To allocate is the process of assigning indirect costs to a variety of cost objects, based on a rational and consistently applied methodology. The allocation of costs is required under Generally Accepted Accounting Principles for the valuation of inventory. Allocations are also used within the activity-based costing methodology.
Any allocation is based on an estimated relationship between the cost being assigned and the cost object to which it is assigned, which may not be valid. Thus, allocated costs tend to be viewed with some suspicion when using the information to arrive at operational decisions.
Indirect costs are those costs that are not directly associated with a specific product, activity, or event. Examples of indirect costs are:
- Equipment maintenance
- Production supervisor salaries
- Production utilities
- Production facility rent
- Production equipment depreciation
Examples of cost objects are:
- Distribution channels
- Geographic regions
Examples of the methods used to allocate costs include:
- Based on square footage used
- Based on electricity consumed
- Based on machine hours consumed
- Based on direct labor hours used
- Based on direct labor cost used
In general, the simplest possible allocation methodology is recommended if the outcome is only to generate GAAP-compatible financial statements. A higher level of precision may be required if the outcome is to be used to support management decision-making. No matter what level of precision is used, allocations can cause incorrect decision making, unless managers are warned about how allocated expenses may not change if the cost objects to which they are assigned are terminated.