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What Is Indirect Cost Allocation?

Jim B.
Jim B.

Indirect cost allocation is the process of accounting for all the costs incurred by a business or organization that do not directly lead to some sort of output. As a result, these costs are often hard to assign to simply one part of an organization, and must sometimes be shared among various departments. One method of indirect cost allocation is the case-by-case method, which attempts to assign indirect costs based on the department which uses them. Another method is to develop an indirect cost, which totals all of the indirect costs and assigns them based on the size of each department's budget.

Budgeting is a crucial part of any business operation. Knowing how much money is needed to keep operations afloat for a specific time period and keeping that capital in reserve is all part of the process. Such a process becomes tricky when it needs to account for the costs that are not directly attributable to some sort of output but actually accrued by several departments at once. These costs are known as indirect costs, and firms must devise methods for indirect cost allocation that are both efficient and accurate.

Businessman with a briefcase
Businessman with a briefcase

There are many types of indirect costs which might be accrued by an organization. For example, if a firm doesn't own its place of business, rental costs are essentially shared by every department. The salaries of individual employees can be attributed to the departments for which they work, but the salaries of executives who oversee all departments can be harder to allocate. Such examples illustrate the difficulties involved with indirect cost allocation.

Fortunately, there are a few different methods that a business can employ for indirect cost allocation. One, the case-by-case method, attempts to take each indirect cost separately and assign them accordingly. The benefit of this method is that it can provide the most accurate accounting of indirect costs, making budgeting more precise. Such a method requires a great deal of time to complete, however, and can still become inexact when costs are shared by many departments.

Another method of indirect cost allocation occurs when firm management assigns an indirect cost rate to solve the problem. In this method, all indirect costs are totaled. They are then parceled out to each department depending on the size of the department's budget. For example, imagine that a company amasses $500 US Dollars (USD) in indirect costs in a month and $1,500 USD direct costs. That means that the indirect costs make up 25 percent of the company's $2,000 USD budget, and, as such, each department would carry an additional 25 percent of their direct costs as their indirect cost burden.

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