Cost Allocation
| Author | Lawrence Klein, Clifford Brown |
| Pages | 164-167 |
Page 164
A cost is generally understood to be that sacrifice incurred in an economic activity to achieve a specific objective, such as to consume, exchange, or produce. All types of organizations—businesses, not-for-profits, governmental—incur costs. To achieve missions and objectives, an organization acquires resources, transforms them in some manner, and delivers units of product or service to its customers or clients. Costs are incurred to perform these activities. For planning and control, decisions are made about areas such as pricing, program evaluation, product costing, outsourcing, and investment. Different costs are needed for different purposes. In each instance, costs are determined to help management make better decisions.
When incurred, costs are initially reviewed and accumulated by some classification system. Costs with one or more characteristics in common may be accumulated into cost pools. Costs are then reassigned, differently for specified purposes, from these cost pools to one or more cost objects. A cost object is an activity, a unit of product or service, a customer, another cost pool, or a segment of an organization for which management needs a separate measurement and accumulation of costs. Costs assigned to a cost object are either direct or indirect. A direct cost can be traced and assigned to the cost object in an unbiased, cost-effective manner. The incurrence of an indirect cost cannot be so easily traced. Without such a direct relationship to the cost object, an indirect cost requires an in between activity to help establish a formula relationship. When the indirect cost is assigned through the use of this formula, the cost is considered allocated. The activity used to establish the in-between linkage is called the basis of allocation.
Cost allocations can be made both within and across time periods. If two or more cost objects share a common facility or program, the cost pool of the shared unit is a common cost to the users and must be divided or allocated to them. Bases of allocation typically are based on one of the following criteria: cause-and-effect, benefits derived, fairness, or ability to bear. The selection of a criterion can affect the selection of a basis. For example, the allocation of the costs of a common service activity across product lines or programs based on relative amounts of revenue is an ability to bear basis, whereas the same allocation based on the relative number of service units consumed by each product line or program would reflect either the benefits derived or the cause-and-effect criteria. Cost allocation then is the assignment of an indirect cost to one or more cost objects according to some formula. Because this process is not a direct assignment and results in different amounts allocated depending on either the basis of allocation or the method (formula) selected, some consider cost allocation to be of an arbitrary nature, to some extent.
Costs of long-lived assets are allocated and reclassified as an expense across two or more time periods. For anything other than land, which is not allocated, the reclassification of tangible assets is called depreciation (for anything other than natural resources) or depletion (for natural resources) expense. The bases for these allocations are normally either time or volume of activity. Different methods of depreciation and depletion are available. The costs of long-lived intangible...
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