A cost allocation system is used to allocate overhead directly to a department or cost center. Allocation can only be used when overheads are specifically identified or attributable to the particular department which resulted in the cost being incurred.
For example, the salary cost of a production supervisor is an overhead which is allocated to the production department, the repair costs for a machine are allocated to the department in which the machine is located, marketing overheads are allocated to the marketing department. In each case, the entire cost is allocated to a particular department or cost center.
In order to understand cost allocation, it is first necessary to distinguish it from cost apportionment, which is a method of apportioning costs between cost centers, and cost absorption which is the addition of allocated and apportioned costs to unit, job, or batch costs.
Take for example, a business which has three cost centers, general overhead, manufacturing and finishing departments shown in the diagram below.
Overheads specifically attributable to each cost center are allocated directly to that department. For example, the manufacturing departments supervisors salary cost is allocated to manufacturing, the depreciation of the finishing machines is allocated to the finishing department, and the rent for the premises is allocated to the general overhead cost center. At the next level the costs allocated to the general overhead cost center are apportioned between the manufacturing and finishing departments on a suitable basis. Finally, the allocated and apportioned costs of the manufacturing and finishing departments are absorbed and added to the costs of the production units.
Cost Allocation Example
A business operates three cost centers, general overhead, production, and selling. During the accounting period the business incurs the following costs.
- Factory supervisors salary 3,000
- Rent on the premises 5,000
- Marketing brochure costs 1,000
- Legal fees 500
- Insurance expense 800
The factory supervisors salary relates to production and is therefore allocated to the production cost center. The rent is for the whole premises including the factory and the offices, it is therefore allocated to the general overhead cost center and will be apportioned between the other cost centers at a later stage. The marketing brochure costs will be allocated to the selling department, and finally the legal fees and insurance expense will be attributed to the general overhead cost center.
Using the cost allocation system the overhead costs are allocated to the departments as follows.
- General overhead = 5,000 + 800 + 500 = 6,300
- Production = 3,000
- Selling = 1,000
An overhead cost allocation system is the first step in ensuring costs are correctly apportioned, absorbed and added to unit production costs. Cost allocation helps to determine the cost of a product which in turn leads to correct pricing. In addition, by allocating costs to a cost center or department the business is able to monitor the effectiveness of the management within the department to ensure it is being operated efficiently.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.