Cost Allocation

Overview

Cost allocation is the process of taking a set of costs and assigning or allocating them to the production of a given unit of product.

Firms will typically have a record of total costs, which is reported in their financial statements. However, these costs are reported on a aggregate basis. For example, when manufacturing cars, a firm will have to purchase steel. But the firm will purchase the steel in bulk, to cover the required amount for many cars. As such, the firm will have to actively partition out the costs from the bulk steel to each car it produces.

The cost of material inputs to a product can be rather straightforward, but other costs are not so easy. For instance, most firms incur Information Technology (IT) costs. Every product produced benefits from a company's IT, but it is not clear cut how much each product benefits.

Cost allocation is an example of the mathematical problem of attribution and suffers from some of the same complexities.

Purposes of Cost Allocation

The purpose of doing a cost allocation is to begin to map out an understanding of a firms cost curves. (see firm costs) It is important to understand that the cost per product faced by a firm will change as the amount of product produced changed. That is, the cost to produce a single pencil is different when one is already producing a million pencils, versus the cost to produce just a single pencil.

With this in mind, analysts should structure their analysis to answer the question being asked.

• Cost Benchmarking: is the process of comparing a firms costs versus those of similar firms in the same industry. For example, a bank may wish to compare its IT costs to that of other banks.
• Profit Optimization: understanding a firms cost curves is a critical part of understanding the firms optimal production points.
• Product Profitability: is the process of understanding how much a given product contributes to a firms overall profitability, particularly in the case where the firm has multiple products.
• Client Profitability: is similar to the product profitability measure. It seeks to understand how much a given customer contributes to a firms bottom line.

Classifying Costs

• Direct Costs: are costs that can be traced directly back to the product that drove the cost. (see firm costs in micro-economics)
  • Fixed Costs: are one time costs that apply over a range of quantity of product produced.
  • Variable Costs: are costs that change as the quantity of product changes.
• Indirect Costs: are costs such as marketing expense that are general in nature and not tied to any one product.

Cost Allocation Implementation

Implementation - samples of code used to run a cost allocation.