What is Cost Allocation? An Introduction to Cost Allocations

Cost allocation is the distribution of one cost across multiple entities, business units, or cost centers. An example is when health insurance premiums are paid by the main corporate office but allocated to different branches or departments.

When cost allocations are carried out, a basis for the allocation must be established, such as the headcount in each branch or department.

A cost allocation methodology identifies what services are being provided and what these services cost. It also establishes a basis for allocating these costs to business units or cost centers based on their appropriate share of such cost.

The basis for allocating costs may include headcount, revenue, units produced, direct labor hours or dollars, machine hours, activity hours, and square footage.

Companies will often implement a cost allocation methodology as a means to control costs. Under an effective cost allocation methodology, business units become directly accountable for the services they consume. As a result, both the service provider and the respective consumers of that service become aware of service requirements and usage, and how such usage influences the costs incurred.

As business units begin seeing the cost of the services they consume, they can make more informed choices—such as trade-off decisions between service levels and costs, and benchmarking internal costs against outsourced providers.

Using a basis for allocation, costs are spread to each business unit or cost center that incurred the cost based on their proportional share of the cost. For example, if headcount forms the basis of allocation for insurance costs, and there are 1000 total employees, then a department with 100 employees would be allocated 10% of the insurance costs.

While there are numerous ways cost allocations can be calculated, it is important to ensure the reasoning behind them is documented. This is often done by establishing allocation formulas or tables.

Once the calculation is established and cost distributions are calculated, journal entries are created to transfer costs from the providing or paying entity to the appropriate consuming entities. During each financial period, as periodic expenses are incurred, this calculation is repeated and allocating entries are made.

A cost allocation system consists of a way to track which entity within an organization provides a product and/or service, the entity that consumes the products and/or services, and a means of distributing this cost from the provider to the consumer or consumers. Depending on the operating structure of the company, the cost allocation may be performed by internal invoice, through a chargeback module in the ERP system, or more commonly, through journal entries performed by accounting staff each financial period.