Cost allocation is the process of identifying and assigning costs to activities, people, projects or any other cost objects. It’s goal is to spread costs fairly across departments, to calculate profitability and derive transfer prices. Essentially, it works to measure financial performance and improve decision making.

An organization has many types of costs. Fixed costs are those that don’t vary, like rent or insurance premiums. Variable costs are those costs tied to production, like labor, packaging and materials. Operating costs are the day-to-day costs. Think travel expenses, salaries, utilities. Direct costs are the expenses related to developing a product, like the amount of material needed,  while indirect costs would be not directly tied to the product, like accounting.

Activity Based Costing is a common costing allocation method that assigns indirect costs to products by recognizing the relationship between costs, activities and products.
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