Cost allocation methods are used to resolve the accounting problem that specific costs do not always match specific outputs such as products or services. Different cost allocation methods can involve basing the allocation on time, physical measures such as staffing costs, or on output. Generally the methods should be rational, reasonable and capable of clear explanation.
The main reason for having to choose between different cost allocation methods is for accounting purposes. In some cases this can be for internal use, such as management being able to spot areas where profitability can be increased. In other cases it can be for external use, such as when an investor considers buying part of the company. It can also affect accounts for tax purposes and thus the tax that becomes due. In some cases, either financial or tax regulations may restrict the methods used.
As an example of cost allocation, imagine a company that produces plastic and wooden widgets. Some cost allocation is simple: the cost of buying plastic is clearly assignable as a cost of producing the plastic widgets. If the company sells all the widgets for the same price, but the plastic costs more to buy than the wood, cost allocation will fairly show that the plastic widgets are less profitable.
Other areas of cost allocation are more complicated. For example, the electricity used on the production line needs to be allocated between the costs of producing each type of widget. Some cost allocation methods might involve looking at the proportion of time the production line was producing each type of widget. More complicated methods could involve taking into account how many of each type was produced in this time. If the situation is complicated, such as a company that produces 50 plastic widgets a day on Monday and Tuesday, and 40 plastic widgets a day on Wednesday, Thursday and Friday, which allocation method is used can have an important effect on the cost figures.
In some cases, the need to clearly allocate costs is even greater as the differences are more distinct. One example would be a company that has six retail stores and a head office. Clearly the company will want to see how profitable each store is. It could simply ignore the costs of the head office, or split the costs evenly between each store for accounting purposes.
In this example, the company could also use more specific cost allocation methods. It could divide the head office costs based on the size of each retail store and on the turnover of each store. It could even divide them based on the actual proportion of staff time dealing with specific issues from specific stores. This method would mean that a store that generated a lot of customer complaints or other head office work would wind up appearing less profitable than more low-maintenance stores.