Why Allocating Costs Is Important for Your Small Business

Even small businesses can benefit from properly allocating costs. Learn what cost allocation is and why you should be using this accounting measure in your business.

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Business owners use cost allocation to assign costs to specific cost objects. Cost objects include products, departments, programs, and jobs. Cost allocation is necessary for any type of business, but it's more frequently used in manufacturing businesses that incur a wider variety of costs.


Overview: What is cost allocation?

Part of doing business is incurring costs. To ensure accurate financial reporting, it’s vital these costs are allocated to the appropriate cost object.

While bookkeepers and accounting clerks may need some guidance in properly allocating expenses, using accounting software can help to automate and simplify the entire process considerably.

To track and allocate costs, the cost needs to first be associated with a specific cost object. For example, your company pays $3500 property insurance annually for two buildings you currently own.

One building is 4,000 square feet, while the other building is 8,000 square feet. Your cost object is the square footage of each building, which will be used to allocate the cost to the correct building.


3 types of costs

Most businesses incur a variety of costs while doing business. These costs can range from the cost of materials needed to produce a finished product, to the direct labor wages paid to the employee running the machine used to assemble the product, to the overhead costs you incur every day simply by opening your doors.

Before you get started, familiarize yourself with the various types of costs your business is likely to incur.

1. Direct costs

A direct cost is anything that your business can directly connect to a cost object. Tied directly to production, direct costs are the only costs that need not be allocated, but instead are used when calculating cost of goods sold.

The most common direct costs that a business incurs include direct labor, direct materials, and manufacturing supplies. An employee working the assembly line is considered direct labor, a direct cost.

Same goes for the plastic needed to manufacture a toy, or the glue that holds pieces of the toy together. Direct costs are almost always variable because they vary based on production levels. However, if production remains constant, direct costs may remain constant as well.

2. Indirect costs

Indirect costs are costs incurred in the day to day operations of your business. Indirect costs cannot be tied back to one particular product, but are still considered necessary for production to occur or services to be delivered.

Indirect costs, such as utilities and line supervisor salaries are considered necessary for production, but are not tied to a specific product or service, so they’ll need to be allocated accordingly.

3. Overhead costs

Overhead costs, also known as operating costs are the everyday cost of doing business. Overhead costs are never tied to production, either directly or indirectly, but instead are the costs that your business incurs whether or not they’re producing goods or providing services.

For example, rent, insurance, and office supplies are considered overhead costs, which are costs incurred regardless of production levels.

Some overhead costs such as supplies and printing can be variable, while others, such as rent, insurance, and management salaries are all fixed costs, since the cost does not change from month to month. Like indirect costs, overhead costs will need to be allocated regularly in order to determine actual product cost.


Cost allocation examples

Cost allocation isn’t only necessary for manufacturing companies. There are plenty of reasons other companies may need to allocate costs.

Allocating an employee’s salary between two departments, allocating a utility bill between administrative and manufacturing facilities, or a nonprofit that needs to allocate costs between various programs are just a few reasons almost any business may need to regularly allocate costs.

When allocating costs, there are four allocation methods to choose from.

  • Direct labor
  • Machine time used
  • Square footage
  • Units produced

In the examples below, we used the square footage and the units produced methods to calculate the appropriate cost allocation.

Cost allocation example 1

Ken owns a small manufacturing plant, with administrative offices housed on the second floor. The square footage of the plant is 5,000 square feet, while the administrative offices are 2,500 square feet, with rent for the entire facility $15,000 per month. Rent must be allocated between the two departments.

The calculation would be:

$15,000 (rent) ÷ 7,500 (square feet) = $2 per square foot

Next, Ken, will calculate the rental cost for the plant:

$2 x 5,000 = $10,000

That means that Ken can allocate $10,000 to overhead expenses for the factory.

Next, Ken will calculate the rental cost for the administrative offices:

$2 x 2,500 = $5,000

The balance of the rent, $5,000, will be allocated to the administrative offices.

Cost allocation example 2

Carrie’s manufacturing company manufactures backpacks. In July, Carrie produced 2,000 backpacks with direct material costs of $5.50 per backpack, and $ 2.25 direct labor costs per backpack.

She also had $7,250 in overhead costs for the month of July. Using the number of units produced as the allocation method, we can calculate overhead costs using the following overhead cost formula:

$7,250 ÷ 2,000 = $3.63 per backpack

When added to Carrie’s direct costs, the cost to produce each backpack is $11.38, calculated as follows:

  • Direct Materials: $ 5.50 per backpack
  • Direct Labor: $ 2.25 per backpack
  • Overhead: $ 3.63 per backpack
  • Total Cost: $11.38 per backpack

If Carrie did not allocate the overhead costs, she probably would have underpriced the backpacks, resulting in a loss of income.


Cost allocation frequently asked questions

Is cost allocation just for manufacturing companies?

No, cost allocation is necessary for any business including service businesses and nonprofit organizations.

What is a cost object?

To track and allocate costs, the cost needs to be identified with a cost object, which costs are assigned to. Cost objects can include:

  • Products
  • Departments
  • Programs
  • Customers
  • Jobs

Almost anything can be considered a cost object if you’re able to assign a cost to it.

Is cost allocation important for small businesses?

Yes. While larger companies may have a greater need to allocate costs, smaller businesses can also benefit from allocating costs properly.

For example, even a small car repair shop will need to allocate parts and labor costs properly, while a small consulting business will need to allocate travel costs to the appropriate customer.


Why you should be allocating costs

Cost allocation is important for any business, large or small. How can you determine how much to charge for goods or services if you have no idea how much it costs to produce the goods or services you currently offer your customers?

Properly allocating costs is also essential for accurate financial reporting. Business owners rely on financial statements to make management decisions, and if the reports are inaccurate, it’s likely the decisions made will negatively affect the business.

Finally, allocating costs properly can help you identify profitable areas of your business and products or services that may be losing money, enabling you to make proactive decisions regarding both.

There’s no good reason not to allocate your business costs, so why not get started today?

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