COST ALLOCATION: HOW TO APPROACH EQUITABLE COST SHARING
The definition of “Allocate” for purposes of accounting is to spread an expense over a period of time or group of cost centers to achieve more realistic financial reporting.
The definition of “Allocate” for purposes of accounting is to spread an expense over a period of time or group of cost centers to achieve more realistic financial reporting.
An example of spreading an expense over a period of time is depreciation. The purchase price of an asset is recorded on a monthly basis over a predetermined length of time representing the typical useful life of that type of asset. There is no guess work here, as the IRS has publications clearly defining the useful life and depreciation method to be used for various types of assets. Generally Accepted Accounting Principles (GAAP) also has standards by which an item should be depreciated.
However, spreading a cost over multiple cost centers is done when you have expenses benefiting more than one activity. You have various methods and bases at your disposal to accomplish this task. Many times, doing the actual allocation seems simple when compared to the process of deciding which is the most equitable base. Establishing equitability in a base is a simple concept but can prove to be a difficult task when things such as budget restrictions become an obstacle.
Let’s look at a simple example. You have a program administrative cost that is specific to only three of your organization’s cost centers. You don’t want to direct charge this cost as that will put you in a situation where you have to arbitrarily pick a ratio to allocate this expense. So you create a spreadsheet containing your possible bases for this allocation. This will give you a picture of how the program administrative cost would be allocated if you used Salaries, Hours or Total Direct Costs (three possible bases) as your base.
The spreadsheet can show you all three results as to how much of the Program Administrative costs will be charged to each cost center depending on the base used. For base # 1, Program A receives 50 % of the allocated costs, Program B receives 35 % and Program C receives 15%. But if base # 2 is used, it is a more even distribution where all three programs receive approximately 33% of the allocated cost.
This is where you need to be very honest with yourself as you analyze the spreadsheet. Just because base # 2 gives you a more even distribution, it might not be the more realistic option as in reality Program A does require more of this particular program admin cost. This “honest” approach to allocating costs may be difficult to embrace at times because of budget constraints. But the goal for any accounting system is to provide the most accurate Financial Reports possible. This is essential in order for you to truly understand what it costs to operate specific programs.
Remember, if you apply this practice of an honest approach to both your budgeting and allocation methods, your Financial Reports will give you a true picture of your Organizations fiscal health. Never confuse your realistic allocation methodology with budget constraints.
