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What Is an Indirect Cost?

To turn a profit in your business, you need to make sure your products or services bring in more money than what you put into them. But if your business expenses are greater than your revenues, you won’t stay afloat. Learn about indirect cost and how to calculate and reduce it.

What is indirect cost?

Indirect expenses, or overhead costs , are expenses that apply to more than one business activity. You cannot apply an indirect cost directly to the production of a specific good or service. Instead, they are costs that go into running your business as a whole. If you want to determine the portion of your indirect costs that go towards producing certain items, you must distribute the costs.

Your indirect expenses can be either fixed costs or variable costs .

Fixed costs are expenses that are the same regardless of how many goods or services you produce. An example of a fixed indirect cost would be rent.

On the other hand, variable costs are expenses that change depending on how many goods or services you produce. An example of a variable indirect cost includes equipment maintenance.

For more examples of indirect costs, see the list below.

Indirect cost examples

Every business has indirect costs. Here are just some of the indirect expenses you might have:

• Professional fees
• Administrative expenses
• Office supplies
• Employee salaries
• Advertising
• Equipment maintenance

The above expenses are considered indirect if they cannot be applied toward a single product or service. Office supplies, for example, are indirect if they are not direct materials to create products.

Let’s look at rent. You need to pay rent to keep your business building. But, the money you pay towards rent does not go towards producing a specific product. Instead, rent payments make it possible to produce all your products and run your business.

What is the difference between indirect and direct costs?

Indirect expenses aren’t the only costs you will have at your business. You will also have direct costs, which are expenses you can assign to the production of a specific product or service.

Unlike indirect costs, you do not divide direct costs among different departments or projects. You must know your business’s direct and indirect costs when pricing products and updating your accounting books so your records are accurate. And, you need to separate costs to claim tax deductions.

Examples of direct expenses include manufacturing materials, direct materials, and direct labor.

Identifying your indirect expenses might be a little tricky. What is considered an indirect cost for one company might be considered a direct cost for another. And, one employee’s salary might be an indirect cost while another’s is a direct cost. For example, an employee on an assembly line receives wages that are considered direct costs. But an employee who works as a secretary in the same company would receive wages that are considered indirect expenses.

Indirect cost rate calculation

If you want to determine your indirect cost rate, you need to use cost allocation. Cost allocation is the process of distributing your indirect costs among specific departments or projects.

You can use the indirect rate calculation to price your products. You want your offerings to generate enough money to cover your expenses. By considering your indirect and direct expenses, you can determine a reasonable cost for your products or services so you don’t underprice.

Another reason to use the indirect cost rate formula is so you can decide whether your expenses are too much. If your indirect costs are too high, you can find ways to reduce your expenses.

You can allocate indirect costs by taking your total indirect expenses and dividing them by some sort of allocation measure, like direct labor expenses, direct machine costs, or direct material costs.

Here is the indirect cost formula, or overhead rate:

Indirect Rate = Indirect Costs / Allocation Measure

The formula gives you a ratio. Let’s say that you want to find your overhead rate using your direct labor expenses.

Your total indirect costs are $10,000 and your direct labor expenses are $5,000. Your formula would look like:

Indirect Rate = $10,000 / $5,000

In this example, your indirect rate is 2:1, meaning you spend $2 of overhead per $1 of direct labor expenses. The lower your indirect rate, the better.

How to reduce indirect expenses

Knowing how to reduce expenses in business is essential if you need to increase your profits. You can reduce your indirect expenses using the following strategies.

Compare vendors to make sure you are getting the best deal. Expenses like office supplies can vary from provider to provider, so see if there are others who are less expensive.

If you want to reduce indirect expenses like utilities, cut your bills down by conserving energy. You can power down equipment when you aren’t using it, purchase energy-conserving equipment, or switch utility providers.

You can reduce other indirect costs, like advertising, by engaging customers through social media or using other inexpensive marketing ideas.

There are many ways you can reduce your indirect expenses. Consider how valuable the expense is to operating your business and come up with ways to slash the price.

Use Patriot’s online accounting software to track all of your business expenses. Our software is made for the non-accountant, so you can update your books on your own. Try it for free today!

This article is updated from its original publication date of March 13, 2018.

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General Guidance on Calculating Indirect Costs 

Published february 1, 2023.

General Guidance on Calculating Indirect Costs (PDF)

Introduction

This document provides introductory guidance to NEH applicant and recipient organizations on calculating indirect costs as part of an NEH grant or cooperative agreement application budget. This guidance does not supersede information and requirements on the development, calculation, and application of indirect costs and indirect cost rates in 2 CFR Part 200, Uniform Administrative Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards and the General Terms and Conditions for Awards to Organizations (For grants and cooperative agreements issued January 1, 2022, or later) .

Refer to the Notice of Funding Opportunity (NOFO) for statutory or administrative information regarding the allowability of indirect costs. NEH does not reimburse indirect costs under the following types of awards:

• construction
• general operating support costs to State Humanities Councils (SHC)
• awards to individuals  

What are Indirect Costs?

NEH Project Budget Applicant organizations submit an NEH project budget using the Research and Related budget form , unless otherwise instructed in the NOFO . You should prepare a project budget in coordination with your organization’s Institutional Grant Administrator (IGA) and/or Office of Sponsored Projects.

When preparing your budget, you must treat costs that you classify as direct or indirect consistently. You cannot assign a cost to an NEH award as a direct cost if you have allocated any other cost incurred for the same purpose to the award as an indirect cost ( 2 CFR § 200.403(c) ).

Direct Costs

Direct costs are salaries, services, and goods that are directly related to the project and are accounted for with a high degree of accuracy. Direct costs must align with the cost principles, including allowability ( 2 CFR § 200.403 ), reasonableness ( 2 CFR § 200.404 ), and allocability ( 2 CFR § 200.405 ). Examples include salaries and benefits for staff and consultants working on the project, project-related travel, and supplies and equipment used on the project.

Indirect Costs

Indirect costs represent administrative expenses associated with the cost of doing business that are not readily identified project activities. Indirect costs, also referred to as facilities and administrative costs (F&A) , are incurred for the benefit or joint objectives of a specific project and organizational activities. These costs are allocated equitably across all of your organization’s activities. Examples include costs for clerical and managerial staff, depreciation, office space rental, and utilities.

To recover indirect costs related to an NEH award, your organization must either negotiate an indirect cost rate with its cognizant agency prior to a federal award or elect to use a de minimis rate of 10% of modified total direct costs (MTDC) ( 2 CFR § 200.414(f) ) . In your application, you must include your project budget and the base, rate, and amount of indirect costs you will recover during period of performance.

Negotiated Indirect Cost Rate Agreements

A Negotiated Indirect Cost Rate Agreement (NICRA) is a formal written agreement between your organization and its cognizant federal agency describing how the organization will calculate indirect costs. A NICRA establishes the following to calculate indirect costs:

• applicable period(s)

The rate(s) established in a NICRA are typically effective for a two- to four-year period. If your organization has a NICRA, you may apply to your cognizant agency for a one-time extension of a current agreement for a period of up to four years, in accordance with 2 CFR § 200.414 (g) .

De Minimis Rate

Organizations without a current or provisional NICRA

Per 2 CFR § 200.414 (f) , if you do not have a current or provisional negotiated rate (except for local governments claiming central service costs under 2 CFR § 200, Appendix VII D.1.b ), you may choose to use a de minimis rate of 10% of modified total direct costs (MTDC). If you choose the de minimis, you must use the rate consistently for all federal awards until your organization chooses to negotiate its own indirect cost rate.

Organizations with a NICRA but without an applicable rate

Your organization may also selectively apply the de minimis rate in cases in which it does not have an applicable rate. For example, research rates are not applicable to the scholarly research that NEH funds, except in rare circumstances. In cases in which an organization has only negotiated a research rate (see below for an explanation of rate types), the organization may apply the de minimis rate.

The de minimis uses a Modified Total Direct Costs (MTDC) base, which consists of:

“All direct salaries and wages, applicable fringe benefits, materials and supplies, services, travel, and up to the first $25,000 of each subaward (regardless of the period of performance of the subawards under the award). MTDC excludes equipment, capital expenditures, charges for patient care, rental costs, tuition remission, scholarships and fellowships, participant support costs and the portion of each subaward in excess of $25,000. Other items may only be excluded when necessary to avoid a serious inequity in the distribution of indirect costs, and with the approval of the cognizant agency for indirect costs ( 2 CFR § 200.1 ) .”

Acceptance of Indirect Cost Rates

NEH must accept valid and applicable indirect cost rates ( 2 CFR § 200.414 (c)(1) ), or if no current or provisional negotiated rate exist, accept the de minimis rate, if requested in the application budget. NEH must use the negotiated rates in effect at the time of the initial award throughout the life of the award, except as provided in 2 CFR § 200.414  (c)(1 ) . If the rate agreement in effect at the beginning of the period does not cover the entire period of performance, then NEH will use the rate in effect for the last year of the negotiated rate agreement to determine indirect costs for the duration of the period of performance ( 2 CFR Appendix III (c)(7)(a) ).

