How to Allocate Corporate Costs to Divisions

Corporate cost allocation is the practice of assigning shared, indirect business expenses to a company’s different divisions. The goal is to gain a clearer understanding of each division’s true profitability. By distributing central overhead costs, a business can more accurately assess the financial performance of its various segments, which helps management make informed decisions.

This practice is part of management accounting, used for internal decision-making. It moves expenses from a general corporate account to the parts of the business that benefit from those expenditures. While external financial reporting follows strict rules, companies have flexibility in how they allocate costs internally. This helps reveal which divisions are self-sustaining and which may be a drain on company resources.

Identifying Costs for Allocation

The first step in the allocation process is to distinguish between direct and indirect costs. Direct costs are expenses that can be specifically and exclusively traced to a single business unit. For example, the salary of a salesperson who works only for the commercial refrigerator division is a direct cost to that division and does not need to be allocated.

Indirect costs, often called corporate or common costs, are expenses that benefit multiple divisions or the organization as a whole and cannot be tied to a single unit. These are the costs that are subject to allocation. A part of the process is gathering these shared expenses into a “cost pool,” which is a group of individual costs that can be distributed using a common activity or basis.

Common examples of indirect costs include the salaries of corporate executives, such as the CEO and CFO, whose work supports the entire organization. The costs associated with central departments like human resources, accounting, and IT are also indirect because they provide services across the company. Rent and utilities for a corporate headquarters building that houses central staff, as well as company-wide insurance policies and legal fees, are other examples of costs that are pooled for allocation.

Common Allocation Methods

Once indirect costs are identified, a method must be chosen to distribute them to the various divisions. Common techniques include:

• Square Footage: This method is often used for facility-related costs, such as rent, utilities, and building maintenance. The total cost is allocated based on the amount of physical space each division occupies.
• Headcount: This approach is suitable for allocating people-centric costs like the expenses of the human resources or payroll departments. The logic is that a division with more employees consumes a larger share of these services.
• Sales Revenue: This is a frequent practice for expenses like corporate marketing or the salaries of top executives. The rationale is that divisions generating more revenue receive a greater benefit from corporate-level support.
• Activity-Based Costing (ABC): A more sophisticated technique, ABC identifies the specific corporate activities that drive costs and then assigns expenses based on each division’s consumption of those activities, such as the number of IT support tickets generated.

Companies must also decide between a single-rate or dual-rate allocation method. The single-rate method combines all indirect costs into one large cost pool and allocates them using a single base. The dual-rate method separates indirect costs into two pools: one for fixed costs (like salaries and rent) and one for variable costs (like supplies), with each pool allocated using a different base.

Selecting an Appropriate Allocation Base

Choosing the right allocation base is a decision that directly impacts the perceived profitability of each division. The primary principle guiding this choice should be the cause-and-effect relationship. This criterion suggests that the allocation base selected should be the one that drives the cost being allocated. For instance, allocating machinery maintenance costs based on the number of machine hours used by each division reflects a direct causal link.

Another guiding principle is the benefits received. This approach allocates costs based on the extent to which each division benefits from the expenditure. Using divisional sales revenue to allocate the costs of a national advertising campaign is a classic example of this principle. The assumption is that divisions with higher sales benefited more from the advertising.

A less favored, though sometimes used, criterion is the ability to bear. This method allocates costs based on a division’s profitability, meaning more successful divisions are assigned a larger share of corporate overhead. This approach can be misleading as it can penalize high-performing divisions and mask inefficiencies in underperforming ones.

The choice of allocation base can have significant behavioral consequences, as divisional managers are often evaluated based on their unit’s profitability. A poorly chosen base can lead to disputes and decisions that benefit a single division at the expense of the company as a whole.

The Allocation Process in Practice

Once an allocation method has been selected, the practical application involves a straightforward calculation. The first step is to sum the total indirect costs that will be allocated from a specific cost pool. For this example, assume the total annual rent for the corporate headquarters building is $100,000.

The next step is to measure the chosen allocation base in its entirety across the organization. If the square footage method is selected, the total square footage of all divisions that will receive an allocation must be calculated. Let’s say the company has two divisions that together occupy 10,000 square feet.

With the total cost and total base measured, the allocation rate can be calculated. This is done by dividing the total indirect cost by the total units of the allocation base. In this case, the allocation rate is $100,000 divided by 10,000 square feet, which equals an allocation rate of $10 per square foot.

The final step is to apply this rate to each division to determine its share of the cost. The allocation rate is multiplied by the number of units of the base consumed by each division. If Division A occupies 6,000 square feet, its allocated rent cost would be $60,000. If Division B uses 4,000 square feet, its allocation would be $40,000.