) examines the impact on the cost of a product by adding one additional unit into production. It is useful for short-term economic decisions. Marginal costing can help management identify the impact of varying levels of costs and volume on operating profit. This type of analysis can be used by management to gain insight into potentially profitable new products, sales prices to establish for existing products, and the impact of marketing campaigns.

The  break-even point —which is the production level where total revenue for a product equals total expense —is determined by calculating the total fixed costs of a company and dividing that by its contribution margin. The contribution margin , calculated as sales revenue minus variable costs, can also be calculated on a per-unit basis in order to determine the extent to which a specific product contributes to the overall profit of the company.

History of Cost Accounting

Scholars believe that cost accounting was first developed during the Industrial Revolution; the emerging economics of industrial supply and demand forced manufacturers to start tracking their fixed and variable expenses to optimize their production processes.

How Does Cost Accounting Differ From Traditional Accounting Methods?

In contrast to general accounting or financial accounting, cost accounting is an internally focused, firm-specific method used to implement  cost controls . Cost accounting can be much more flexible and specific, particularly when it comes to the subdivision of costs and inventory valuation. Cost-accounting methods and techniques will vary from firm to firm and can become quite complex.

Why Is Cost Accounting Used?

Cost accounting is helpful because it can identify where a company is spending its money, how much it earns, and where money is being lost. Cost accounting aims to report, analyze, and improve internal cost controls and efficiency. Even though companies cannot use cost-accounting figures in their financial statements (or for tax purposes), they are important for internal controls.

Which Types of Costs Go Into Cost Accounting?

These will vary from industry to industry and firm to firm. However, certain cost categories will typically be included (some of which may overlap), such as direct costs, indirect costs, variable costs, fixed costs, and operating costs.

What Are Some Advantages of Cost Accounting?

Since cost-accounting methods are developed by—and tailored to—a specific firm, they are highly customizable and adaptable. Cost accounting is useful because it can be adapted, tinkered with, and implemented according to the changing needs of a business. Unlike the  Financial Accounting Standards Board (FASB) -driven financial accounting, cost accounting need only concern itself with insider eyes and internal purposes. Management can analyze information based on criteria that it specifically values; that information can then be used to guide how prices are set, resources are distributed, capital is raised, and risks are assumed.

What Are Some Drawbacks of Cost Accounting?

Cost-accounting systems, and the techniques that are used with them, can have a high start-up cost to develop and implement. Training accounting staff and managers in new accounting systems takes time and effort, and mistakes may be made early on. Higher-skilled  accountants  and  auditors  are likely to charge more for their services when evaluating a cost-accounting system.

Cost accounting is one method a company can use to estimate how well the business is running. Cost accounting looks to assess the different costs of a business and how they impact operations, costs, efficiency, and profits. Individually assessing a company's cost structure allows management to improve the way it runs its business and, therefore, improve the value of the firm. Since it is not GAAP-compliant, cost accounting cannot be used for a company's audited financial statements released to the public. Figures from cost accounting are meant to be internal metrics only.

Fleischman, Richard K., and Thomas N. Tyson. "The Economic History Review: Cost Accounting During the Industrial Revolution: The Present State of Historical Knowledge." Economic History Review , vol. 46, no. 3, 1993, pp. 503-517.

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Module 5: Job Order Costing

Introduction to accumulating and assigning costs, what you will learn to do: assign costs to jobs.

Financial and managerial accountants record costs of production in an account called Work in Process. The total of these direct materials, direct labor, and factory overhead costs equal the cost of producing the item.

In order to understand the accounting process, here is a quick review of how financial accountants record transactions:

Let’s take as simple an example as possible. Jackie Ma has decided to make high-end custom skateboards. She starts her business on July 1 by filing the proper forms with the state and then opening a checking account in the name of her new business, MaBoards. She transfers $150,000 from her retirement account into the business account and records it in a journal as follows:

For purposes of this ongoing example, we’ll ignore pennies and dollar signs, and we’ll also ignore selling, general, and administrative costs.

After Jackie writes the journal entry, she posts it to a ledger that currently has only two accounts: Checking Account, and Owner’s Capital.

Debits are entries on the left side of the account, and credits are entries on the right side.

Here is a quick review of debits and credits:

You can view the transcript for “Colin Dodds – Debit Credit Theory (Accounting Rap Song)” here (opens in new window) .

