All of us have used cost allocation as part of our Financial Services offerings since it is required by GAAP. Cost allocation is the process of assigning common costs to ending inventory and cost of goods sold (COGS). Our goal has been to either reduce taxes or increase reported earnings, but this all depends on our client’s needs and circumstances. But what about cost allocation’s other uses? Are we shortchanging our clients by not offering services in this area (usually referred to as cost or management accounting services)?
Implementing Activity Based Costing
Managers’ use cost allocation for a number of reasons. First and foremost, cost allocation provides a methodology for assigning overhead costs of various activities, usually support departments, to products or services being produced and/or sold allowing upper management to assess and analyze their profitability.
By knowing what the true “cause-and-effect” relationship is, managers can more accurately assess the true cost of a product or service. Then they can determine if carrying certain products and/or services contributes to overall profitability given the demand for and price these products/services sell for. This is especially important as it pertains to both operational decisions and capital/long-term decisions.
Some of the operational decisions include the following:
- Calculating the maximum price a firm can charge, especially for a “commodity” product
- Determining the maximum cost a firm is willing to pay to provide this product or service
- In making special order and transfer pricing decisions
Some of the capital/long-term decisions include the following:
- Make-or-buy component decisions
- Continue or discontinue a product line decisions
- Process further decisions
- And more…
You can also use cost allocation to reduce wasteful spending and/or promote more efficient use of resources (especially PP&E). Accomplish this by evaluating needs and uses for the year to come as part of the planning/budgeting process. Managers can then be evaluated on their planning effectiveness, leading to better communication, sharing of resources, and cost efficiency. You can also use it to manage product and process design. As one breaks down and/or determines allocations, the use of resources becomes transparent from a process standpoint. This allows managers to improve operations as needed….