An expense allocation occurs when indirect costs are assigned to cost objects. Expense allocations are required by several accounting frameworks in order to report the full cost of inventory in the financial statements.
A cost object is anything for which a cost is compiled. Examples of cost objects are products, product lines, customers, sales regions, and subsidiaries. An indirect cost is a cost that is not associated with a single activity. Examples of indirect costs are facility rent, utilities, and office supplies.
A company may allocate its indirect costs in order to determine the entire cost of a cost object on a full absorption basis. Full absorption refers to the assignment of all possible costs to a cost object, so that the costs of all activities are considered. This approach is required under the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting standards (IFRS) accounting frameworks.
By its definition, an allocation is bound to be imprecise. Thus, the resulting full absorption costing of a cost object is inherently inaccurate. If a business does not require an overly precise expense allocation, it can rely upon a simple formula that is easy to derive. This approach is commonly taken when using expense allocation to comply with the dictates of an accounting standard. However, if considerably more precision is needed, perhaps to make a management decision, then a more complex allocation method can be used, such as the activity-based costing system.
Examples of expense allocation methods are as follows:
- Direct labor hours. Factory overhead costs are routinely allocated to products based on the number of direct labor hours used in the production of the products. The resulting allocation can be quite inaccurate, but is easy to derive.
- Revenue. The cost of corporate headquarters may be allocated to subsidiaries based on their revenue. The reasoning behind this allocation is that the subsidiary with the highest activity level can afford to bear the burden of corporate overhead.
- Square feet. If a cost object (such as a production line) takes up a fair amount of square feet, those expenses related to facilities costs can be allocated based on the square feet used by the cost object.
- Staffing. If the bulk of a company's costs are related to personnel costs, consider allocating the indirect costs of personnel based on the number of employees or the number of labor hours consumed. This approach works best in a services business, where there are many employees.