Cost Allocation

Some costs can be traced directly to a product or department, such as the materials used to make a product. Others are shared, and must be divided using an allocation base that reflects how the cost is used.

Common allocation bases include floor space for rent, headcount for human resources and IT costs, machine hours for factory overheads and revenue for some general costs.

For example, an IT department costing 90,000 serves three departments with 20, 30 and 50 staff. Allocating by headcount assigns 18,000, 27,000 and 45,000 respectively.

Cost allocation helps set prices, measure profitability and make sure all costs are recovered. But allocations can be misleading if the base does not reflect what actually drives the cost. A product might appear unprofitable only because it carries a large share of overheads it barely uses. Activity-based costing aims to improve accuracy by using more precise cost drivers. For decisions such as whether to drop a product, managers should focus on costs that would actually change.