Also, this system of debits and credits is based on the following accounting equation:

Assets = Liabilities + Equity.

• Assets are resources that the company owns
• Liabilities are debts
• Equity is the amount of assets left over after all debts are paid

Let’s look at one more initial transaction before we dive into recording and accumulating direct costs such as materials and labor.

Jackie finds the perfect building for her new business; an old woodworking shop that has most of the equipment she will need. She writes a check from her new business account in the amount of $2,500 for July rent. Because she took managerial accounting in college, she determines this to be an indirect product expense, so she records it as Factory Overhead following a three-step process:

• Analyze transaction

Because her entire facility is devoted to production, she determines that the rent expense is factory overhead.

2. Journalize transaction using debits and credits

If she is using QuickBooks ® or other accounting software, when she enters the transaction into the system, the software will create the journal entry. In any case, whether she does it by hand or computer, the entry will look much like this:

3. Post to the ledger

Again, her computer software will post the journal entry to the ledger, but we will follow this example using a visual system accountants call T-accounts. The T-account is an abbreviated ledger. Click here to view a more detailed example of a ledger .

Jackie posts her journal entry to the ledger (T-accounts here).

She now has three accounts: Checking Account, Owner’s Capital, and Factory Overhead, and the company ledger looks like this:

In a retail business, rent, salaries, insurance, and other operating costs are categorized into accounts classified as expenses. In a manufacturing business, some costs are classified as product costs while others are classified as period costs (selling, general, and administrative).

We’ll treat factory overhead as an expense for now, which is ultimately a sub-category of Owner’s Equity, so our accounting equation now looks like this:

Assets = Liabilities + Owner’s Equity

147,500 = 150,000 – 2,500

Notice that debits offset credits and vice versa. The balance in the checking account is the original deposit of $150,000, less the check written for $2,500. Once the check clears, if Jackie checks her account online, she’ll see that her ledger balance and the balance the bank reports will be the same.

Here is a summary of the rules of debits and credits:

Assets = increased by a debit, decreased by a credit

Liabilities = increased by a credit, decreased by a debit

Owner’s Equity = increased by a credit, decreased by a debit

Revenues increase owner’s equity, therefore an individual revenue account is increased by a credit, decreased by a debit

Expenses decrease owner’s equity, therefore an individual expense account is increased by a debit, decreased by a credit

Here’s Colin Dodds’s Accounting Rap Song again to help you remember the rules of debits and credits:

Let’s continue to explore job costing now by using this accounting system to assign and accumulate direct and indirect costs for each project.

When you are done with this section, you will be able to:

• Record direct materials and direct labor for a job
• Record allocated manufacturing overhead
• Prepare a job cost record

Learning Activities

The learning activities for this section include the following:

• Reading: Direct Costs
• Self Check: Direct Costs
• Reading: Allocated Overhead
• Self Check: Allocated Overhead
• Reading: Subsidiary Ledgers and Records
• Self Check: Subsidiary Ledgers and Records
• Introduction to Accumulating and Assigning Costs. Authored by : Joseph Cooke. Provided by : Lumen Learning. License : CC BY: Attribution
• Colin Dodds - Debit Credit Theory (Accounting Rap Song). Authored by : Mr. Colin Dodds. Located at : https://youtu.be/j71Kmxv7smk . License : All Rights Reserved . License Terms : Standard YouTube License
• What the General Ledger Can Tell You About Your Business. Authored by : Mary Girsch-Bock. Located at : https://www.fool.com/the-blueprint/general-ledger/ . License : All Rights Reserved . License Terms : Standard YouTube License

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Cost Accumulation: Meaning, Types, and More

Cost accumulation: meaning.

Cost Accumulation is the process of collecting all costs information about the business with the help of the cost accounting system . It is a process of collection of all relevant data regarding the various costs incurred by the company at various stages of production. This calculation is the result or outcome of the cost accounting system prevalent or practices in the company.

Cost Accumulation calculates all manufacturing costs in a sequential pattern. It considers all costs in the production process, starting from inventory to the finished goods. The focus and the objective are to come up with the cost of a particular product or service by identifying various cost objects and their respective cost drivers . Here there exists a cause-effect relationship between cost object and their cost drivers. Thus Cost Accumulation becomes a very connected and integral part of the Cost Accounting System.

Whether Cost Accumulation a part of Managerial accounting too?