Once NEH issues an award, it is not obligated to make adjustments due to increases in your organization’s indirect cost rate agreement. 

Likewise, recipient organizations that issue subawards (referred to as pass-through entities) must accept subrecipients’ applicable federally negotiated indirect cost rates. If no approved rate exists, the pass-through entity may negotiate an indirect cost rate with the subrecipient or accept the de minimis rate ( 2 CFR § 200.332 (a)(4) ).

Negotiating New Indirect Cost Rates

If your organization does not have a current negotiated (including provisional) rate or has an expired rate, your organization may choose to negotiate a rate with its cognizant agency. If your organization wants to negotiate a NICRA and NEH is its c ognizant a gency , see Guidance for Negotiating an Indirect Cost Rate Agreement with NEH .

Reviewing and Calculating Indirect Costs using a NICRA

NICRA Structure

Applying the correct indirect cost rate requires an understanding of the structure of your NICRA. A NICRA generally includes the following information:

Effective date of the agreement EIN (Employer Identification Number) of the organization Organization name and address Indirect Cost Rate type(s) Common indirect cost rate types include: Provisional – an interim rate applicable to a specified period time pending the establishment of a final rate for that period. Final – a permanent rate determined after an organization’s actual costs for a current year are known. A final rate is used to adjust indirect costs claimed based on a provisional rate. Predetermined – a permanent rate, applicable to a specified current or future period based on a review of actual costs incurred during a prior period. A predetermined rate is typically not subject to adjustment. Fixed rate with carry-forward – a rate with the same characteristics as a predetermined rate, except that the difference between the estimated costs and the actual costs of the period covered by the rate is carried forward as a rate adjustment in future years. Effective Period (“From” and “To”) The period during which the indirect cost rate is applicable. Applicable Rate Location Locations for where the organization will perform most of the substantive work of the project. Common locations include: On-Site/Campus (organizations conduct activities in a space they either own or lease) Off-Site/Campus (organizations conduct activities in a space for which they do not own or lease) Type of programs that rates are applicable to Common program types include: Other Sponsored Activities – programs and projects that involve the performance of work other than instruction and organized research. Instruction – teaching and training activities of an institution except for research training. All Programs Organized Research – research and development activities of an institution that are separately budgeted and accounted for as scientific research and generally not scholarly inquiry of the type most often supported by NEH. Indirect Cost Rate (Allocation) Base Defined The cost base describes the direct cost pool (types of costs and cost caps) to which the indirect cost rate is applied. Common bases for indirect costs include: modified total direct costs (MTDC) direct salaries and wages including (or excluding) fringe benefits direct salaries and wages including vacation, holiday, sick pay, and other paid absences total direct costs (TDC) Fringe Benefit Rates Provides the separate rates for allocating employee benefits (e.g., payroll taxes, vacation, sick, retirement, health care, bonus, deferred compensation, insurance). General Terms and Conditions Identifies any limitations on the use of the rates, the basis of accounting, rate specific information (such as fixed or provisional rates), the use of the NICRA by other federal agencies, and other information. Special remarks (composition of the indirect cost pool) Defines the costs that compose the indirect cost pool.

Calculating Indirect Costs

When calculating indirect costs, select the appropriate cost base, as established in the NICRA, to determine the direct costs to be multiplied by the applicable negotiated indirect cost rate. The result of this calculation represents the allowable indirect costs for the project.

This section provides two examples of calculating indirect costs.

Example 1: Applying a 34% Indirect Cost Rate using a MTDC base

  Salaries $100,000.00 Fringe @ 28%  $28,000.00 Equipment $50,000.00 Subawards $30,000.00 Contracts $-   Supplies $5,000.00 Travel $-   Other $10,000.00 Total Direct Costs $223,000.00 Total Indirect Costs (34%) $57,120.00 Total Project Costs $280,120.00

Base MTDC Rate Indirect Costs Modified Total Direct Costs, excludes equipment, capital expenditures, rental costs, tuition remission, scholarships and fellowships, participant support costs and the portion of each subaward in excess of $25,000. $168,000.00 X 34% = $57,120.00

Example 2: Applying a 34% Indirect Cost Rate using direct salaries and wages, excluding fringe benefits, base

Salaries $100,000.00 Fringe @28%  $28,000.00 Equipment $50,000.00 Subawards $30,000.00 Contracts $-   Supplies $5,000.00 Travel $-   Other $10,000.00 Total Direct Costs $223,000.00 Total Indirect Costs (34%) $34,000.00 Total Project Costs $257,000.00 Base Direct Costs Rate Indirect Costs Salaries excluding fringe $100,000.00 X 34% = $34,000.00

Definitions

Indirect costs – costs incurred for a common or joint purpose benefitting more than one cost objective, and not readily assignable to the cost objectives specifically benefitted, without effort disproportionate to the results achieved. To facilitate equitable distribution of indirect expenses to the cost objectives served, your organization may need to establish a number of pools of indirect costs. Indirect cost pools must be distributed to benefitted cost objectives on bases that will produce an equitable result in consideration of relative benefits derived ( 2 CFR § 200.1 ).

Cognizant agency for indirect costs – The cognizant agency for indirect costs is the federal agency that is responsible for establishing cost allocation plans or indirect cost proposals on behalf of all federal agencies ( 2 CFR § 200.1 ). The cognizant agency is typically the federal  awarding agency that provides the largest amount of direct funding (as listed on the schedule of expenditures of Federal awards, see § 200.510(b) ) to a non-Federal entity unless OMB designates a specific cognizant agency for audit.

Facilities and administrative costs – Facilities costs are the overall costs of operating and maintaining facilities owned or leased by the organization in which activities that may directly or indirectly support your project are taking place. Examples include depreciation on buildings, equipment and capital improvement, interest on debt associated with certain buildings, equipment and capital improvements, and operations and maintenance expenses.

Administration costs include general administrative expenses that are not specific to the project but serve the entire organization. Examples include general administration and general expenses such as the director's office, legal, accounting, and administrative personnel.

• 2 CFR § 200.332 – Requirements for pass-through entities
• 2 CFR 200 Subpart E, Cost Principles
• 2 CFR § 200.414 – Indirect (F&A) Costs
• 2 CFR Part 200, Appendix III – Indirect (F&A) Costs Identification and Assignment, and Rate Determination for Institutions for Higher Education (IHEs)
• 2 CFR Part 200, Appendix IV – Indirect (F&A) Costs Identification and Assignment, and Rate Determination for Nonprofit Organizations

What is Cost Assignment?

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Cost assignment.

Cost assignment is the process of associating costs with cost objects, such as products, services, departments, or projects. It encompasses the identification, measurement, and allocation of both direct and indirect costs to ensure a comprehensive understanding of the resources consumed by various cost objects within an organization. Cost assignment is a crucial aspect of cost accounting and management accounting, as it helps organizations make informed decisions about pricing, resource allocation, budgeting, and performance evaluation.

There are two main components of cost assignment:

• Direct cost assignment: Direct costs are those costs that can be specifically traced or identified with a particular cost object. Examples of direct costs include direct materials, such as raw materials used in manufacturing a product, and direct labor, such as the wages paid to workers directly involved in producing a product or providing a service. Direct cost assignment involves linking these costs directly to the relevant cost objects, typically through invoices, timesheets, or other documentation.
• Indirect cost assignment (Cost allocation): Indirect costs, also known as overhead or shared costs, are those costs that cannot be directly traced to a specific cost object or are not economically feasible to trace directly. Examples of indirect costs include rent, utilities, depreciation, insurance, and administrative expenses. Since indirect costs cannot be assigned directly to cost objects, organizations use various cost allocation methods to distribute these costs in a systematic and rational manner. Some common cost allocation methods include direct allocation, step-down allocation, reciprocal allocation, and activity-based costing (ABC).

In summary, cost assignment is the process of associating both direct and indirect costs with cost objects, such as products, services, departments, or projects. It plays a critical role in cost accounting and management accounting by providing organizations with the necessary information to make informed decisions about pricing, resource allocation, budgeting, and performance evaluation.

Example of Cost Assignment

Let’s consider an example of cost assignment at a bakery called “BreadHeaven” that produces two types of bread: white bread and whole wheat bread.

BreadHeaven incurs various direct and indirect costs to produce the bread. Here’s how the company would assign these costs to the two types of bread:

• Direct cost assignment:

Direct costs can be specifically traced to each type of bread. In this case, the direct costs include:

• Direct materials: BreadHeaven purchases flour, yeast, salt, and other ingredients required to make the bread. The cost of these ingredients can be directly traced to each type of bread.
• Direct labor: BreadHeaven employs bakers who are directly involved in making the bread. The wages paid to these bakers can be directly traced to each type of bread based on the time spent working on each bread type.

