Cost allocation from an accounting point of view

As per the Oxford dictionary definition, cost accounting involves recording all the costs incurred in a business in a way that can be used to improve its management. There are two approaches to cost allocation in cost accounting: traditional and activity-based cost (ABC).

In traditional cost accounting, we have a plant-wide overhead rate. It is calculated using machine hours or labor hours. This will give us one rate that we can allocate throughout the year. Due to this simplicity, traditional costing is easier to implement.

In traditional costing, only the product cost is allocated. It only considers manufacturing overhead. Selling, general, and administrative (SG&A) costs are not considered in traditional costing. Traditional costing can be used to calculate the cost of goods sold and it is an accepted method by auditors. But there are disadvantages to the traditional costing method – for example, it only factors in one rate. Let’s take a scenario where one product is causing issues and requires a lot more customer support hours. In that case, we are understating our cost because we did not allocate the cost to that product line.

Cost accounting is all about making quality decisions, and ABC allocation is the method that will provide us with accurate costs. ABC will compute the rate for each cost pool as that activity occurs. Once we have the accurate cost, we can make the best decision on whether to keep the product line, drop it, or optimize certain processes.

Having covered the advantages of ABC, let’s now look at it in detail.

What is ABC allocation?

ABC in cost accounting is a method of accurately spreading the cost to the relevant business activities so that overhead costs can be calculated in proportion to the rate of the activities.

Let’s understand the key definitions first before we look at an example of ABC allocation:

• Product: This is an item or a service that a business sells to its customers. These products can be physical or virtual. Backpacks, suitcases, furniture, and computers are examples of physical products, while email, credit card processing, and appointment services are examples of virtual products.
• Overhead: This is an expense that a business must pay so that the business can continue operating. Rent, electricity, admin, and customer support are examples of overhead expenses.
• Cost pool: These are business process activities that are grouped into a pool for cost allocation. Each organization defines the most relevant cost pools to their business needs. Assembly, order processing, marketing, and customer support are examples of cost pools.
• Measure: This is a driver for the cost pool. The most common example of a measure is the number of units, number of customers, or number of orders.
• Activity rate: This is calculated by dividing cost by activity. It is the per-unit cost of the activity – for example, the assembly cost of 500,000/20,000 units = $25 per unit activity rate.

To better understand this, here is an example of World Travel Inc., which manufactures travel backpacks and suitcases. World Travel Inc. has an overhead expense of $1,000,000 that needs to be allocated to these product lines. The line manager has identified the following cost pools, measures, and weights:

Cost Pool	Measure	Weight
Assembly	# of Units	50%
Order Processing	# of Orders	10%
Customer Support	# of Customers	25%
Other	N/A	15%

Now, we can calculate the ABC for the $1,000,000 overhead cost as follows:

Cost Pool	Cost	Measure	Activity Rate
Assembly	$500,000	20,000 Units	$25 per Unit
Order Processing	$100,000	2,000 Orders	$50 per Order
Customer Support	$250,000	5,000 Customers	$50 per Customer
Other	$150,000	N/A	N/A

We can use the activity rate to calculate the cost of backpacks and suitcases:

	Backpacks		Suitcases
Assembly	10,000 Units	$250,000	10,000 Units	$250,000
Order Processing	700 Orders	$35,000	300 Orders	$15,000
Customer Support	150 Customers	$7,500	50 Customers	$2,500

As you can see in the preceding calculation, for 10,000 units of orders for two different product lines, the order processing and customer support costs are different. This is the exact problem that ABC solves. In conclusion, the main driver for implementing ABC is that it is much more accurate than traditional costing, which takes one plant-wide overhead rate and asserts that overhead is just driven by machine hours or labor hours. ABC is the method that will give an accurate cost for the product. When we have the most accurate cost, we can make the best decision about whether to keep the product line or optimize the operations.

How do we allocate costs in Azure? We’ll explore that in the next section.