Job costing system, assumptions of process costing system, hybrid costing system, difference between job costing and process costing, cost accumulation vs cost assignment vs cost tracing.

The management of the company, after collecting and analyzing the cost data, makes calculative decisions regarding the day-to-day working of the company. The costing data helps the management at all stages of operations, including planning, monitoring, controlling, and decision making. The management also decides when and how the assignment of cost to a particular job or process will happen. And thus, Cost Accumulation becomes a part of both Cost Accounting and Managerial Accounting.

Types of Cost Accumulation

There are majorly three types of Cost Accumulation methods, as follows:-

Job Costing System is most useful when the total production quantity is small or there exist small batches of production. It is also relevant and important when each job is unique. It is a process of accumulating cost information about a particular project or a specific production or product. Under this system, linking and recording the accumulation of direct labor, direct materials, and manufacturing overhead costs happens with respect to the particular job or batch.

Also Read: Types of Costing

This system is widely useful in the delivery of a special or customized product. It also helps while asking for cost- reimbursements or stage-wise advances from the customer. Once the job completion happens, all the costs of the respective job are accumulated. And after that, that particular job sheet and costing exercise on that job also close. It is necessary to consider both direct and indirect costs under this system. At times calculation of indirect costs for a particular job may become difficult.

Thus under the Job Costing System, accumulation takes place according to the respective job order.

Process Costing System

Accumulation of cost through the Process Costing System occurs when the production of a huge amount of identical goods occurs. In this system, the accumulation of costs for a large batch of products takes place. And afterward, further allocation of all such accumulated costs takes place for an individual unit.

Process Costing System accumulates costs on the basis of departments or divisions. In this system, identification and booking of costs to respective cost centers take place. Cost centers are the places of origination of the costs. Accumulation of costs takes place according to the cost centers they belong to.

This method is best suitable when the production is very large in quantity. The production process is also generally continuous in nature without any customization.

Also Read: Cost Accounting Systems – Meaning, Importance And More

• The first assumption is that all products are identical in nature.
• The second assumption of this system is that the costs of all units of production are the same.

At the end of this process, the creation of a ‘Cost of Production Report’ takes place. This report shows the total cost for a particular cost center and the state of both opening and closing inventory. 

Manufacturing units where some production is large while some are small, this is best suitable. Under Hybrid Costing System, process costing is used where the production quantities are large. While if the product is in small batches, the Job System is used. Thus this hybrid system is widely used and now well accepted in such circumstances.

The key differences between both this system of cost accumulation and accounting are:

Sometimes, both Cost Assignment and Cost Accumulation are loosely called and referred to as the same. But it is not so, and they both are different. Cost Assignment is the identification and attachment of costs to the respective costs driver. It is a process of linking costs to their place of origin. Cost Assignment is mainly useful for an activity-based costing method, where linking of overhead expenses occurs where incurrence takes place of these overheads. Cost Allocation is the other name of Cost Assignment.

On the other hand, Cost Accumulation is a completely different concept. And here, the focus and objective are to collect all costs/total costs of that product or service. It is to know the overall cost of production and stages of the cost incurred and analyze this information about the costs for further management decisions. In this system, the process begins with recognizing cost objects and their respective cost drivers.

Cost Tracking is the third term here, which is useful in assigning costs to the departments. Cost Assignment and Cost Tracking helps in the Allocation of costs to the respective department. Thus the main focus of Cost Tracking is to trace back the origin of indirect costs and also establish a causal relationship with the cost driver.  

In simple words, Cost Assignment and Cost Tracking helps in the allocation of costs, and Cost accumulation helps in the collection of costs.

Cost Accumulation is an important step in the cost accounting process. Moreover, accumulating the costs according to the cost object and its drivers is the base of all other cost accounting processes. And the decision is with the management whether to adopt a Job, Process, or Hybrid Costing System. Moreover, it is of vital importance to accumulate costs without any error. Because all further processes are dependent on the accuracy of these figures. Thus Cost Accumulation is one of the important tools for the management of the company to guide and help them in making correct decisions.

Refer to Costing Terms for various other basic cost concepts.

RELATED POSTS

• Cost Accounting and Management Accounting
• Types of Costs and their Classification
• Cost Hierarchy – Meaning, Levels and Example
• Cost Object – Meaning, Advantages, Types and More
• Job Costing – Meaning, Benefits, Process and More
• Types of Cost Accounting

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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