For example, if BreadHeaven spent $2,000 on direct materials and $1,500 on direct labor for white bread, and $3,000 on direct materials and $2,500 on direct labor for whole wheat bread, these costs would be directly assigned to each bread type.

• Indirect cost assignment (Cost allocation):

Indirect costs, such as rent, utilities, equipment maintenance, and administrative expenses, cannot be directly traced to each type of bread. BreadHeaven uses a cost allocation method to assign these costs to the two types of bread.

Suppose the total indirect costs for the month are $6,000. BreadHeaven decides to use the number of loaves produced as the allocation base , as it believes that indirect costs are driven by the production volume. During the month, the bakery produces 3,000 loaves of white bread and 2,000 loaves of whole wheat bread, totaling 5,000 loaves.

The allocation rate per loaf is:

Allocation Rate = Total Indirect Costs / Total Loaves Allocation Rate = $6,000 / 5,000 loaves = $1.20 per loaf

BreadHeaven allocates the indirect costs to each type of bread using the allocation rate and the number of loaves produced:

• White bread: 3,000 loaves × $1.20 per loaf = $3,600
• Whole wheat bread: 2,000 loaves × $1.20 per loaf = $2,400

After completing the cost assignment, BreadHeaven can determine the total costs for each type of bread:

• White bread: $2,000 (direct materials) + $1,500 (direct labor) + $3,600 (indirect costs) = $7,100
• Whole wheat bread: $3,000 (direct materials) + $2,500 (direct labor) + $2,400 (indirect costs) = $7,900

By assigning both direct and indirect costs to each type of bread, BreadHeaven gains a better understanding of the full cost of producing each bread type, which can inform pricing decisions, resource allocation, and performance evaluation.

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What Is Activity-Based Costing (ABC)?

How activity-based costing (abc) works, requirements for activity-based costing (abc), benefits of activity-based costing (abc).

• Corporate Finance

Activity-Based Costing (ABC): Method and Advantages Defined with Example

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

Key Takeaways

• Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services. 
• The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task with a specific goal.
• An activity is a cost driver , such as purchase orders or machine setups. 
• The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate the amount of overhead and indirect costs related to a particular activity. 

ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. 

Investopedia / Theresa Chiechi

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.

This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. 

The formula for activity-based costing is the cost pool total divided by cost driver, which yields the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity. 

The ABC calculation is as follows:  

• Identify all the activities required to create the product. 
• Divide the activities into cost pools, which includes all the individual costs related to an activity—such as manufacturing. Calculate the total overhead of each cost pool.
• Assign each cost pool activity cost drivers, such as hours or units. 
• Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers. 
• Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate. 
• Multiply the cost driver rate by the number of cost drivers. 

As an activity-based costing example, consider Company ABC that has a $50,000 per year electricity bill. The number of labor hours has a direct impact on the electric bill. For the year, there were 2,500 labor hours worked, which in this example is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. For Product XYZ, the company uses electricity for 10 hours. The overhead costs for the product are $200, or $20 times 10.

Activity-based costing benefits the costing process by expanding the number of cost pools that can be used to analyze overhead costs and by making indirect costs traceable to certain activities. 

The ABC system of cost accounting is based on activities, which are any events, units of work, or tasks with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. Activities consume overhead resources and are considered cost objects.

Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders.

There are two categories of activity measures: transaction drivers, which involve counting how many times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

Unlike traditional cost measurement systems that depend on volume count, such as machine hours and/or direct labor hours, to allocate indirect or overhead costs to products, the ABC system classifies five broad levels of activity that are, to a certain extent, unrelated to how many units are produced. These levels include batch-level activity , unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.

Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity. 

Second, it creates new bases for assigning overhead costs to items such that costs are allocated based on the activities that generate costs instead of on volume measures, such as machine hours or direct labor costs. 

Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation , utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.

Chartered Global Management Accountant. " Activity-Based Costing (ABC) ."

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Cost objects: direct and indirect costs

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Managerial accounting is the art of planning, decision making, and controlling in business and the cost object helps us assign cost. In order to do that, we must identify what we want to track. Are we looking at a product, a store, a department within the company, or even a customer? Since managerial accounting gives us so much flexibility, we need to make sure we understand what we want to assign costs.

Cost Objects in Managerial Accounting

A  cost object is anything for which a company wants to assign costs. They can take many different forms including:

Cost Objects include

• Individual units of a product
• An order for a specific customer
• A product line
• A department within the company, like the marketing or human resources department
• A geographic segment of the business
• A service provided by the company

There is almost no limit to what you can identify as a cost object as long as you can find a way to assign costs to it. The most critical aspect of determining a cost object is the ability to allocate costs in order to get a complete picture to plan, make decisions, and perform controlling activities.

If you cannot fully assign costs to the object, you may want to consider if the object chosen is the correct one. In most cases, we can find ways to allocate costs, however.

All costs related to a cost object are either direct costs or indirect costs.

Direct Costs

A  direct cost is a cost that is easy to trace to a cost object. For an accounting or law firm, it is easy to determine the number of hours and cost of working on a client because all staff is required to assign their time to clients throughout the work week.

Engines used in a Boeing 747 are easy to trace to each plane, and therefore the cost is easy to calculate. The salaries for marketing employees are easy to trace to the marketing department of a company. Direct costs are assigned to a cost object easily.

Indirect cost

An  indirect cost is a cost that must be allocated to a cost object because it cannot be directly traced. The cost of a receptionist in an accounting firm is hard to assign to individual clients because his or her time is not being tracked by the client.

Supervisors at the Boeing plant are supervising employees working on several different projects, and it is impractical to track his or her time to each individual plane. Some materials are so insignificant that the cost of monitoring how much glue goes into a product outweighs the benefit of knowing the cost of glue per unit.

Sometimes it is possible for a cost to be a direct cost for one cost object and an indirect cost for another object. For example, if my object is the marketing department, costs associated with marketing salaries are a direct cost, which is easy to assign to the marketing department.

However, if the cost object is one of 20 products a company manufactures, the marketing salaries are an indirect cost for that product since the cost is not easy to trace back to our cost object.

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Module 5: Job Order Costing

Introduction to accumulating and assigning costs, what you will learn to do: assign costs to jobs.

Financial and managerial accountants record costs of production in an account called Work in Process. The total of these direct materials, direct labor, and factory overhead costs equal the cost of producing the item.

In order to understand the accounting process, here is a quick review of how financial accountants record transactions:

Let’s take as simple an example as possible. Jackie Ma has decided to make high-end custom skateboards. She starts her business on July 1 by filing the proper forms with the state and then opening a checking account in the name of her new business, MaBoards. She transfers $150,000 from her retirement account into the business account and records it in a journal as follows:

For purposes of this ongoing example, we’ll ignore pennies and dollar signs, and we’ll also ignore selling, general, and administrative costs.

After Jackie writes the journal entry, she posts it to a ledger that currently has only two accounts: Checking Account, and Owner’s Capital.

Debits are entries on the left side of the account, and credits are entries on the right side.

Here is a quick review of debits and credits:

You can view the transcript for “Colin Dodds – Debit Credit Theory (Accounting Rap Song)” here (opens in new window) .

Also, this system of debits and credits is based on the following accounting equation:

Assets = Liabilities + Equity.

• Assets are resources that the company owns
• Liabilities are debts
• Equity is the amount of assets left over after all debts are paid

Let’s look at one more initial transaction before we dive into recording and accumulating direct costs such as materials and labor.

Jackie finds the perfect building for her new business; an old woodworking shop that has most of the equipment she will need. She writes a check from her new business account in the amount of $2,500 for July rent. Because she took managerial accounting in college, she determines this to be an indirect product expense, so she records it as Factory Overhead following a three-step process:

• Analyze transaction

Because her entire facility is devoted to production, she determines that the rent expense is factory overhead.

2. Journalize transaction using debits and credits

If she is using QuickBooks ® or other accounting software, when she enters the transaction into the system, the software will create the journal entry. In any case, whether she does it by hand or computer, the entry will look much like this:

3. Post to the ledger

Again, her computer software will post the journal entry to the ledger, but we will follow this example using a visual system accountants call T-accounts. The T-account is an abbreviated ledger. Click here to view a more detailed example of a ledger .

Jackie posts her journal entry to the ledger (T-accounts here).

She now has three accounts: Checking Account, Owner’s Capital, and Factory Overhead, and the company ledger looks like this:

In a retail business, rent, salaries, insurance, and other operating costs are categorized into accounts classified as expenses. In a manufacturing business, some costs are classified as product costs while others are classified as period costs (selling, general, and administrative).

We’ll treat factory overhead as an expense for now, which is ultimately a sub-category of Owner’s Equity, so our accounting equation now looks like this:

Assets = Liabilities + Owner’s Equity

147,500 = 150,000 – 2,500

Notice that debits offset credits and vice versa. The balance in the checking account is the original deposit of $150,000, less the check written for $2,500. Once the check clears, if Jackie checks her account online, she’ll see that her ledger balance and the balance the bank reports will be the same.

