What is Cost Allocation? Definition & Process

More #CostAllocation help: floqast.com/blog/what-is-cost...
00:00 Introduction
00:15 What is Cost Allocation?
00:51 What types of cost are allocated?
02:14 What are the four purposes of cost allocation?
02:18 Why are costs allocated?
05:10 What is the process?
07:27 Recap
We’re going to define cost allocation, explain the process, and provide examples to help you understand why cost allocation is useful.
Basically, a cost allocation system is a process for assigning costs to the different businesses, departments or products that benefit from those costs, also known as cost drivers.
Throughout this video, we’re going to illustrate cost allocation methods using a fictional business: a chain of lemonade stands known as Lisa’s Luscious Lemonade. If Lisa wants to know what it costs to produce a jug of lemonade, she needs to allocate several different types of costs (or, a cost pool) to each jug she produces.
What types of costs are allocated?
There are three broad categories of costs used in cost accounting:
Direct Costs
You can trace direct costs right to the product or service. Lisa’s Luscious Lemonade has direct materials, such as lemons, sugar, and water. She also has direct labor for the wages she pays to employees who make the lemonade.
Indirect Costs
Indirect costs can’t be traced directly to a product or service, but they are necessary. Indirect costs may be fixed or variable. Fixed costs stay the same from month to month, no matter how the company’s production or sales volume fluctuates. A few common examples of fixed costs include renting manufacturing equipment or a supervisor’s salary.
Variable costs increase when sales or production volume goes up. One example of a variable cost is equipment maintenance because a heavily used piece of equipment needs more frequent maintenance.
Overhead Costs
Overhead costs aren’t part of producing a good or service, but they benefit the business as a whole. Some examples include advertising, insurance, human resources, and wages paid to the sales team.
What are the four purposes of cost allocation?
So why bother with cost allocation? Because it provides several benefits.
To justify costs for pricing or reimbursement
Cost allocation helps a business know how much to charge for its products or services.
For example, suppose Lisa bases the price of a glass of lemonade on direct costs alone without allocating overhead costs. She would lose money on every glass of lemonade she sells and eventually have to close up shop.
To measure the costs of inventory and cost of goods sold
Businesses also use cost allocation for financial reporting. Generally Accepted Accounting Principles - otherwise known as GAAP - requires companies to match expenses with related revenues.
For Lisa’s Luscious Lemonade, this means Lisa can’t expense the cost of lemons and sugar when she buys ingredients. Instead, she allocates those costs to inventory, where they remain until she sells the lemonade. Once Lisa makes the sale, she can finally expense those costs as a part of cost of goods sold.
Cost allocation gives business owners and managers the information they need to make financial and economic decisions.
A company might use GAAP for its financial reporting, but GAAP isn’t always helpful for internal decision-making. That’s why many businesses use activity-based costing in addition to the cost allocation used for financial reporting.
In activity-based costing, a business assigns products to all of the overhead costs they can reasonably be assumed to have caused. This usually includes some - but not all - manufacturing overhead costs and some operating expenses they don’t assign to products under GAAP rules.
Say Lisa is considering selling freshly baked muffins in addition to lemonade. Lisa needs to know the cost of producing those muffins. Using activity-based costing, she can assign costs to each activity in the production process, allowing her to more accurately adjust her pricing methodology to set a price that accounts for how much it costs to create each muffin. Then she can compare that cost to the price her customers are willing to pay and decide whether it’s worth the effort and expense of producing and selling them.
To motivate managers and employees
Cost allocation can also help motivate managers and employees. For example, say Lisa has two shifts of employees making the lemonade. One shift uses more lemons and sugar but makes fewer jugs of lemonade per shift. Maybe untrained employees are making mistakes. Maybe someone is stealing products. Either way, allocating costs to the different shifts has uncovered a problem Lisa needs to look into.

[@realkkayy]

this was extremely helpful and super simple, I've watched more than 100 videos and non of them explained it this well!! thank you

[@JoshuaYuan36]

I have a test on introduction to managerial accounting tomorrow, and this video is my cram video.

[@marromanugalde8015]

I understand every point. I wonder if you have samples for IRs?

[@Sotnascire519]

Awesome explanation. Very thorough. Thank you

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I think i'm in love

[@priyanshuranjandas188]

thanks, helped a lot 🙏🏼🙏🏼

[@SwiftGQ]

Excellent explanation.

[@luzungkennardp.6417]

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excellent video.

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Need more videos on ' Accounting'.

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