Cost allocation / Cost apportionment
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2011 by Marty J.Schmidt.
The Meaning of Cost Allocation and Cost Apportionment
Cost allocation and cost apportionment are methods for attributing cost to particular cost objects (Cost object is a term referring simply to any item associated with a cost figure of its own).
The assignment of cost figures to specific cost objects is a central task in budgeting, planning, and financial reporting. The task may involve both cost accountants and financial accountants, who may use any of several different approaches. The approaches are illustrated here with cost objects common to product manufacturing companies, but the costing principles apply to a very wide range of organizations and their cost objects.
Direct Measurement
In product manufacturing, the costs of labor and materials used directly for producing specific product units can be known with high accuracy by direct measurement. Income statement figures for direct labor and direct materials expenses are called "direct" because it is known which hours and which materials were used for which specific product units.
Allocation or Apportionment
Other income statement figures for "manufacturing overhead costs," such as indirect labor, or factory floor space rental, or machine or computer usage costs, are typically assigned through allocation or apportionment, the practice of assigning a common cost to several different cost objects (such as several different product lines or several different cost centers).
Many business people use these two terms more or less interchangeably, while others prefer to distinguish allocation from apportionment by saying that:
- One of these approaches assigns costs more on the basis of rather arbitrary, or even subjective, rules.
- The other is more "precise" because it assigns costs using rules based on factors such as actual usage or consumption.
Unfortunately, there is no common agreement on which term (allocation or apportionment) is described by each of the points above. In any case, examples of allocation or apportionment might include:
- Manufacturing floor space rental costs assigned to a specific product line in proportion to floor space used for manufacturing that line. For a product line whose manufacture uses 25% of the total manufacturing floor space, the assigned floor space costs might be set at 25% of the total floor space costs. Other product lines would be assigned the remaining 75% of floor space costs.
- The total costs of acquiring, maintaining, and using information systems may be assigned among (divided among) several manufacturing cost centers that use the systems. The proportion of total systems costs for each cost center might be decided on the basis of such factors as the relative:
- Manufacturing volume produced by each cost center.
- Average system transaction volume for each cost center.
- The average processing time requirements for each cost center.
- Number of computer users in each cost center.
Activity Based Costing
Shortcomings of allocated (or apportioned) costing methods are well known and often a matter of concern, especially in situations where it is important to know accurately the "true cost" of, say, manufacturing Product A vs. the "true cost" of Manufacturing product B.
Knowing these costs precisely can be essential for accurate financial accounting reports, effective product life cycle management, and effective product portfolio management. Nevertheless, there may be little assurance that cost assignment rules like those above accurately reflect real differences in product costs.
As a result, some organizations have turned from allocated and apportioned costing to activity based costing (ABC). The reasoning underlying ABC is based on the idea that product production should be analyzed first in terms of the activities that go into it (e.g. manufacturing machine set up and machine maintenance). Then, each activity is analyzed in terms of the resources it uses (e.g., skilled labor hours, unskilled labor hours, electricity, fuel, replacement parts, etc.). The total cost for each activity is determined by the very measurable costs of the resources it uses.
The assigned cost of producing each product is then determined from the extent to which it uses each activity. (For more on ABC, see the encyclopedia entry activity based costing). The advantage to ABC is that it comes closer to accurate, direct measurement of some cost objects than does traditional cost allocation/apportionment. The disadvantage to ABC is that it is "accounting intensive," that is, it requires substantially more hours of analysis and accounting time than traditional methods.
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