Building Your Business What Is Cost Allocation? Cost Allocation Explained in Less Than 5 Minutes By Sierra Kennedy Sierra Kennedy Website Sierra Kennedy is a contributing writer for The Balance covering small business terms and topics. She began freelance writing in 2010, and also launched her first LLC shortly thereafter. An online dropshipping boutique, meanwhile, marked her first foray into the e-commerce space. Sierra's writing clients have included Florida State University, Penn State, Rebel's Market, SportingNews, and Zippia. She now uses her expertise to teach others how to be successful online whether for writing, launching a new store, or overall help with getting their small business started. learn about our editorial policies Updated on July 30, 2022 Reviewed by Robert C. Kelly Reviewed by Robert C. Kelly Robert Kelly is managing director of XTS Energy LLC, and has more than three decades of experience as a business executive. He is a professor of economics and has raised more than $4.5 billion in investment capital. learn about our financial review board Fact checked by Kiran Aditham Fact checked by Kiran Aditham Kiran Aditham has over 15 years of journalism experience and is an expert on small business and careers. As a senior editor he ensures editorial integrity through fact checking and sourcing and reinforces our mission to provide the most informative, accessible content to job seekers and small business owners. learn about our editorial policies Share Tweet Pin Email In This Article View All In This Article Definition and Examples of Cost Allocation How Cost Allocation Works Types of Cost Allocation Photo: miodrag ignjatovic / Getty Images Cost allocation is a method used to assign costs to cost objects for a specific department, project, program, or other area. The methods for cost allocation involve simple calculations, which can be beneficial to small business owners who need accurate financial information to help them price their products or services and make overall decisions. Learning about these methods can help you get a handle on your expenses and positively affect your bottom line. Definition and Examples of Cost Allocation Cost allocation is a method used to assess the costs associated with cost objects in specific categories within a business. Cost objects might include a product or service you sell, a particular department within your company, or the costs of dealing with a supplier. Cost allocation is not just for large corporations looking to reduce expenses. Small business owners can greatly benefit from cost allocation; you get a more detailed look into the actual costs associated with your business, which allows you to assess prices better and increase your profitability. For example, you might want to determine the costs of dealing with one of your suppliers, so you’d add up all of the associated costs. These costs can include everything from the phone calls you make to the time spent dealing with issues caused by them. Additionally, you could count how much you pay for the supplies you get from them. How Cost Allocation Works Cost allocation essentially works by assigning costs to smaller areas within the overall business so that you can view profits or losses at a more granular level. When you use cost allocation, you might discover that your true production cost per unit is higher than expected. Note It’s important to remember that cost objects will vary depending on your business and industry. That means you might consider increasing prices to maintain a specific profit margin. On the opposite end of the spectrum, you may decide to scrap a product that turned out to be a money pit. To accurately calculate cost allocation, you must first identify the cost object, then begin to assess the actual cost. Determining Costs Spreading costs is not an exact science when it comes to cost objects. Some ways to allocate costs are based on units manufactured, square footage, number of hours, headcount, or usage. Let’s say you have a building with a photography studio on the first floor and a salon on the second floor; you’ll use square footage as your cost object. The salon is 2,000 square feet, and the studio is 1,000 square feet. The total rent for the building is $6,000 per month. To allocate rent between the two spaces, you would first divide the total rent by the total square footage of the building: $6,000 (overall rent) ÷ 3,000 sq. ft. (total space) = $2 per sq. ft. Second, you’ll want to calculate the rent for the photography studio: $2 (price per sq. ft.) x 1,000 (studio sq. ft.) = $2,000 Third, you can calculate the rent for the salon: $2 (price per sq. ft.) x 2,000 (salon sq. ft.) = $4,000 Your rent per space should be $2,000 for the overhead expense of the studio and $4,000 for the overhead expense of the salon. Other scenarios might include payroll cost allocation based on employee cost centers, or payment processing cost allocation based on transactions per location or franchise. Note Cost objects can be just about anything you assign a cost to. Some examples of cost objects are jobs, payroll, departments, projects, financial systems, IT, and programs. Types of Cost Allocation Cost allocation is based on different types of costs that fall into one of three categories, generally speaking. Direct Costs Direct costs are the easiest to assign to an identified cost object, because they are directly related. For example, a direct cost could be the labor required to produce a product or the materials used. Indirect Costs When you have an indirect cost, it is not attached to a specific cost object but still is necessary for the business to function. For example, common indirect costs could be security costs or administrative costs not related to a specific department. Overhead Costs Overhead costs—also called operating costs—are those costs associated with the day-to-day operations of your business. These accrue regardless of actual production, but still support productivity. Operating costs might include insurance, rent, and legal fees. Note Costs can be fixed or variable depending on the type. A fixed cost is constant, while a variable cost can fluctuate depending on other factors. The cost type factors into how you allocate the cost later. For example, if you were cost allocating rent, it would be allocated to overhead expenses. You would likely use the square-footage method to allocate the cost. When allocating costs directly related to a product, you might use the units-produced allocation method to factor in overhead costs with the direct costs to create the product. This will allow you to determine better the price you should be asking. Key Takeaways Cost allocation helps business owners identify areas of opportunity with their products or services.Cost objects can include anything you want to measure and assign a cost to, such as products, programs, projects, or even a customer.Ways to allocate costs include square footage, units produced, usage, and headcount. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Warren Averett. "Types of Cost Allocation Methods for Government Contractors." Municipal Research and Services Center of Washington. "Cost Allocation."