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 purchase 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 the process of allocating a firms costs to its products in order to help maximize its profits. It 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 to 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.
Economic Classification of Costs
Economic Classification of 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.
Accounting Statement Costs
The following sample income statement illustrates the general expense categories reported on the income statement.
Typically, costs included in COGS (Cost of Goods Sold) represent costs that have been allocated to particular products. In general, these costs do not need to be re-allocated (unless the grain of the allocation is too broad). That is, cogs is measured by tracing a cost directly to the product. For example, the amount of material input used in a product can be traced to the product directly.
Most cost allocation exercises focus on allocating (as opposed to tracing) the costs that fall under the Operating Expense category. (see income statement) That is, these costs cannot be traced to a particular product, and in a sense are for the benefit of all products, or at least a group of products. Many of them are not necessary to producing the product itself, but in selling or developing the product.
Cost Allocation Implementation
Implementation - samples of code used to run a cost allocation.