Here is a summary of the rules of debits and credits:

Assets = increased by a debit, decreased by a credit

Liabilities = increased by a credit, decreased by a debit

Owner’s Equity = increased by a credit, decreased by a debit

Revenues increase owner’s equity, therefore an individual revenue account is increased by a credit, decreased by a debit

Expenses decrease owner’s equity, therefore an individual expense account is increased by a debit, decreased by a credit

Here’s Colin Dodds’s Accounting Rap Song again to help you remember the rules of debits and credits:

Let’s continue to explore job costing now by using this accounting system to assign and accumulate direct and indirect costs for each project.

When you are done with this section, you will be able to:

• Record direct materials and direct labor for a job
• Record allocated manufacturing overhead
• Prepare a job cost record

Learning Activities

The learning activities for this section include the following:

• Reading: Direct Costs
• Self Check: Direct Costs
• Reading: Allocated Overhead
• Self Check: Allocated Overhead
• Reading: Subsidiary Ledgers and Records
• Self Check: Subsidiary Ledgers and Records
• Introduction to Accumulating and Assigning Costs. Authored by : Joseph Cooke. Provided by : Lumen Learning. License : CC BY: Attribution
• Colin Dodds - Debit Credit Theory (Accounting Rap Song). Authored by : Mr. Colin Dodds. Located at : https://youtu.be/j71Kmxv7smk . License : All Rights Reserved . License Terms : Standard YouTube License
• What the General Ledger Can Tell You About Your Business. Authored by : Mary Girsch-Bock. Located at : https://www.fool.com/the-blueprint/general-ledger/ . License : All Rights Reserved . License Terms : Standard YouTube License

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• Best Practices

Indirect Cost Allocation

Gfoa recommends governments allocate their indirect costs and address factors described in this best practice to prepare indirect cost allocation plans.

In addition to the direct cost of providing services, governments also incur indirect costs. Such indirect costs include shared administrative expenses where a department or agency incurs costs for support that it provides to other departments/agencies (e.g., legal, finance, human resources, facilities, maintenance, technology). The cost to governments to track every expense and directly attribute each cost to each function would exceed the benefits. Indirect cost allocation is an accounting function by which estimates are made to distribute indirect costs to programs or functions, in order to approximate their full cost. Certain important management objectives (measuring the cost of government services, establishing fees and charges, charging back the cost of internal services to departments/agencies, fully utilizing restricted funds, and requesting reimbursements under federal and state grants, when allowed) can be served by allocating indirect costs. Regardless of the purpose of an indirect cost allocation, a systematic and rational methodology should be used.

GFOA recommends governments allocate their indirect costs. There are a number of issues a government needs to address in connection with indirect cost allocation. Because of the varied reasons for which indirect cost allocations are performed, a one-size-fits-all approach typically is not possible. Therefore, the GFOA recommends that governments address the following when planning the preparation of indirect cost allocation plans:

1. Who should perform the allocation? An indirect cost allocation can be performed either by the government’s own staff or by an external party. Specific factors that should be addressed in choosing between the two include:

• In certain political environments, a government’s constituents may be more accepting of an externally prepared cost allocation;
• The optimal choice may depend on the purpose of the cost allocation (for example, departmental chargebacks vs. grant reimbursement); and
• Regardless of who prepares the cost allocation, management needs to be involved in the process and knowledgeable about the methodology used.

2. What factors need to be addressed if an external party is selected to perform the allocation? If an external party is engaged to perform a cost allocation, the government should address the following:

• The need for independence may prevent the financial statement auditor from serving in this role;
• The selected preparer should have knowledge and experience that is specifically relevant to the purpose for which the cost allocation will be used;
• The government should obtain ownership of the final work product;
• The government’s staff should obtain at least a basic understanding of the process used to prepare the cost allocation;
• For cost allocations that will be used for claiming indirect costs for grants, the contract for services with the preparer should state whether the preparer will assist in negotiating with a grant provider, if necessary, and which party (the government or the preparer) would be responsible for any indirect costs that are ultimately disallowed; and
• The government is responsible for having a system in place that ensures that data are appropriately classified in the accounting system.

3. How often should a cost allocation be performed? An indirect cost allocation should be evaluated annually to ensure that factors that can have a significant effect on the allocation (e.g. changes to cost centers, involvement of new funds). The basis and methodology for the cost allocation should be reviewed regularly to ensure the allocation is fair, consistent, reasonable and rational, based on the following:

• Complexity of the calculation;
• Changes in grant requirements;
• Purpose for which the allocation is to be used[1];
• Implementation of a new enterprise resource planning (ERP) system;
• A significant change in economic factors affecting cost basis (e.g. inflation);
• A change in the government’s administration; or
• A structural change in the government.

4. What factors need to be addressed if a cost allocation is to be performed by the government’s own staff? If in indirect cost allocation is to be performed by the government’s own staff, a team approach normally is preferable. That team should consist of stakeholders from the government’s departments/agencies and should have a designated team leader to make decisions when there are differing positions on the team and it is not possible to reach consensus. In addition:

• The internal staff that works on the project should have knowledge and experience that is specifically relevant to the purpose for which the indirect cost allocation will be used. Likewise, it is important that internal staff be aware of all applicable laws and regulations if the cost allocation is to be used as the basis for requesting reimbursement under an intergovernmental grant;
• The government should develop an educational process to ensure that the staff involved remain knowledgeable;
• Agencies/departments of the government should be responsible for using classifications which, to the greatest extent possible, identify direct costs, to maximize the amount recovered from grant providers, when applicable (also applicable to externally prepared cost allocations); and
• Data and the related source documentation should be captured and simultaneously to avoid audit problems that could otherwise arise as a result of subsequent data changes.[2]

5. Should the government use an indirect cost allocation plan or an overhead percentage rate? There are pros and cons to using either an indirect cost allocation plan or an overhead percentage rate for recouping indirect costs, regardless of whether cost allocations are performed by an external party or by the government’s own staff. Since an indirect cost allocation plan involves a greater level of detail and more complex calculations, a government should determine whether increased cost recovery from grantors and ratepayers would justify the extra effort.

6. What are other items that governments should address when developing an indirect cost allocation?

• The methodology used in the allocation should be fair, rational, and consistently applied with few exceptions to that methodology.
• The basis for allocation of each indirect cost should reasonably approximate the proportional share of service received from the service provider.[3]
• For example, a cost allocation used to chargeback costs to governmental departments/agencies may need to take place more frequently.
• As systems are updated, the data used for the allocation can change throughout the year. For example, if information technology expenditures are allocated based on the number of computers used for various functions, the number of computers used as a base at the point in time of the calculation should be documented. Similarly, if an allocation is based on the number of full-time employees, the date of the personnel report used should be documented.
• For example, information technology services could be allocated by computer devices, financial services could be allocated by the number of transactions processed.

This best practice was previously titled Taking Advantage of Indirect Cost Allocations.

• Board approval date: Thursday, September 1, 2022

The Comprehensive Guide to Cost Allocation in Accounting

Accounting is a fascinating field, and cost allocation is one of the most important concepts in accounting. Whether you’re an accounting student or an accountant just starting out, it’s important to understand how to allocate costs.

In this comprehensive guide, we’ll cover everything from what it means to its pros and cons. 

How Can Costs Be Allocated Among Departments or Product Lines When There Is No Clear Source?

Allocation is distributing costs among different departments or product lines in an organization. Trying to accurately estimate the cost of producing a good or rendering a service is a common challenge for many businesses.

This is especially true when there is no apparent source of the costs, as it requires the use of various techniques and methods to distribute the expenses fairly and reasonably.

What Is the Concept of Allocation?

Allocation (also known as “cost allocation”) is a process used to distribute the costs of a shared resource or expense among different departments, product lines, or activities within an organization.

This process is necessary to accurately determine the cost of producing a product, providing a service, or running a business. Allocation allows firms to identify the expenses incurred by each department or product line and helps make informed decisions about allocating resources.

The allocation concept has existed for centuries and is a fundamental part of modern accounting and financial management. The cost allocation process involves assigning costs to specific departments or product lines based on objective criteria, such as resource use or the benefit received from the expense.

The objective criteria used in the allocation process may vary depending on the type of business, but the goal is always to distribute the costs fairly and reasonably.

One of the main challenges of allocation is that many expenses cannot be traced directly to a specific department or product line. For example, the cost of electricity used to run a manufacturing plant cannot be directly traced to one particular product line.

In such cases, the cost of electricity must be allocated to different departments or product lines based on objective criteria, such as the number of hours each department uses the electricity or the production output of each product line.

There are different methods of allocation, each with its strengths and weaknesses. Some of the most common ways include direct allocation, step-down allocation, sequential allocation, and activity-based allocation. Each mode uses a different approach to allocating costs, but the goal is always to ensure that the costs are distributed fairly and reasonably.

What Doesn’t the Term Allocation Mean?

