Cost Allocation – Evaluating Theory of Cost Distribution Fundamentals


Cost allocation is a method used by organizations in determining the cost of services provided to users and customers of the services. Cost allocation encapsulates the process of identifying, aggregating, and assigning costs to cost objects. A cost object is taken as any item or activity for which one intends to separately measure costs. Cost allocation therefore fundamentally presents the problem of linking up some or groups of costs with one or more cost objectives which may include products, divisions or departments. It is imperative to note that cost allocation is achieved by identifying cost drivers necessary in linking costs to cost objectives. A cost driver used for the purposes of cost allocation is often referred to as a cost-allocation base (Bragg, 2013). When a group of individual costs are allocated to cost objectives through a single cost driver, the costs are referred to as a cost pool. This implies that all costs in a given cost pool are caused by the same factor.

Included in cost allocation are direct, indirect and incremental costs. The direct cost, also known as separable costs, represents costs that are allocated to a single type of service and are related to one type of output. Indirect costs, on the other hand, are related to more than one type of service. Indirect costs are also referred to as common costs (Bragg, 2013). Incremental costs are used in measuring the changes in output since they change with the level of output produced.

Cost Allocation Methods

There are basic methods of cost allocation namely; direct method, step-down method, and reciprocal method. Direct method of cost allocation majorly assigns support cost only to operating departments. In this case there is no interaction between support departments prior to allocation. In step-down method, support cost is allocated to other support departments and to operating departments that partially recognizes the mutual services provided among all the support departments of an organization. In this case there is a one-way interaction between support Departments prior to cost allocation. The reciprocal method allocates support department costs to operating departments through the full recognition of the mutual services provided among all support departments. This method effects a full two-way interaction between support departments prior to allocation of costs.

Typically cost allocations do fall under three basic forms. One, there is allocation of joint costs to the appropriate responsibility centers. In this case, costs that are used jointly by more than one unit are assigned on the basis of cost-driver activity in the units. For instance, rent is allocated to departments based on the floor space occupied or allocating general administrative expenses subject to total direct cost. Two, there is reallocation of costs from one responsibility center to another. This implies that when one unit gives provision of services and products to another, the costs are transferred along with the products or services to another. Three, is the allocation of costs of a particular organization unit to its output of products and services.

The Purposes of Cost Allocation

The conventional cost allocation primary goal is to formulate decisions that maximize the company’s value.  Another fundamental objective of the cost allocation decision making is to maximize the wealth of the stockholder. Consequently, the stock price is maximized when the markets are deemed to be efficient. It is crucial to make note of the fact that all the other objectives of the company are intermediate goals and operate either in maximizing the value of the firm or work as constraints on the maximization of the firm value. The company costing process and decision making largely involve forecasting the business profits which should assess the business break point (Amdur, 2009).  Understanding the nature and amount of the required assets, crucial in attaining the optimal hurdle ratio and their financing prerequisites is fundamental in the corporate cost allocation decision making.

Managers in an organization ought to be aware of all the consequences of their decisions including consequences emanating from outside their unit. One of the major purposes of cost allocation is to obtain desired motivation. Cost allocations can at times be made to influence the management behavior and in so doing enhance goal congruence and managerial effort. Subsequently, there is no cost allocation for legal or internal auditing services in some organization since the top management intends to encourage their use. On the contrary, some organizations allocate costs for such items with the view of spurring managers to ensure the benefits of such services exceed the costs. Secondly, cost allocation is employed to compute income and asset valuations. In this case, costs are allocated to projects and products with the intention of measuring inventory cost and the cost of goods sold. Beyond servicing financial accounting services, this form of allocation is often used by managers in planning, motivating managers and evaluating performance (Lemaire, n.d.). The third major purpose of cost allocation is to justify costs or in obtaining reimbursement. In the event that prices are subject to costs, the cost allocation becomes the substitute for the usual working of the market in setting the prices.

In the event that a conventional cost allocation process does not yield a desired hurdle rate, it is necessary to choose a different mechanism for the company costing decision making and corporate governance. It is also vital to choose different company goals and objectives. Additionally, there is need to maximize the stock price while reducing the potential for breakdown and conflict (Pratheepkanth, 2011). This can be achieved by incorporating the managers and other decision makers as stockholders as well as allowing honest and prompt provision of information to financial markets. 

