Cost allocation is very crucial for any budgeting decision to be made especially in big companies. There are various departments within the company or organization. For instance, in a manufacturing company, there can be production departments and service departments. The service departments provide services to the other departments of the organization. When allocating costs to the service departments, it is prudent to assign their costs to the production departments which should be shared by the production departments.
Understanding cost allocation can be crucial in estimating any future expenditure as the budget is being prepared. Budgets also include the revenues expected to be received from each of the departments or each activity of the business. An organization has to price its products and services in a profitable way especially in making sales budgets.
Edmonds, Olds, McNair, and Tsay (2012) explain that Costs are divided into categories of direct labor, direct materials, and overheads. Direct costs can be traced and hence easily allocated unlike the overheads or indirect costs. The two methods used in the allocation of overheads are a direct method and cost allocation method. The direct method may lead to misallocation of costs and poorly set prices. The company has to make a decision on the method to be used in the preparation of its budgets. The cost allocation method is the most efficient method in which Activity-Based Costing (ABC) is used to accurately determine the costs.
The cost drivers are used where products that use specific activities are identified and then resources are measured based on consumption by the products. For example, in a production cost budget, a product may have a cost per machine set up as the cost driver. Assuming that the number of machine set-ups needed for this product is 10, and the cost per machine set up is $2, then the cost to be allocated is $20.Another cost driver like several orders and inspections can be calculated. The costs can then be accurately used in the preparation of production cost budgets.
Products that do not use certain activities do not share the cost burden with other products (Edmonds et al, 2012). This is more accurate and therefore will be useful in the calculation of costs for a given product. The mark-up is then computed to determine the price to be charged for each of the products made. The company will be more competitive in the market as it can allocate the costs and decide to reduce the prices of those products that are overpriced.
In the long run, the business can maximize profits as it correctly prices its products in the market (Garrison, 2007). ABC is mostly associated with product differentiation and therefore many companies will confidently determine how much to produce and make accurate estimates of the profitability of the various products that they produce. The firm can then increase the production of products that are very profitable and less costly instead of continuing the production of highly costly products.
ABC has the disadvantage of being complex to apply in the business. Most managers and accountants may find it difficult to use, however, it can be very useful in making effective budget decisions for the firm which in the long run can lead to the high profitability of the business. Large companies which have various departments should allocate the costs efficiently especially when dealing with overheads or indirect costs.
References
Edmonds, T., Olds, P., McNair, F., & Tsay, B. (2012). Survey of accounting. New York, NY: McGraw-Hill/Irwin.
Garrison R. (2007). Managerial accounting. New York, NY: McGraw-Hill/Irwin.