Allocation Base
An allocation base is a measure or variable used to distribute or allocate costs among different cost centers, departments, or products within a company. It serves as a basis for assigning indirect costs, such as overhead or administrative expenses, to specific cost objects in a fair and systematic manner. The allocation base should have a logical relationship with the cost being allocated, so that the distribution of costs reflects the actual use of resources by the cost objects.
Examples of common allocation bases include:
- Direct labor hours: Allocating overhead costs based on the number of direct labor hours worked in each department or on each product.
- Machine hours: Allocating costs based on the number of machine hours used in each department or for each product.
- Square footage: Allocating costs such as rent, utilities, and maintenance based on the square footage occupied by each department or cost center.
- Sales revenue: Allocating costs like marketing and advertising expenses based on the sales revenue generated by each product or division.
The choice of an appropriate allocation base depends on the nature of the costs being allocated and the specific characteristics of the business. The goal is to distribute costs fairly and accurately, enabling better decision-making and resource management.
Example of an Allocation Base
Let’s consider a manufacturing company that produces two types of products: Product A and Product B. The company has indirect costs or overheads, such as rent, utilities, and depreciation, totaling $100,000. These costs need to be allocated to both products based on an appropriate allocation base.
In this example, we’ll use machine hours as the allocation base. Suppose Product A requires 2,000 machine hours for production, while Product B requires 3,000 machine hours. In total, the company uses 5,000 machine hours for production.
To allocate the overhead costs to each product, we will use the following formula:
(Overhead costs of each product) = (Total overhead costs) × (Machine hours for each product) ÷ (Total machine hours)
Product A’s overhead allocation: = ($100,000) × (2,000 machine hours) ÷ (5,000 machine hours) = $100,000 × 0.4 = $40,000
Product B’s overhead allocation: = ($100,000) × (3,000 machine hours) ÷ (5,000 machine hours) = $100,000 × 0.6 = $60,000
Using machine hours as the allocation base, we have allocated $40,000 of the overhead costs to Product A and $60,000 to Product B. This allocation helps management better understand the total cost of producing each product, which can aid in pricing, cost control, and resource management decisions.