Diversification of Cost Objectives and Risk Reduction

Diversification of cost objectives significantly cushions a business against the risks by compensating the effect of poor performing entities by the gains of better performing investments. It should be noted that comprehensive and effective diversification does not only involve having a wide continuum of cost objectives but also requires the selection of an optimal mix of cost objectives that will ensure returns will surpass the minimum hurdle ratio (Amdur, 2009).

Ensuing from the fact that in a given context and set of conditions some cost objectives operate differently from others, highlights the concept that different cost objectives bear different correlations.  Correlation is considered to be a statistical measure of the extent to which two cost objectives or investments tend to perform the same in particular market conditions. It is in distributing the risk factor through allotting a company’s cost objectives across a range ventures such as stocks, bonds and short-term investments, that portfolio performance of the company is enhanced. A well-adjusted business portfolio involves holding differentiated classes of assets and assortment of cost objectives.

Situational Analysis of Cost Allocation in Auto Industry

                Over the years, product innovation is proceeding fast in the automobile products market. The rise of new models has been commensurate with the ever changing competitive landscape. Such market prerequisites call for companies to make decisions on the cost allocation of their different products, services and departments simultaneously.  A product passes through a conventional set of stages referred to as the product life cycle as it hits the market. The four stages of a product life cycle are: introduction stage, growth stage, maturity stage, and decline stage. In the course of the introduction stage, there is product promotion in a bid to create awareness. At this stage a limited number of products are available in the market and thus makes it very unlikely that companies will make any significant profit on products (Kazemi et al., 2011). Monitoring at this stage is vital in a bid to ensure that products do starts to grow else the products ought to be withdrawn from the market. A product enters the growth stage once it starts to grow in the market. The growth stage is usually marked by a rise in the number of sales as well as profits. The increase in prices at this stage is attributed to an increase in output and conceivably enhanced prices.  During the maturity stage, the overall profit is earned by the market while as the competition begins to intensify. At this stage, companies are compelled to constantly develop new ideas and spending more on research and development in order to ensure their product has a competitive advantage against other similar products in the market (Nissim and Thomas, 2000). The decline stage marks the last phase of the product life cycle. In the course of this stage, the profits are not high and the market undergoes shrinking. At this stage a company may be forced to take off the product from the market. These four stages of the product life cycle call for managers to adopt relevant cost allocation approaches for each respective maturity stage.

The costs of producers, such as automobile manufacturers, are typically categorized into two broad classes: direct manufacturing cost and indirect costs. Direct manufacturing costs include manufacturing labor as well as direct material costs. These costs can be estimated by use of reverse engineering among other approaches. The indirect costs include corporate operations, research and development, marketing and dealer support. Indirect costs in the manufacturing sector are difficult to estimate. This follows from the fact that many indirect costs are difficult to assign to specific production activities or are not subject to the levels of production. Following such difficulties in estimating indirect cost, the cost allocation in the automobile manufacturing sector relies on scaling factors to changes in estimated direct costs to capture the changes in the indirect costs (Helfand et al., 2009). This is vital in the view of new technologies, in predicting the full impact of vehicle modifications to the final selling price.

One of the commonly used scaling factors is the retail price equivalent (RPE) multiplier. This factor is historically based and draws a comparison between direct manufacturing costs and other factors that influence the final selling price of the vehicle. The use of RPE multipliers implicitly assumes that the incremental changes in direct manufacturing costs have a common fraction change on all indirect cost components as well as the gained profits (Helfand et al., 2009).  


The term cost allocation in theory implies that there is no single precise method available for assigning a cost to a cost objective and hence the allocating a cost entity is fundamentally an approximation method. However, there is need to refine the basis upon which one allocates costs. It should be noted that whatever the goal one has to settle on a given method of cost allocation should be spread the cost in the fairest manner possible. Additionally, the optimal cost allocation method should impact the behavior patterns of the cost objectives involved.

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