Cost Allocation

Cost allocation is key a component of successful and strategic financial reporting, budgeting, forecasting, pricing, and performance and profitability analysis.

The purpose of cost allocation is to ensure that costs are distributed fairly based on usage, consumption, or benefit received. To ensure costs are allocated consistently, the process is governed by allocation rules and drivers that define how costs flow from source cost centers to target cost objects.

Let’s say a company’s total HR costs amount to $600,000 per year, including recruiting, payroll processing, and employee relations. The source cost center is the HR department.

The cost objects are:

• The Italian business unit, which has 300 employees 
• The Canadian business unit, which has 150 employees 
• The Japanese business unit, which has 150 employees 

To ensure costs scale with headcount and are assigned based on benefit received, the finance team chooses headcount as their allocation driver. Under this allocation logic, 50% ($300,000) of HR costs would be allocated to Italy, and 25% ($150,000) would be allocated to both Canada and Japan. 

Cost allocation is not a one-size-fits-all process. Different scenarios, business activities, and cost structures require different types of allocation. Some situations are simple and don’t require complex calculations, while others are more intricate and may involve a waterfall approach, where costs cascade sequentially through a chain of cost centers and cost objects.

Direct cost allocation

Best used when costs can be clearly and exclusively traced to a single cost object.
Example: Shipping costs tied to a single customer order are directly allocated to that specific order.

Indirect cost allocation

Best used when costs are shared across multiple cost objects.
Example: Factory electricity is a shared cost that is allocated across multiple products and departments.

Service department allocation

Service department allocation: Best used when costs from support departments like HR and IT need to be allocated to operating departments.
Example: The cost of a shared software subscription used by sales and marketing is a shared cost that is allocated to each department based on the number of users or level of usage.

Joint cost allocation

Best used when allocating the costs incurred to produce multiple products simultaneously
Example: The cost of mining crude oil, which produces gasoline, diesel, and jet fuel simultaneously, is a joint cost that is allocated to each product based on the volume or market value of each fuel type.

Overhead cost allocation

Best used when allocating general operating expenses.
Example: The cost of a shopping mall store’s rent is an overhead cost that is allocated across different product categories, such as Apparel, Accessories, and Footwear, based on the sales revenue or square footage each category occupies.

While cost allocation types are scenario-focused and refer to the kinds of costs being allocated and why, cost allocation methodology refers to the process and formulas used to distribute the costs to cost objects. Finance teams must choose an appropriate method to ensure allocations are both fair and consistent. 

Direct method

The direct method allocates service department costs directly to operating departments without recognizing services provided between support departments, making it simple but less precise. 
Example: If a HR runs a workshop exclusively for the sales team, the training costs could be allocated directly to sales without considering any other department. 

Step-down (sequential) method

The step-down method allocates service department costs in a defined sequence, partially recognizing interdepartmental services and providing more accuracy than the direct method, though still with limitations. 
Example: If operations first allocates building maintenance costs to IT and HR, and then IT allocates its costs to marketing and production, the step-down method would be useful.  

Reciprocal method

The reciprocal method allocates service department costs while fully recognizing mutual services exchanged among departments, making it the most accurate approach but also the most complex to implement. 
Example: If IT provides support to HR and HR manages HR software used by IT, the reciprocal method allocates costs considering the two-way support. 

Activity-based costing (ABC)

ABC allocates costs based on the activities that determine them. It’s a detailed method that provides high accuracy and detailed insight into cost drivers and resource consumption. 
Example: If a company produces both city and mountain bikes, ABC could allocate machinery costs based on the number of production hours each bike type consumes, rather than just units produced. 

Single-rate method

A simpler means of allocation, the single-rate method allocates costs using one rate for all costs, making it easy to apply but not very detailed or precise. 
Example: If a company allocates office costs to departments based on the number of employees in each department, regardless of usage, that’s a single-rate allocation. 

Dual-rate method

The dual-rate method separates fixed and variable costs before allocating costs out. 
Example: If a software provider charges departments a monthly subscription cost and an add-on of usage-based storage costs, the dual-rate method would make it possible to allocate out the fixed costs evenly and then allocate the variable portion based on consumption. 

Physical measure method

The physical measure method allocates joint costs based on a measurable physical quantity, like the weight, volume, or units produced of a product, at the point when products become separately identifiable.
Example: If you were allocating the processing costs of crude oil, you could do so based on the volume of gasoline and diesel it produces. 

Sales value at split-off method

The sales value at split-off method allocates joint costs based on the market value of each product at the point where products become separately identifiable.  
Example: This is similar for the physical measure method but would use market value instead of volume as the cost driver. 

Waterfall cost allocations

The waterfall cost allocation method is a complex; multi-step allocation process best used in cases where service departments provide support to other service departments before supporting operating departments. The waterfall method distributes costs sequentially from one cost center to multiple cost objects, so the results of one allocation flow into the next step in the chain. 
Example: IT department costs are first allocated to sales, marketing, and production based on number of users, then HR costs are allocated across the same departments based on headcount.

Circular allocations

The circular allocation method allocates costs in situations where service or support departments provide services to each other, creating a loop. It ensures that all interdepartmental services are accounted for before costs are distributed to operating departments.
Example: IT provides support to HR and HR provides support to IT, with both departments’ costs then allocated to sales, marketing, and production.

Cross-entity allocations

The cross-entity allocation method distributes costs across different legal entities within a company, ensuring that shared services or corporate overhead are fairly assigned. 
Example: Corporate IT costs are allocated to subsidiaries in different countries based on number of users or revenue. 

CCH Tagetik Budgeting, Planning & Forecasting uses a powerful allocation engine designed to support cost management, profitability analysis, scenario modeling, and what-if planning. Finance teams can allocate direct and indirect costs to any cost object, including cost centers, products, projects, customers, or channels, using the most appropriate methodology, whether it’s activity-based costing, the direct method, or your preferred approach.

Our cost allocation engine is fully configurable and finance-friendly. It’s built to enable finance teams to easily define allocation rules and drivers, set up multi-step waterfall allocations, and implement complex logic, including circular or cross-entity allocations, without any scripting or coding.

Whether finance teams are preparing next year’s budget or analyzing aggregated reports to see how costs were distributed, CCH Tagetik’s allocation engine provides a 360-degree view of your costs, past, present, and future.