Allocated Expenses: What They Are and How to Calculate Them

Allocated expenses are business costs not tied to a single department or product, but instead distributed among various parts of the company. This process involves assigning shared costs, such as rent or administrative salaries, to specific activities. Spreading these costs provides a more complete picture of the true operational expenses for each business segment. This method is used for internal financial reporting to help management make informed decisions about resource consumption and profitability.

Differentiating Direct and Indirect Costs

A direct cost is an expense that can be specifically traced to a single business activity or product, known as a cost object. For a company that manufactures furniture, the cost of wood used for a particular model of table is a direct cost. The wages of the employee who assembles that specific table are also direct costs because they are tied to its production.

In contrast, indirect costs, or overhead, are expenses that support the entire business operation and cannot be linked to a single cost object. These costs benefit multiple departments, products, or projects. Using the furniture company example, the monthly rent for the factory is an indirect cost. The electricity bill for the facility is another example, as it is not feasible to measure the exact amount used for each table produced.

These indirect costs are the subject of allocation. For instance, while the total factory rent is known, it is not immediately clear how much of that cost should be attributed to producing tables versus chairs. Administrative salaries for personnel in human resources or accounting are also indirect costs. These roles support the entire organization rather than a single production line, making their salaries an operational expense that must be shared across the company’s activities.

Establishing Cost Pools and Allocation Bases

Before allocating costs, a business must organize its indirect expenses into logical groups called cost pools. A cost pool is a collection of individual indirect costs that have a similar cause. For instance, all expenses related to facilities, such as rent, property insurance, and utilities, can be grouped into a “Building Occupancy” cost pool. This simplifies the process by combining related expenses into one total amount to be distributed.

Once cost pools are established, the next step is to select an allocation base for each pool. An allocation base, or cost driver, is the metric used to distribute the costs in the pool to different parts of the business. The chosen base must have a clear cause-and-effect relationship with the costs being allocated to ensure a fair distribution.

For example, a “Building Occupancy” cost pool is allocated based on the square footage each department occupies, as a department using more space should bear more of the cost. A cost pool for administrative salaries can be allocated based on the number of employees in each department. An IT support cost pool, which includes software licenses and help desk salaries, is often allocated by the number of computers or employees.

A Guide to Calculating and Applying Allocations

The calculation of allocated expenses follows a systematic process. The first step is summing all individual indirect costs within a cost pool to arrive at a total. For example, a “Facility Costs” pool might include $8,000 in rent, $1,500 in utilities, and $500 in maintenance, making the total cost pool $10,000. This figure is the total amount that needs to be distributed.

Next, the total for the chosen allocation base is calculated. If the company uses square footage to allocate facility costs, it would measure the space each department uses. If Department A occupies 3,000 square feet and Department B uses 2,000 square feet, the total is 5,000 square feet. This total serves as the denominator for the allocation rate.

With the totals determined, the allocation rate is calculated by dividing the total costs in the pool by the total of the allocation base. In this scenario, the allocation rate is $10,000 divided by 5,000 square feet, which equals $2 per square foot. This rate represents the indirect cost that will be assigned for each unit of the allocation base.

The final step is to apply this rate to each department. Department A’s allocated cost is its 3,000 square feet multiplied by the $2 per square foot rate, resulting in a $6,000 allocation. Department B’s allocation is its 2,000 square feet multiplied by the same $2 rate, for a total of $4,000. The sum of these allocations equals the original $10,000 cost pool, ensuring all indirect costs have been distributed.

Analyzing Results for Business Insights

Allocating expenses provides a more accurate understanding of each business segment’s profitability. By assigning a fair share of indirect costs, managers can see a financial picture that reflects all resources consumed, not just direct ones. This analysis makes a standard income statement more useful for internal decision-making.

In the previous example, Department A was allocated $6,000 in facility costs and Department B was allocated $4,000. Before this allocation, a profit and loss statement might have shown both departments as highly profitable based only on their revenue and direct costs. After subtracting the allocated costs, Department A’s profitability might be significantly lower than initially thought, while Department B remains strong.

This financial insight helps managers make more informed decisions regarding budgeting, resource management, and product pricing. If a department consistently shows low profitability after allocations, management might investigate its operational efficiency or re-evaluate its budget. Conversely, a highly profitable department might justify receiving additional resources to expand its operations. This analysis helps ensure that strategic decisions are based on a comprehensive view of costs.