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How can you allocate costs to the right drivers?

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Cost allocation is the process of assigning indirect costs to different products, services, or activities within an organization. It helps managers to measure the profitability and performance of each cost object and make informed decisions. However, cost allocation can be challenging and complex, especially when there are multiple cost drivers and allocation bases. How can you allocate costs to the right drivers that reflect the actual consumption of resources and avoid distortion or arbitrariness?

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GBENGA OMOLERE

FINANCE MANAGER

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Tomi Akinwale ACCA, ACA, ACTI, B.TECH, FMVA, AAT.

Tax | Deloitte | Financial Reporting | Unlocking Your Career Potential
Ammar S.

1 What are cost drivers and allocation bases?

A cost driver is any factor that causes a change in the total cost of an activity. For example, the number of machine hours, labor hours, or units produced can be cost drivers for manufacturing overhead. An allocation base is the measure of the cost driver that is used to distribute the cost pool among the cost objects. For example, if machine hours is the cost driver, then the total machine hours for each product or service is the allocation base.

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GBENGA OMOLERE

FINANCE MANAGER
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Identify the total amount of the joint cost for a given period & then identify the total amount of the cost driver for each output in that same period. Next, calculate the allocation rate by dividing the total joint cost by the total cost driver. E.G, the cost driver selected is machinery hrs. After every 1,000 machine hrs, there is a maintenance expense of $500. Therefore, every machine hr results in a 50-cent (500 / 1,000) maintenance cost allocated to the product being manufactured based on the cost driver of machine hrs. Identify your chosen cost object. To allocate costs, begin by deciding which cost objects you want to connect with specific costs. Accumulate associated costs. Choose a cost allocation method. Perform your calculations.

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Ammar S.
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Here are some steps you can take to allocate costs: 1- Cost drivers are factors that directly affect the cost of a particular activity or process. 2- There are several methods you can use to allocate costs to cost drivers. 3- Collect accurate and detailed cost data related to the activities or operations to which you want to allocate costs. 4- Determine allocation rates for each cost driver based on the relationship between the driver and the costs being allocated. 5-Apply the allocation rates to the actual usage of each cost engine to allocate costs 6-Once costs are allocated, review the results to make sure they make sense. 7.Review and modify your cost allocation methods and rates periodically to ensure they remain relevant and accurate.

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2 How to identify the right cost drivers and allocation bases?

The right cost drivers and allocation bases should meet two criteria: causality and benefits received. Causality means that there is a logical and direct relationship between the cost driver and the cost pool. Benefits received means that the cost objects that use more of the activity should bear more of the cost. To identify the right cost drivers and allocation bases, you should analyze the cost behavior, the production process, and the output characteristics of each cost object. You should also consider the trade-off between accuracy and simplicity, as using more cost drivers and allocation bases can increase the precision of cost allocation, but also the complexity and cost of implementation.

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Tomi Akinwale ACCA, ACA, ACTI, B.TECH, FMVA, AAT.

Tax | Deloitte | Financial Reporting | Unlocking Your Career Potential
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You have to follow an effective strategy such as the one below; 1 First define your specific cost objects involved in the allocation 2. Analyze the production process and activities involved 3. Identify potential variables that causes change in cost

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3 How to calculate the allocation rate and allocate the costs?

The allocation rate is the ratio of the total cost pool to the total allocation base. It represents the amount of cost assigned to each unit of the allocation base. To calculate the allocation rate, you should first estimate the total cost pool and the total allocation base for the period. Then, you should divide the total cost pool by the total allocation base. To allocate the costs, you should multiply the allocation rate by the actual allocation base for each cost object.

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4 What are some common methods of cost allocation?

When it comes to cost allocation, there are different methods that can be used depending on the number and type of cost drivers and allocation bases. The single-rate method uses one cost driver and one allocation base for the entire cost pool, making it simple and easy to apply but potentially not capturing the diversity and complexity of the cost objects. The dual-rate method splits the cost pool into two parts: fixed and variable, using different cost drivers and allocation bases for each part. This is more accurate than the single-rate method, but requires more data and calculations. Activity-based costing identifies multiple activities that cause costs and assigns costs to each activity based on its cost drivers and allocation bases, then allocates costs from each activity to the cost objects based on their usage of the activity. This is more precise and realistic than the single-rate or dual-rate method, but also more costly and time-consuming.

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Diva Ugbobuaku

SAIPA Trainee Accountant | Bcom Financial Sciences (UP)
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Activity-based costing (ABC) is a more sophisticated method of allocating overhead costs that aims to provide a more accurate picture of product or service profitability. Unlike traditional methods that use a single allocation base, ABC recognizes that different activities consume overhead costs at different rates.

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5 What are some benefits and challenges of cost allocation?

Cost allocation can provide several advantages to managers and stakeholders, such as improving the accuracy and relevance of cost information for decision making, planning, and control. It can also enhance accountability and motivation of managers and employees for their performance and resource utilization, as well as facilitate pricing and profitability analysis of products, services, and customers. Additionally, cost allocation can support the allocation of corporate costs to business units or divisions. However, cost allocation also presents some challenges, such as selecting the appropriate cost drivers and allocation bases that reflect causal and beneficial relationships between costs and cost objects. Estimating the total cost pool and the total allocation base accurately is also difficult, as is updating the cost allocation system regularly to reflect changes in cost behavior, production process, and output characteristics. Lastly, there is a need to balance the trade-off between accuracy and simplicity, as well as between cost and benefit of cost allocation.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can you allocate costs to the right drivers?

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1 What are cost drivers and allocation bases?

2 How to identify the right cost drivers and allocation bases?

3 How to calculate the allocation rate and allocate the costs?

4 What are some common methods of cost allocation?

5 What are some benefits and challenges of cost allocation?

6 Here’s what else to consider

Corporate Accounting

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