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Cost Allocation method is the process used to assign costs to production or services. When assigning costs to production and/ or service activities it is important to know whether the cost is a direct or an indirect cost. This will let the management of the concern know how to deal with the particular cost. The treatment of direct costs will be different from the treatment of indirect costs or overheads.
Direct costs such as direct material, direct labor are used to make specific product or service. The term cost tracing is used to describe what happens when it is possible to assign a cost directly to a specific product or service. An example of this would be the wood. It is possible to calculate how much wood was used to make a desk or a chair.
But, indirect costs or overheads benefit several products or services and cannot be traced directly to a specific product or service. An example of this would be the wood glue that is used to manufacture the tables, chairs and desks. It is hard to say exactly how much glue was used in making tables, chairs and desks. So, another method of allocating such costs to products that used the glue must be found. Such methods are referred to as cost allocation methods. These methods are used when it is not possible to say exactly how much of a particular resource has been used to make a particular product or service.
Costs are allocated to products using an allocation basis to cost driver when a cost allocation method is used. The cost driver is what causes the cost. It is responsible for the cost. If the cost driver used is one of the major causes of the cost, the allocation basis is known as a cause-and-effect allocation basis. For example, the number of days a material is in storage will have an influence on how much the company has to pay for storage. So, if the material uses the whole storage room for 20 days out of 365 days, then, 5.5% (20/365*100) of the storage costs must be allocated to the material.
If the allocation basis is not one of the major causes of the cost, then it is known as an arbitrary allocation basis. An example of an arbitrary allocation basis is when direct labor hours are used to allocate storage or holding costs to products. The number of direct labor hours does not determine the level of holding costs and cannot determine how to divide the costs fairly among the products.
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