The term allocation” is commonly used in various contexts, such as finance, economics, project management, and resource management. However, it’s essential to understand that allocation ” doesn’t mean “equal distribution” or “uniform distribution” of resources.

Allocation refers to assigning a portion of resources, such as time, money, or labor, to specific tasks or activities. The goal of allocation is to optimize the use of resources to achieve the desired outcomes.

One of the most common misunderstandings about allocation is that it means dividing resources equally among tasks or activities. However, this is only sometimes the case. Resources are often not distributed evenly because different tasks or activities have different requirements and priorities.

For example, in project management, some jobs may require more time, money, or labor than others. In such cases, the project manager must allocate more resources to these critical tasks to ensure the project’s success.

Another misunderstanding about allocation is that it means distributing resources inflexibly and rigidly. Allocation is a flexible process that can be adjusted based on priorities or changes in resource availability. For example, in a business setting, the budget allocation may change based on market conditions or changes in customer demand. In these situations, the business must be able to reallocate its resources to respond to these changes.

The allocation also doesn’t mean that the resources are assigned once and never adjusted. Allocation is an ongoing process requiring constant monitoring and adjustments to ensure that resources are used optimally.

For example, in finance, the allocation of investments must be reviewed regularly to ensure that the portfolio is aligned with the investor’s goals and objectives.

Another misconception about allocation is that it only applies to tangible resources, such as money or equipment. However, allocation also applies to intangible resources like time and labor. These intangible resources are often more critical and limited than tangible ones. For example, allocating time is crucial in project management to ensure that projects are completed on time and within budget.

As you can see, allocation is a complex and flexible process that requires careful consideration of multiple factors, such as resource availability, priorities, and goals. It’s essential to understand that allocation doesn’t mean equal distribution or limited distribution of resources.

Instead, it’s a dynamic process that requires ongoing monitoring and adjustments to ensure the optimal use of resources. By avoiding common misconceptions about allocation, individuals and organizations can more effectively allocate their resources and achieve their desired outcomes.

Where the Term Allocation Originated From?

The word “allocation” comes from the Latin word “allocare.” The word allocation ” refers to setting aside or assigning a particular portion, amount, or portion of something for a specific purpose or recipient.

The allocation comes from the Latin prefix ad- (meaning “to”) and the noun loci (meaning “place”). The combination of these two words implies the idea of assigning a place, or portion of something, for a specific purpose.

In finance and economics, “allocation” refers to distributing resources, such as money, to different projects or initiatives based on their perceived importance and likelihood of success.

The allocation concept is ancient and can be traced back to the earliest civilizations, where resources were allocated based on the community’s needs. In early societies, central planning or direct control by the ruling class were common methods of allocation.

However, with the advent of market-based economies, the allocation has become more decentralized and is now primarily done through the market mechanism of supply and demand.

In modern economies, allocation is crucial in ensuring that resources are used efficiently and effectively. For example, in capital allocation, investors allocate their funds to different projects and businesses based on the perceived potential return on investment. This helps direct investment toward the most promising and profitable opportunities, thereby increasing the economy’s overall efficiency.

Similarly, prices play a crucial role in allocating goods and services in directing resources to where they are most needed. In a market economy, the interaction of supply and demand determines prices. When demand for a particular good or service is high, the price will increase, directing more resources toward its production. On the other hand, when demand is low, the price will decrease, reducing the allocation of resources to its production.

Government policies and regulations can also have an impact on allocation in addition to the market mechanism. For example, the government may allocate resources to specific sectors through funding or subsidies, such as education or healthcare.

Similarly, government regulations and taxes can also impact the allocation of resources by affecting the incentives for businesses and individuals to allocate their resources in a particular way.

How Allocation Relates to Accounting?

In accounting, allocation determines the cost of producing a product or providing a service. This information is then used to create accurate financial statements and make informed decisions about allocating resources in the future.

For example, a company may allocate resources to a new product line based on the expected revenue it will generate or distribute costs to specific departments based on their usage of resources.

The allocation also plays a crucial role in cost accounting . Cost accounting involves analyzing the cost of production, including direct and indirect costs, and using this information to make decisions about pricing and resource allocation.

By accurately allocating costs, a company can determine the actual cost of production and make informed decisions about pricing , production volume, and resource allocation.

In addition, allocation is used to allocate the costs of long-term assets, such as property, plant, and equipment. This is done through the process of depreciation, which is a systematic allocation of the cost of an asset over its useful life. Depreciation is used to determine the value of an investment for financial reporting purposes and the amount of tax that a company must pay.

Finally, allocation is also used in the budgeting process. In budgeting, an organization allocates resources to various departments and activities based on their priorities and goals. By accurately allocating resources, a company can ensure that it has enough resources to meet its goals and objectives while staying within its budget.

3 Examples of Allocation Being Used in Accounting Practice

Example #1 of allocation being used in accounting practice.

Allocating the Cost of Goods Sold In accounting, “cost of goods sold” (COGS) refers to the direct costs associated with producing a product or providing a service. These costs include the raw materials, labor, and overhead expenses incurred to produce the goods. COGS is crucial in determining a company’s gross profit because it represents the cost of producing and selling a product.

One example of allocation in accounting practice is when a company allocates the cost of goods sold to each product. This is done to understand the cost of producing each product and identify the most profitable products. 

The allocation process involves dividing the total COGS by the number of units sold to arrive at an average cost per unit. This average cost per unit is then applied to each unit of product sold to determine the COGS for that specific product.

This allocation process is vital because it allows the company to accurately determine the cost of producing each product. This information is then used to make informed business decisions such as pricing strategies, production decisions, and cost control measures. 

For example, suppose a company realizes that the cost of producing one product is much higher than the cost of producing another. In that case, it may choose to discontinue the higher-cost product or find ways to reduce the cost of production.

Example #2 of Allocation Being Used in Accounting Practice

One example of allocation in accounting practice is allocating indirect costs to different departments or products within a company. Indirect costs, such as rent, utilities, and office supplies, cannot be directly traced to a specific product or department. These costs must be allocated among different departments or products to calculate the cost of each accurately.

For example, consider a manufacturing company with three departments: production, research and development, and administration. The company has a total indirect cost of $100,000 for the year, which includes rent, utilities, and office supplies.

The company might determine the proportion of space each department uses to allocate these costs. If production uses 40% of the total space, R&D uses 30%, and administration uses 30%, the company would allocate 40% of the indirect costs to production, 30% to R&D, and 30% to administration.

Next, the company might allocate indirect costs based on the number of employees in each department. If production has 20 employees, R&D has 15, and administration has 10, the company would allocate indirect costs based on the ratio of employees in each department.

In this example, production would receive 40% of the indirect costs, R&D would receive 30%, and administration would receive 30%.

Finally, the company might allocate indirect costs based on the number of products produced in each department. If production produces 1000 products, R&D produces 500, and administration produces none, the company would allocate indirect costs based on the ratio of products produced in each department.

In this example, production would receive 67% of the indirect costs, R&D would receive 25%, and administration would receive 8%.

Example #3 of Allocation Being Used in Accounting Practice

Suppose a manufacturing company produces two products: Product A and Product B. To determine the cost of each product, the company must allocate the factory overhead costs, including utilities, rent, maintenance, and supplies, among other expenses. The overhead costs must be assigned to each product based on the proportion of total machine hours used to produce each product.

For example, if the company uses 60% of the total machine hours to produce Product A and 40% to produce Product B, then 60% of the factory overhead costs would be allocated to Product A and 40% to Product B. The company would then use the allocated overhead costs and the direct costs of material and labor to calculate the total cost of each product.

The allocation of overhead costs to each product is critical for the company to accurately determine the cost of goods sold and price its products competitively. The company can use an allocation method to ensure a fair and accurate picture of the costs of producing each product.

How to Do Cost Allocation in Simple Steps?

Cost allocation can be complex, but it doesn’t have to be. Here are five simple steps for cost allocation:

Step 1: Identify the Costs That Need to Be Allocated

The first step in cost allocation is identifying the costs that need to be allocated. This includes both direct and indirect costs. Direct costs can be easily traced to specific products or services, while indirect costs, such as rent and utilities, cannot.

Step 2: Choose the Appropriate Method of Cost Allocation

Once you have identified the costs that need to be allocated, the next step is to choose the appropriate cost allocation method. The most common methods include direct cost allocation, step-down allocation, sequential allocation, and activity-based costing. The method chosen will depend on the nature of the costs and the objectives of the cost allocation process.

Step 3: Determine the Allocation Base

The allocation base is the basis on which the costs will be allocated. This can be the number of units produced, the number of employees, or any other relevant factor that can be used to determine the cost of goods or services.

Step 4: Allocate the Costs

Once you have determined the allocation base, the next step is to allocate the costs. This can be done by dividing the total cost by the number of units, employees, or another relevant factor and multiplying this by the number of units, employees, or another relevant factor for each product, service, or department.

