Cost allocation is the process of identifying and assigning the costs of services necessary for the operation of a business or other type of entity. Unlike a cost rating, the allocation is less concerned with the actual amount of the cost, and more concerned with allocating or assigning the cost to the correct unit within the organization. From this perspective, cost allocation can be seen as a tool that helps track all costs associated with the ongoing operation more efficiently, since each cost is associated with specific departments or groups of departments within the organization.
A simple example of cost allocation would be the wages or salary of an employee assigned to work in a specific department. In a hospital, a nurse is normally assigned to a specific wing or floor, with the costs allocated to the general operation of that unit. As long as the nurse continues to work his or her assigned shift within that unit, the salary and benefits accrued are associated with that unit. However, if the nurse is called upon to fill in on another floor or unit, such as spending an entire shift working in the emergency room, the salary and benefits earned for that period of time may very well be allocated to the unit where the nurse worked, instead of his or her permanent wing or floor.
There are several reasons why cost allocation is important. One has to do with accurately assigning costs within an organization, so that it is possible to know exactly what types of costs were incurred in the operation of a given area in the organization. This is not only important information to consider when creating an operating budget, but is also key in calculating taxes that must be paid to local, state, and federal tax agencies. In a number of countries around the world, the way that costs are allocated can have an impact on how much the organization pays in taxes, making it necessary to comply with any government regulations that have to do with the allocation of costs within the organization.
Another benefit of cost allocation has to do with simply keeping track of expenses for internal planning purposes. While some expenses are indirect costs and benefit more than one area of the operation, there is still a need to allocate direct costs in a manner that is logical and accurate. Even when the costs are incremental, meaning they are stretched out over several accounting periods, making sure the costs are assigned properly can make a big difference in how well each unit within the business or other entity works within their share of the overall budget. When it is apparent that one unit will exceed its assigned budget, steps can be taken to implement cutbacks on non-essential service costs, while finding ways to adjust the overall budget to allow for the continuing support of essential functions.
Organizations of all types and sizes engage in the task of cost allocation. Businesses use this strategy as a tool for planning and keeping within a budget. Non-profit entities utilize the tool as a way of providing as many services to its members as possible, while still making the most effective use of its resources. Even households can make use of the concept of cost allocation when planning the operating budget for the family. As a means of identifying and properly assigning costs, this approach to allocation helps to provide focus and structure to financial planning in a way that would be extremely difficult otherwise.