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What are the most effective ways to improve cost allocation accuracy?

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Cost allocation is the process of assigning the costs of shared resources or activities to different products, services, or departments within an organization. It is essential for accurate and fair invoicing, budgeting, and performance evaluation. However, cost allocation can also be challenging and complex, especially when there are multiple cost drivers, interdependencies, or uncertainties involved. How can you improve the accuracy of your cost allocation methods and avoid common pitfalls? Here are some effective ways to consider.

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Hanan Hasbullah

Senior Accountant @ Coreo Real Estate | Head of Finance

1 Choose appropriate cost drivers

A cost driver is a factor that influences the amount or frequency of a cost. For example, the number of hours worked, the volume of output, or the complexity of a task. Choosing appropriate cost drivers is crucial for ensuring that the costs are allocated proportionally to the benefits or responsibilities of each unit. You should avoid using arbitrary or outdated cost drivers that do not reflect the actual consumption of resources or the value of activities. You should also review and update your cost drivers periodically to account for changes in technology, processes, or market conditions.

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2 Use activity-based costing

Activity-based costing (ABC) is a method of cost allocation that identifies and assigns the costs of each activity involved in producing or delivering a product or service. It is more accurate and detailed than traditional methods that use broad overhead rates or averages. ABC can help you capture the complexity and diversity of your operations, as well as the indirect and hidden costs that are often overlooked or misallocated. ABC can also help you identify and eliminate waste, inefficiency, or non-value-added activities that increase your costs without improving your quality or customer satisfaction.

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Hanan Hasbullah

Senior Accountant @ Coreo Real Estate | Head of Finance
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ABC allocates costs based on specific activities rather than broad averages. For example, instead of assigning overhead costs based solely on labor hours, ABC identifies activities like machine setup or quality control and allocates costs accordingly. This method provides a more accurate picture of product costs, aiding in better decision making.

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3 Implement cost pools and cost centers

A cost pool is a group of costs that share a common cost driver or allocation base. A cost center is a unit or department that incurs costs but does not generate revenue. By using cost pools and cost centers, you can simplify and streamline your cost allocation process. You can reduce the number of calculations and allocations required, as well as the risk of double-counting or omitting costs. You can also improve the transparency and accountability of your cost allocation by clearly defining the scope and purpose of each cost pool and cost center, and by monitoring and reporting their performance regularly.

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Hanan Hasbullah

Senior Accountant @ Coreo Real Estate | Head of Finance
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Cost pools and cost centers streamline cost management. For instance, in a manufacturing company, production, marketing, and administration are cost centers. Expenses like labor and materials are pooled within these centers, aiding accurate cost tracking and allocation for better decision making.

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4 Apply the matching principle

The matching principle is an accounting principle that states that the costs and revenues of a period should be matched and reported in the same period. It is important for ensuring the consistency and reliability of your financial statements and reports. Applying the matching principle to your cost allocation means that you should allocate the costs of a resource or activity to the period in which it generates revenue or provides benefits, not to the period in which it is incurred or paid. This way, you can avoid distortions or discrepancies in your income and expenses, and better reflect the profitability and efficiency of your units.

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Hanan Hasbullah

Senior Accountant @ Coreo Real Estate | Head of Finance
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Applying the matching principle, a software company aligns the costs of developing a new product with the revenue generated from its sales in the same period. For example, if research and development expenses occur in January and sales start in March, matching these costs with the revenue in March ensures accurate financial reporting, aiding stakeholders' understanding of profitability.

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5 Seek feedback and improvement

Cost allocation is not a one-time or static process. It is an ongoing and dynamic process that requires constant evaluation and improvement. You should seek feedback and input from your stakeholders, such as your customers, suppliers, managers, and employees, on how to improve your cost allocation methods and outcomes. You should also benchmark and compare your cost allocation practices with your competitors or industry standards, and identify and implement best practices and innovations. You should also conduct regular audits and reviews of your cost allocation system, and make adjustments and corrections as needed.

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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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Monica Vasquez

| Finance Leader | Business Partner | C-Suite Support | FP&A | Budgeting & Forecasting | Management Reporting | P&L | Variance Analysis | Financial Planning | M&A | Strategic Finance | GTM Finance | Communications |
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You may consider including multiple allocation bases. This diversifies the criteria by which costs are allocated across different cost centers or activities. Rather than relying solely on a single allocation base, such as direct labor hours or machine hours, this approach considers various factors that influence the incurrence of costs. Here's why using multiple allocation bases can enhance accuracy: -Reflects the complexity of production processes -Provides better cost differentiation -Reduces distortion in cost allocation -Increases flexibility in choosing allocation bases -Enhances decision-making by providing more accurate cost information

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What are the most effective ways to improve cost allocation accuracy?

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1 Choose appropriate cost drivers

2 Use activity-based costing

3 Implement cost pools and cost centers

4 Apply the matching principle

5 Seek feedback and improvement

6 Here’s what else to consider

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