Definition: An allocation is the process of shifting overhead costs to cost objects, using a rational basis of allotment. Allocations are most commonly used to assign costs to produced goods, which then appear in the financial statements of a business in either the cost of goods sold or the inventory asset. If financial statements are not to be distributed outside of an entity, then there is less need to use allocations.
If used improperly, cost allocations can cause incorrect management decisions. For example, assigning overhead costs to a product can make it appear to have an excessively low profit, which could lead to a decision to terminate a product that is still generating a reasonable contribution margin.