Cost allocation - key takeaways
After reading this article, you should be able to:
- define cost allocation and factor that affect it,
- identify the cost objects that need to be taken into account in the process,
- use the cost allocation formula and cost allocation method to assign spendings to departments and projects with great accuracy.
Cost allocation - definition
Cost allocation is the process of matching the cost objects with the departments or operations that generate them. It is mostly used for calculating the financial performance of a company or its parts, such as teams or projects and determining where given costs objects came from.
For example, in a typical service company, costs can be allocated to non-production departments (i.e. marketing, sales, administration), as well as project and teams.
What is the cost allocation used for?
Alright, but what is the point of calculating all of these things?
Cost allocation is very helpful not only when it’s time to sum up the employee performance, results of particular project managers or finances that may interest the stakeholders. On a daily basis, it can also help you:
- make sure that budgets are on track - applies to the budget of the entire company, as well as finances of particular departments or projects,
- point to the fields of operation that generate excessive costs and act on the information,
- check whether the money is really spent on the right endeavors.
In other words, cost allocation is the process of identifying the source of the costs and evaluating its importance.
Types of costs in cost allocation
Cost allocation involves all the people and assets in the organization. Therefore, it includes dozens of different types of costs that project managers and executives need to take into consideration while managing project budgets and other finances.
Let’s take a look at the types of costs in cost allocation.
Basic costs in cost allocation
In the simplest classification possible, costs in cost allocation are divided into 3 categories:
Direct costs in cost allocation are the spendings that have already been attributed to certain departments, projects or teams and there are no doubts as to their origin. These costs contribute to the profit billable operations are supposed to generate as they are required in the production processes.
For example, in a service company direct costs are usually included in the project budget, or even a project timeline in general. They usually refer to the wages and salaries, but they may also cover other resources required for the project. Therefore, allocating costs such as this is basically a piece of cake, as they are generated directly by the department, services or other costs objects they are related to.
The definition of indirect costs in cost allocation is a bit more complicated, especially for endeavors closely related to professional services. These are costs that are not associated with any organizational unit in particular; they are simply needed to keep the company running and growing.
The indirect costs usually involve the spendings made by all the support staff that help the production department do its job, as well as their wages These include cost objects such as: marketing and sales specialists, administration employees, and any other support department. Indirect costs also often refer to internal projects.
However, there is one more type of indirect costs in cost allocation that we need to consider - the overhead costs.
Overhead costs cover all the costs that need to be continually paid regardless of the company's business performance.
Project overheads vs organizational overheads
Overhead costs are usually divided into 2 categories:
- project overheads, for example equipment, subscriptions and programs,
- organizational overheads, such as utilities, bills, rent, etc.
- cost of services needed to keep the company running, i.e. security expenses, business management, etc.
Cost allocation method
At this point you may ask yourself “How can I allocate costs on my own?”. Fortunately, the answer to this question is not as complicated as it may seem - here’s a cost allocation method that can help you.
Cost allocation method - example
Some organizations, particularly service companies, profit only from their projects and they do not need to allocate the costs for the entire business - they just need to share the costs between the profitable operations and departments, as well as other cost objects. Here’s how the process of identifying them looks like.
- Define which costs you want to allocate
First, calculate the costs you want to allocate in the first place. For example, if you want to allocate the cost of utilities in your office, add them to get a bigger picture. But let's see how examples of cost shape the profitability of the operations.
For the sake of this cost allocation example, let’s assume that The Best Company is focused on allocating costs of their support departments to the project for the month (also known as a business overhead). The costs include:
- the costs of marketing department - 40 000$,
- the costs of administration - 15 000%
- the costs of the sales department - 45 000$.
Together all these departments account for 100 000$ of additional overhead or expenses that need to be allocated.
- Determine the base for sharing the costs
Depending on the type of business, you can divide the costs based on different factors. The most popular ones include:
- billable hours tracked in the services,
- generated income,
- generated profit.
For this example, we will use the former of indicators - the billable hours. That method is considered to be the simplest way of allocating costs in a proportional manner.
The Best Company has 2 projects - Project A and Project B. To complete all the activities planned in Project A for the month, the project managers and their team members will need 1800 hours. For Project B, the number of hours needed is 1200. Both projects combined require 3000 hours to complete. Therefore, Project A accounts for 60% of all billable hours in the company, while Project B includes only 40% of them. These are the proportions we are going to use in the cost allocation in this method.
- Allocate the costs proportionally
If Project A includes 60% of all billable hours while project B only accounts for 40% of them, we can now use the numbers to share the costs between them. Let's focus on identifying how should they contribute to it.
According to the examples above, he total amount of costs to be shared between billable operations is 100 000$. Project B requires more hours, therefore it should pay for a larger chunk of the costs - exactly 60% of them. As a result, 60 000$ of costs are allocated to the project.
Project B, on the other hand, only requires 40% of all the billable hours. Therefore, it should pay 40% of the costs - 40 000$.
What if I have more operations on my hands?
Admittedly, the example we have shown you above is very simple and it only reflects the reality for small companies. But what if you have a little (or much) more operations on your hands?
In that case, project scheduling software can help you - and Primetric is one of them. Here’s how it handles the most common cases of
Cost allocation in Primetric - project estimates
Let’s start with a simple example of project budgets.
In Primetric, you can create a project budget right after you create a project itself. That’s because the system performs the cost allocations for direct cost in each estimated phase of the operation. As a result, the predicted costs of work are displayed right after you estimate the number of hours needed to complete the job.
Financial report in Primetric
But what if the project has already started and you see whether it stays in the budget? The easiest way to check that is to use the financial report for a project.
Such a report is capable of combining numerous financial data, including:
- project and company overheads,
- costs of each hour of work completed in the project,
- the comparison of costs and incomes.
As a result, it can automatically calculate the final profit margin for the project and show how much costs in the company a given operation covers.
Costs allocation in settlements
Information on the costs in a project can be found in the Budget tab. There, the costs are divided into 4 categories:
- a dashboard with a general overview of the costs,
- 3 separate tabs for scheduled, not settled and settled costs.
There you can monitor all the incomes and expenses in your project and manage them accordingly.
Overheads in Primetric
In Primetric, you can also add both recurring and one-time overheads to the project - there is a special section dedicated just to these costs. These costs are later added or subtracted from the monthly invoice.
Primetric also contains information on company overheads, such as bills, support department or office costs. They also affect the profits from the projects - in fact, each and every one of them has to pay for a part of them!
Company overheads are included in the financial statements as Indirect costs - the costs that are not generated by any project directly. The information can be used for determining the third degree margin, an ultimate indicator for the profitability of your projects.
Cost allocation in settlements reports
Last but not least, cost allocation is clearly visible in the Settlements section. There you can find all the information on overheads, costs, incomes, and more.
Benefits of cost allocation
Fortunately, cost allocation is not only a burden, but also a huge business advantage.
Just to name a few of its benefits, it can help you:
- determine whether your projects are profitable,
- what part the project play in covering the organizational costs,
- check whether the rates are high enough to cover all the costs and generate profits,
- determine whether the indirect costs are not eating up the majority of company’s profits,
- identify the actual cost of services you provide to your customers,
- find out which departments are spending more or less money, and what they use it for,
- assign the lost spendings to the people, teams or departments responsible for them,
- calculate the real profitability of your business as a whole.
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