Simple Rules for Cost Allocation

September 28, 2011 by  Filed under: Management 

Invariably, when the subject of costing comes up, the discussion evolves to a discussion of possible allocation bases, or ways that cost can be distributed to products. However, this polite discussion often degenerates into arguments (could we say battles) over who’s doing what to whom with product cost.

To keep these management discussions polite, a few simple rules are in order. Any contest must have rules that are accepted by all participants. Even a demolition derby has rules. In sports, referees and umpires enforce these rules and assess penalties for their infraction. No referees and umpires work in business. But Finance and Product Managers still must follow these costing rules.

Rule 1: Charge directly whenever possible. While charging may be a foul in basketball, direct charging is encouraged in costing. The classic examples of direct charging are direct material and direct labor. Direct material is easily measured to products using it. Direct Labor is also easily traced to the product that the employees worked on. For a certain bank’s cash services department, an armored car service was hired. The contract specified the branches served, cost per branch, and cost for other special services. In this case, the cost did not need an allocation basis. The armored car service’s invoice provided sufficient information to directly assign this service to the respective branch banks. Direct charges cannot require an instant replay.

Lean Manufacturing often finds great value in dedicating equipment and employees to value streams. Value streams are the processes required for similar products. Where this degree of dedicated resources exists, there is no need for cost allocation. This is direct assignment. For good costing in a lean environment, the products of the value stream must be homogeneous in their usage of the dedicated resources. Otherwise, a foul may be called and the allocations bout begins again.

Rule 2: Follow Cause-And-Effect usage. Here is where the principles and methods of Activity-Based Cost or ABC bear fruit. ABC uses a two stage (or more) cause and effect chain to direct cost of resources consumed. First, the resource cost is assigned (not allocated) to activities representing the work done. This assignment uses a measure called a resource driver to quantify resource consumption. The cost of an activity represents the cost of all resources consumed in performing the activity.

Secondly, the activity cost is assigned to products, or services, or customers that are the outputs of the business. This assignment uses a measure called an activity driver to quantity activity consumption. The cost of these products, services, and customers represents the cost of all activities consumed to produce the product, provide the service, or serve the customer, respectively.

Where direct charges are not possible, ABC is the next best alternative as long as the model builders follow cause and effect. If they forget cause and effect but still call it ABC, call a foul.

Rule 3: Don’t forget rules 1 and 2. Warren Buffet’s investing rules are: #1 Don’t Lose Money; and #2 Don’t forget rule #1. For costing, we’ll insert a new rule two. Now, just don’t forget Rule #1 and Rule #2.

Rule 4: There is no Rule 4: If you’ve broken Rule 1: Charge directly; or Rule 2: Follow Cause-And-Effect; and especially Rule 3: Don’t forget rules 1 and 2; you deserve what you get!

While there are no formal business referees, following these three simple costing rules makes the game much more enjoyable and rewarding.

Often rules need more explanation and examples than allowed in a short article. For more assistance and answers to your Cost Allocation and Activity-Based Cost questions, visit

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