An allocation base is the basis upon which an entity allocates its overhead costs. An allocation base takes the form of a quantity, such as machine hours used, kilowatt hours consumed, or square footage occupied. Cost allocations are mostly used to assign overhead costs to produced inventory, as required by several accounting frameworks.
The typical allocation process in a multi-department company is:
- Allocate service department costs to operating departments.
- Assign operating department costs (including the allocations from service departments) to products and services.
The allocation base should be a cause, or driver, of the cost being allocated. A good indicator that an allocation base is appropriate is when changes in the allocation base roughly correspond to changes in the actual cost. Thus, if machine usage declines, so too should the actual cost incurred to operate the machine.
Here are several examples of appropriate allocation bases:
- The computer services department allocates its expenses based on the number of personal computers used by each operating department, or by the number of service calls to each operating department.
- The janitorial department allocates its expenses based on the square footage occupied by each operating department.
- The human resources department allocates its expenses based on the number of employees working in each operating department.
Most organizations use a very small number of allocation bases to allocate overhead costs, though a detailed activity-based costing system may use quite a large number of them.
Managers should be aware of every allocation base being used, since it is the basis for overhead charges being assigned to their departments. They may alter the activities of their departments to reduce their use of each allocation base, thereby reducing the costs assigned to their departments.