Cost Allocation for Budgeting or Financial Reporting

Developing a solid financial budget for 2022 is a living project for most organizations this time of year. While this budget is designed to provide a unified vision for the entire organization, that vision is sometimes sidetracked by disagreements between management when it comes time to determine who is responsible for shared costs within the organization. This comes as no surprise if management is going to be held accountable for shared costs they do not directly control.

The most common method for allocating costs is to do it the same as last time, whether that be last month, last quarter or last year. While there is value in a consistent allocation of costs from period to period as it provides comparability for the periods, the allocation method of costs can become outdated when an organization grows and changes.

When that same method of allocating costs leads to disagreements between management or provides misleading financial reporting, it’s past time to re-evaluate the cost allocation method utilized. How do you best identify each department’s “fair share” of these costs?

Many organizations will take shared costs and split them evenly over the number of business units or departments within the organization. While this is the simplest way to allocate costs, it is not typically the most representative or appropriate method and is usually not viewed as “fair.” Understanding what drives the specific cost is the best way to identify how to allocate that cost. Common cost drivers that can be used to allocate costs include:

  • Revenue
  • Employee head count
  • Customers served
  • Number of production resources

Here is an example: Company A has five departments and 100 employees. The departments are Marketing, Finance, Production, Human Resources and IT.

Employee benefits (including health insurance) is one of the large expenses each year. They are currently splitting that total cost between their five departments equally, like most other general and administrative costs they incur. This bodes well for Production but yields an imbalanced burden for each of the other departments.  Understanding that head count is one of the primary drivers of the employee benefits cost, this would be a natural allocation method. In doing so, 8% is assigned to Marketing, 4% to Finance, 80% to Production, 3% to Human Resources and 5% to IT.

Another example is Company B, a retailer with four locations. Company B knows that Location 1 is their stronghold and accounts for 40% of sales volume. Locations 2 and 3 both account for about 25% of sales each, and location 4 accounts for 10% of sales. Management has determined that this breakout of sales is due to the size and geographic location of each store and has budgeted future sales forecast using the same expectations. (Store 4 doesn’t have the capacity to meet the sales volume of Store 1.) So how does company B allocate the $50,000 marketing campaign they’ve rolled out this month? They could assign one-fourth of that cost to each store location — assessing a $12,500 cost to each location. Alternatively, they could allocate the cost of that marketing campaign based on their anticipated sales to be generated — assessing 40% to Store 1, 25% to Store 2, 25% to Store 3 and 10% to Store 4. The difference in these two cost allocation methods is $12,500 or $20,000 assessed to Store 1 and $12,500 or $5,000 assessed to Store 4.

Company C has 10 sales associates. They meet with customers of all sizes, and part of the new closing process is to share a leave-behind piece with each customer. Company C has purchased $200,000 of these leave-behinds and intends to charge each sales associate with $20,000 of that total. One sales associate quickly points out that it’s unfair for her to receive $20,000 of that total because she focuses on a much smaller number of large-value customers compared to other sales associates. She feels that she’s being charged for other sales associates’ leave-behind materials. Upon further inspection, the sales manager identifies that she can better allocate the $200,000 using the goals set for each sales associates’ customer visits in the next quarter.

As you work through your budgets for 2022 and historical reporting for 2021, consider how costs are allocated among your business segments and whether they need to be re-evaluated.