Step 5: Review and Adjust the Cost Allocation

Once the costs have been allocated, the final step is to review and adjust the cost allocation as necessary. This may involve reallocating costs based on new information or changes in the business.

Which Industries Can Cost Allocation Be Applied?

With the proper guidance, cost allocation can be applied to almost any industry. It’s all about the data you have and how you use it.

Let’s take a look at some of the industries that could benefit from cost allocation:

The healthcare industry is one of the most expensive in the world. It is also one of the most heavily regulated. These factors make cost allocation a necessity for many healthcare providers.

Healthcare organizations have many different costs, but the most significant sources are labor and supplies. Labor costs can be very high in this industry because it requires highly skilled people to perform various tasks, including surgery, patient care, and patient education. Supplies like bandages and IV bags are also expensive because they have to be sterile and meet regulatory requirements.

A hospital’s supply department has much control over its budget, but it also has little control over what happens in other departments, such as surgery or patient care. This makes it difficult to allocate costs accurately when they don’t know how much they will spend on supplies or how many patients they’ll see each year.

Cost allocation helps solve these problems by allowing managers to see which departments are consuming the most resources. They can adjust accordingly without guessing what’s happening behind closed doors (or behind locked doors).

Manufacturing

The manufacturing industry is one of the most common places where cost allocation can be applied. In this industry, it is crucial to know how much it costs to make each product and how much it costs to produce goods (including materials and labor) for sale.

With this information, manufacturers can determine how much they need to charge for their products to cover all of their expenses, including overhead costs like rent or electricity bills.

Cost allocation can also help manufacturers determine which products are more profitable than others so that they can focus on those areas instead of wasting time and money on less popular lines of goods. For example, suppose a company produces clothing and electronics but finds its clothing line more popular among consumers than its electronics line.

In that case, it may want to stop producing electronics altogether because there would need to be more demand for these products for them to make any money off of them.

This is an industry that benefits from cost allocation. Energy companies have long been able to allocate costs to different projects and branches, but they often face challenges when assigning overhead expenses. That’s because overhead costs are shared among the company’s functions, making them difficult to track.

Cost allocation software can help energy companies assign overhead expenses in a way that makes sense for each project or branch. The software also allows them to better understand where their money is going and gives them more flexibility in budgeting and forecasting future expenses.

Retailers are a great example of an industry that can benefit from cost allocation.

Retailers are often sold on the idea of one-stop shopping: you go to a store and buy everything you need, from clothing to food to furniture. But in reality, there are many different types of retailers, such as grocery stores, department stores, clothing stores, etc. And each has its own distinct set of costs for running that type of business. So how do these retailers know how much each product line contributes to their overall profits? They use cost allocation.

Cost allocation is a technique for allocating overhead costs across product lines based on their relative importance to the company’s overall performance. This way, retailers can determine which products contribute most (or least) to their bottom line and make decisions accordingly.

Information Technology

Information technology (IT) is one of the most significant cost allocation areas. IT costs are often divided into two categories: direct costs and indirect costs. The former refers to those costs that can be directly attributed to a particular project or product, while the latter refers to those costs that cannot be directly attributed.

Cost allocation in IT has many benefits. It helps managers determine how much it costs to develop a new product or service and where inefficiencies lie in their IT departments.

It also allows them to understand better how much revenue they’re generating from each product or service line, which will help them make better decisions about future investments in the company’s infrastructure.

Construction

This is one of the most apparent industries to apply cost allocation. Construction projects are often massive and complex, with many different stakeholders involved in the planning, execution, and completion of a project. It’s common for construction projects to have hundreds or thousands of contracts with hundreds or thousands of different suppliers.

Cost allocation helps ensure that those involved in the project are paid what they’re owed without overpaying anyone else who participated. It’s also used to ensure that a company only spends a little money on a project by ensuring that every expense is only charged once.

Transportation

This is the industry that can benefit the most from cost allocation.

Transportation has many parts that must work in unison to transport goods or passengers. It can be difficult to determine which part of a vehicle’s operation should be allocated to specific parts, and it usually requires a lot of math.

Cost allocation can make it easier for companies in this industry to understand which parts are costing them more than they expected so that they can make changes accordingly.

Food and Beverage

Food and beverage companies can benefit significantly from cost allocation. These companies are typically comprised of many different departments that must be managed to ensure the entire business runs smoothly. Each department has specific costs that it incurs, so allocating those costs among all of the departments will help you understand where your money is going and how it can be used most effectively.

Cost allocation is also helpful when dealing with food or beverage products because it allows you to track the costs associated with each product line and make sure you profit on every product line. This way, you know what kinds of products are selling well, which ones aren’t selling as well, and how much money each product line has made for your company.

Real Estate

This is one of the most common industries to use cost allocation methods. Real estate developers often create multiple project phases, which must be accounted for separately. The costs of these phases are usually allocated to determine how much profit (or loss) will be made in each phase.

This lets developers decide which phases should be completed first and what incentives may be offered to convince buyers to purchase units from those phases.

Utilities are another excellent example of an industry where cost allocation can be used.

They must deal with various costs, including purchasing raw materials, paying for labor, and buying equipment. The type of utility and the sector it operates in determine the cost of each of these. For example, a water utility may have very high costs for purchasing raw materials but low costs for labor and employee benefits because they only need a few employees or benefit packages.

Cost allocation can help utilities determine how much money they should spend on each part of their business so that they’re not overspending on one part while underinvesting in another.

Pros of Cost Allocation

Cost allocation is a common business practice. Companies use it to help determine the profitability of individual products, services, and departments within a company. Here are the pros of cost allocation:

Improved Decision Making

Cost allocation helps businesses make informed decisions by accurately determining the cost of goods or services. Companies can make informed decisions on pricing, production, and marketing strategies with a better understanding of the costs associated with producing a product or offering a service.

Better Resource Allocation

Cost allocation helps businesses to determine the costs associated with different departments, products, or services. This information can then be used to allocate resources more efficiently and allocate more resources to more profitable areas.

Increased Profitability

By allocating costs accurately, businesses can identify less profitable areas and make changes to improve profitability. This could involve reducing costs, improving efficiency, or adjusting pricing.

Better Budget Planning

Cost allocation helps businesses to create more accurate budgets. Companies can plan their budgets more effectively as they understand the costs associated with each product, service, or department.

Improved Internal Control

Cost allocation helps businesses to maintain better internal control over their operations. By allocating costs accurately, companies can track expenses and identify improvement areas. This helps to prevent fraud and embezzlement and increases accountability within the company.

Better Understanding of Overhead Costs

Overhead costs can be challenging to understand and allocate accurately. Cost allocation helps businesses to understand these costs better and allocate them to the proper departments or products. This allows companies to make informed decisions on pricing and production.

Improved Cost Reporting

Cost allocation helps businesses to produce more accurate cost reports. This allows companies to make informed pricing, production, and marketing strategies decisions. Cost reports are also essential for tax purposes and to meet regulatory requirements.

Better Negotiations

Cost allocation helps businesses to understand their costs better, which can be used in negotiations with suppliers and customers. Companies can better understand costs and negotiate better prices, terms, and conditions with suppliers and customers. This helps businesses to maintain better relationships and increase profitability.

Cons of Cost Allocation

Cost allocation can be an excellent tool for helping you understand where your money is going and how to save it, but this method has some drawbacks.

Time-Consuming Process

Cost allocation can be time-consuming and requires significant effort from various departments within the company. This can divert resources from other important tasks and may slow down other processes.

Increased Complexity

Cost allocation can be complex, especially for large organizations with multiple departments and products. This complexity can result in errors and misunderstandings, negatively impacting the accuracy of cost reports and other important financial information.

Implementing a cost allocation system can be expensive and require a significant investment in technology, software, and training. This cost can be a barrier for smaller organizations or those with limited resources.

Unreliable Data

Cost allocation is only as accurate as the data used in the process. Poor quality data, errors in data entry, and outdated data can all result in inaccurate cost reports and inefficient resource allocation.

Resistance to Change

Some employees may resist implementing a cost allocation system, especially if they feel the process may negatively impact their department or lead to job loss.

Limited Flexibility

Cost allocation systems are often rigid and lack the flexibility to adapt to changes in business conditions. This can result in inefficiencies and limit the ability of the company to respond to new opportunities or challenges.

Potential for Misallocation

If not implemented correctly, cost allocation can misallocate costs, negatively impacting decision-making and profitability.

Dependence on Cost Allocation

Overreliance on cost allocation can lead to a lack of creativity and initiative within departments. Employees may become too focused on cost allocation and need to be more focused on driving innovation and growth for the company. This can limit the ability of the company to adapt to changing market conditions.

Frequently Asked Questions- Cost Allocation in Accounting

What are the main objectives of cost allocation.

The main objectives of cost allocation are to accurately determine the cost of goods or services, improve resource allocation, increase profitability, create more accurate budgets, improve internal control, and provide better cost reporting.

What Is Direct Cost Allocation?

Direct cost allocation refers to assigning costs directly to specific products or services. This method is used when the costs can be easily traced to specific business areas.

What Is Step-Down Allocation?

Step-down allocation refers to allocating costs from one department to another department or product. This method is used when costs cannot be directly traced to specific products or services.

What Is Sequential Allocation?

Sequential allocation refers to allocating costs based on the sequence in which they are incurred. This method is used when costs cannot be directly traced to specific products or services.

What Is Activity-Based Costing?

Activity-based costing refers to allocating costs based on the activities involved in producing a product or offering a service. This method is used when multiple activities are involved in creating a product or service.

Why Is Cost Allocation Important for Businesses?

Cost allocation is essential for businesses as it helps them understand the costs associated with each business area and make informed pricing, production, and resource allocation decisions. This leads to improved profitability and better resource allocation.

How Does Cost Allocation Impact Resource Allocation?

Cost allocation helps companies determine the costs associated with each department, product, or service, which are used to allocate resources more efficiently. By allocating resources based on accurate cost

How Does Cost Allocation Impact Pricing Decisions?

Cost allocation helps companies understand the costs associated with each product or service used to make informed pricing decisions. By accurately determining the cost of goods or services, companies can ensure that their pricing is based on a solid understanding of the costs involved.

The Comprehensive Guide to Cost Allocation in Accounting – Conclusion

Allocation of costs is a critical component of any business. By allocating costs, you can ensure that your company makes the best use of its resources and operates efficiently.

The ability to allocate costs allows you to make strategic decisions about your business’s operations and management and take appropriate actions regarding financial reporting.

The Comprehensive Guide to Cost Allocation in Accounting – Recommended Reading

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• Cost Classifications
• Relevant Cost of Material
• Manufacturing Overhead Costs
• Conversion Costs
• Quality Costs
• Revenue Expenditure
• Product Cost vs Period Cost
• Direct Costs and Indirect Costs
• Prime Costs and Conversion Costs
• Relevant vs Irrelevant Costs
• Avoidable and Unavoidable Costs
• Cost Allocation
• Joint Products
• Accounting for Joint Costs
• Service Department Cost Allocation
• Repeated Distribution Method
• Simultaneous Equation Method
• Specific Order of Closing Method
• Direct Allocation Method

Cost allocation is the process by which the indirect costs are distributed among different cost objects such as a project, a department, a branch, a customer, etc. It involves identifying the cost object, identifying and accumulating the costs that are incurred and assigning them to the cost object on some reasonable basis.

Cost allocation is important for both pricing and planning and control decisions. If costs are not accurately calculated, a business might never know which products are making money and which ones are losing money. If cost are mis-allocated, a business may be charging wrong price to its customers and/or it might be wasting resources on products that are wrongly categorized as profitable.

Cost allocation is a sub-process of cost assignment , which is the overall process of finding total cost of a cost object. Cost assignment involves both cost tracing and cost allocation. Cost tracing encompasses finding direct costs of a cost object while the cost allocation is concerned with indirect cost charge.

Steps in cost allocation process

Typical cost allocation mechanism involves:

• Identifying the object to which the costs have to be assigned,
• Accumulating the costs in different pools,
• Identifying the most appropriate basis/method for allocating the cost.

Cost object

A cost object is an item for which a business need to separately estimate cost.

Examples of cost object include a branch, a product line, a service line, a customer, a department, a brand, a project, etc.

A cost pool is the account head in which costs are accumulated for further assignment to cost objects.

Examples of cost pools include factory rent, insurance, machine maintenance cost, factory fuel, etc. Selection of cost pool depends on the cost allocation base used. For example if a company uses just one allocation base say direct labor hours, it might use a broad cost pool such as fixed manufacturing overheads. However, if it uses more specific cost allocation bases, for example labor hours, machine hours, etc. it might define narrower cost pools.

Cost driver

A cost driver is any variable that ‘drives’ some cost. If increase or decrease in a variable causes an increase or decrease is a cost that variable is a cost driver for that cost.

Examples of cost driver include:

• Number of payments processed can be a good cost driver for salaries of Accounts Payable section of accounting department,
• Number of purchase orders can be a good cost driver for cost of purchasing department,
• Number of invoices sent can be a good cost driver for cost of billing department,
• Number of units shipped can be a good cost driver for cost of distribution department, etc.

While direct costs are easily traced to cost objects, indirect costs are allocated using some systematic approach.

Cost allocation base

Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools to different cost objects. A good cost allocation base is something which is an appropriate cost driver for a particular cost pool.

T2F is a university café owned an operated by a student. While it has plans for expansion it currently offers two products: (a) tea & coffee and (b) shakes. It employs 2 people: Mr. A, who looks after tea & coffee and Mr. B who prepares and serves shakes & desserts.

Its costs for the first quarter are as follows:

Total tea and coffee sales and shakes sales were $50,000 & $60,000 respectively. Number of customers who ordered tea or coffee were 10,000 while those ordering shakes were 8,000.

The owner is interested in finding out which product performed better.

Salaries of Mr. A & B and direct materials consumed are direct costs which do not need any allocation. They are traced directly to the products. The rest of the costs are indirect costs and need some basis for allocation.

Cost objects in this situation are the products: hot beverages (i.e. tea & coffee) & shakes. Cost pools include rent, electricity, music, internet and wi-fi subscription and magazines.

Appropriate cost drivers for the indirect costs are as follows:

Since number of customers is a good cost driver for almost all the costs, the costs can be accumulated together to form one cost pool called manufacturing overheads. This would simply the cost allocation.

Total manufacturing overheads for the first quarter are $19,700. Total number of customers who ordered either product are 18,000. This gives us a cost allocation base of $1.1 per customer ($19,700/18,000).

A detailed cost assignment is as follows:

Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000

Manufacturing overheads allocated to Shakes = $1.1×8,000

by Irfanullah Jan, ACCA and last modified on Jul 22, 2020

Related Topics

• Cost Behavior

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2 CFR § 200.414 - Indirect (F&A) costs.

(a) Facilities and administration classification. For major Institutions of Higher Education (IHE) and major nonprofit organizations , indirect (F&A) costs must be classified within two broad categories: “Facilities” and “Administration.” “Facilities” is defined as depreciation on buildings, equipment and capital improvement, interest on debt associated with certain buildings, equipment and capital improvements, and operations and maintenance expenses. “Administration” is defined as general administration and general expenses such as the director's office, accounting, personnel and all other types of expenditures not listed specifically under one of the subcategories of “Facilities” (including cross allocations from other pools, where applicable). For nonprofit organizations , library expenses are included in the “Administration” category; for IHEs, they are included in the “Facilities” category. Major IHEs are defined as those required to use the Standard Format for Submission as noted in appendix III to this part, and Rate Determination for Institutions of Higher Education paragraph C. 11. Major nonprofit organizations are those which receive more than $10 million dollars in direct Federal funding.

(b) Diversity of nonprofit organizations. Because of the diverse characteristics and accounting practices of nonprofit organizations, it is not possible to specify the types of cost which may be classified as indirect (F&A) cost in all situations. Identification with a Federal award rather than the nature of the goods and services involved is the determining factor in distinguishing direct from indirect (F&A) costs of Federal awards. However, typical examples of indirect (F&A) cost for many nonprofit organizations may include depreciation on buildings and equipment, the costs of operating and maintaining facilities, and general administration and general expenses, such as the salaries and expenses of executive officers, personnel administration, and accounting.

(c) Federal Agency Acceptance of Negotiated Indirect Cost Rates. (See also § 200.306 .)

(1) The negotiated rates must be accepted by all Federal awarding agencies. A Federal awarding agency may use a rate different from the negotiated rate for a class of Federal awards or a single Federal award only when required by Federal statute or regulation, or when approved by a Federal awarding agency head or delegate based on documented justification as described in paragraph (c)(3) of this section.

(2) The Federal awarding agency head or delegate must notify OMB of any approved deviations.

(3) The Federal awarding agency must implement, and make publicly available, the policies, procedures and general decision-making criteria that their programs will follow to seek and justify deviations from negotiated rates.

(4) As required under § 200.204 , the Federal awarding agency must include in the notice of funding opportunity the policies relating to indirect cost rate reimbursement, matching, or cost share as approved under paragraph (e)(1) of this section. As appropriate, the Federal agency should incorporate discussion of these policies into Federal awarding agency outreach activities with non-Federal entities prior to the posting of a notice of funding opportunity .

(d) Pass-through entities are subject to the requirements in § 200.332(a)(4) .

(e) Requirements for development and submission of indirect (F&A) cost rate proposals and cost allocation plans are contained in Appendices III-VII and Appendix IX as follows:

(1) Appendix III to Part 200—Indirect (F&A) Costs Identification and Assignment, and Rate Determination for Institutions of Higher Education (IHEs) ;

(2) Appendix IV to Part 200—Indirect (F&A) Costs Identification and Assignment, and Rate Determination for Nonprofit Organizations;

(3) Appendix V to Part 200—State/Local Governmentwide Central Service Cost Allocation Plans;

(4) Appendix VI to Part 200—Public Assistance Cost Allocation Plans;

(5) Appendix VII to Part 200—States and Local Government and Indian Tribe Indirect Cost Proposals; and

(6) Appendix IX to Part 200—Hospital Cost Principles.

(f) In addition to the procedures outlined in the appendices in paragraph (e) of this section, any non-Federal entity that does not have a current negotiated (including provisional) rate, except for those non-Federal entities described in appendix VII to this part, paragraph D.1.b, may elect to charge a de minimis rate of 10% of modified total direct costs (MTDC) which may be used indefinitely. No documentation is required to justify the 10% de minimis indirect cost rate. As described in § 200.403, costs must be consistently charged as either indirect or direct costs, but may not be double charged or inconsistently charged as both. If chosen, this methodology once elected must be used consistently for all Federal awards until such time as a non-Federal entity chooses to negotiate for a rate, which the non-Federal entity may apply to do at any time.

(g) Any non-Federal entity that has a current federally-negotiated indirect cost rate may apply for a one-time extension of the rates in that agreement for a period of up to four years. This extension will be subject to the review and approval of the cognizant agency for indirect costs . If an extension is granted the non-Federal entity may not request a rate review until the extension period ends. At the end of the 4-year extension, the non-Federal entity must re-apply to negotiate a rate. Subsequent one-time extensions (up to four years) are permitted if a renegotiation is completed between each extension request.

(h) The federally negotiated indirect rate, distribution base, and rate type for a non-Federal entity (except for the Indian tribes or tribal organizations, as defined in the Indian Self Determination, Education and Assistance Act, 25 U.S.C. 450b(1) ) must be available publicly on an OMB -designated Federal website.

University of South Florida

USF Research & Innovation

Sponsored Research

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Research cchip #021, clarification or change in procedure (cchip), assignment of indirect costs (f&a) rates.

The recovery of Indirect Costs makes research at the University of South Florida possible by funding the labs, equipment, infrastructure, and the administrative and compliance operations necessary to be the best stewards of sponsored research. In addition, Indirect Costs fund internal awards, and the initiatives of each college and department through distribution to the respective colleges.

USF seeks to recover all indirect costs allowed by a sponsor in order to fund research operations at the University of South Florida. Recovering less than the maximum allowable indirect cost rate disadvantages the University research enterprise and devalues the true cost of conducting organized research. For that reason, USF requires the full recovery of indirect costs whenever possible as outlined in this CCHIP.

DEFINITIONS

Colleges and Universities Rate Agreement – Federally-negotiated indirect cost agreement negotiated between USF and the US Department of Health and Human Services (DHHS).

Facilitates and Administration (F&A) Costs – [see Indirect Costs]

Indirect Cost Rate Agreement – [see Colleges and Universities Rate Agreement]

Indirect Costs  –Those costs incurred for a common or joint purpose benefitting more than one cost objective, and not readily assignable to the cost objectives specifically benefitted, without effort disproportionate to the results achieved.

Instruction  – The teaching and training activities of an institution established by grant, contract, or cooperative agreement. These activities may be offered for credits or on a noncredit basis, and may be offered through regular academic departments or through separate divisions. This term excludes Research Training .

Off-Campus Adjacent – Projects in which all activities are performed in facilities within commuting distance of Tampa, Florida, which are not owned by the institution and where these facility costs are not included in the F&A pools, or where rent is directly allocated/charged to the project.

Off-Campus Remote – Projects in which all activities are performed in facilities outside the commuting distance of Tampa, Florida, which are not owned by the institution and where these facility costs are not included in the F&A pools, or where rent is directly allocated/charged to the project.

On-Campus – Projects in which all activities are performed in facilities which are owned or leased by the institution and where these facility costs are included in the F&A pools; where rent is not directly allocated/charged to the project.

Organized Research  – All research and development activities of an institution that are budgeted and accounted for separately. It includes Sponsored Research and University Research .

Other Sponsored Activities  – Programs and projects which involve the performance of work other than instruction and organized research such as health service projects, community service programs, service and technical assistance projects, and sponsor-designed testing, clinical trials, evaluations, and non-credit community education.

Research Training – Activities involving the training of individuals in research techniques where such activities utilize the same facilities as other research and development activities and where such activities are not included in the instruction function.

Sponsored Research – All research and development activities that are sponsored by Federal and non-Federal agencies and organizations. This term includes Research Training .

University Research – All research and development activities that are budgeted and accounted for separately by the institution under an internal application of institutional funds. University Research , for purposes of this document, must be combined with Sponsored Research under the function of Organized Research .

CLARIFICATION OR CHANGE

USF has negotiated indirect costs for a variety of research categories with our cognizant Federal Agency, the US Department of Health and Human Services (DHHS), which can be found in the Colleges and Universities Rate Agreement attachment on the USF Facilitates and Administrative Cost webpage . 

This webpage displays the appropriate rate to be applied for each respective category of research conducted or proposed at USF. The identified indirect cost rate will be applied in all situations except the identified exceptions below.

USF will WAIVE indirect costs:

• When required as a condition of a funding opportunity or solicitation.
• When USF has already exceeded a sponsor-required cap or limitation on indirect cost recovery from the sponsoring agency.
• As required by the sponsoring agency for sponsor-funded participant costs. (Refer to CCHIP #012 regarding Accounting for Participant Costs on Sponsored Projects . Indirect costs will be waived on participant costs only—and, only when required by the sponsor. USF’s full negotiated indirect cost rate will apply to all other portions of the award.)
• For student-led research. (If only a portion of a sponsored award supports student-led research, that portion will be accounted for separately in a sub- project for which indirect costs will be waived. USF’s full negotiated indirect cost rate will apply to all other portions of the award.)

USF will accept REDUCED indirect costs:

• When required as a condition of a funding opportunity or solicitation. The applied rate shall be the maximum allowable by the sponsor.
• When USF will exceed a sponsor-required cap or limitation on indirect cost recovery from the sponsoring agency. (The appropriate rate shall be the rate that recovers the maximum indirect costs possible within the sponsor required cap or limitation.)

USF will NOT waive or reduce indirect costs:

• For Federally-funded programs, per 2 CFR § 200.414(c).
• For Federal funds from a pass-through entity, per 2 CFR § 200.331(a)(4).
• To increase (or perceive to increase) the competitiveness of a proposal.
• To reallocate funding to, or cover a shortfall in, direct-costs categories.
• To cover unexpected costs, or improperly budgeted expenses.
• Because indirect costs were omitted from the proposed or awarded budget.
• To offset a budget reduction.
• Because an award was received in an amount less than expected.
• For the purpose of establishing relationships.
• In anticipation of future funding with higher indirect costs rates.
• To meet required match or cost-sharing requirements.
• When the proposal is not submitted through the approved institutional channel, or does not follow institutional policies, practices, or guidelines.
• For any other reason without the written approval of the Director of Sponsored Research.

The application of indirect costs shall be USF’s full indirect cost rate as outlined in the Colleges and Universities Rate Agreement, the USF Facilitates and Administrative Cost webpage and this CCHIP unless an exception is outlined explicitly in this document, or approval for a lower rate has been approved by the Director of Sponsored Research. This shall include strict adherence to the definitions of rate types, and research location, including off-campus remote and off-campus adjacent locations.

In the best interest of the USF research enterprise, exceptions to this CCHIP will be rare. The comprehensive review of any request for waived or reduced indirect costs will include, at a minimum, the following:

• The nature of the research or activity.
• The PI’s justification for the request of waived or reduced indirect costs.
• The sponsoring agency’s allowable indirect cost rate.
• The availability of support from other sources.
• The total proposed budget, and the amount of the requested waiver or reduction.
• The effective indirect cost rate proposed, when considering expense categories exempt from indirect cost under Modified Total Direct Cost (MTDC) requirements.
• The financial impact to the University.
• The financial impact to the College/Department.
• The PI, Department, and/or College’s willingness to be financially responsible for some or all of the unrecovered indirect costs.
• The likelihood of being funded without reducing or waiving indirect costs.
• Precedent that may be established. 

All requests for an exception to this CCHIP shall be submitted to the PI’s assigned Sponsored Research Administrator at least five (5) business days before the proposal due date, and shall include a comprehensive budget, and justification for the request. Requests received less than five (5) business days before the proposal due date will not be considered.

Any proposal submitted outside of the approved institutional channel (Sponsored Research), which does not include full indirect cost recovery, shall be re-budgeted to include full indirect cost recovery prior to acceptance by the University. If re-budgeting is not possible one of the following remedies will apply: (a) the proposal will be withdrawn, (b) the award will not be accepted, (c) an alternate unrestricted funding source(s) will be identified to which the unrecovered indirect costs will be charged. This may include future indirect costs rebates to the respective College, with the approval of the College’s Dean or designee.

Please address your questions regarding this CCHIP to your assigned Sponsored Research Administrator.

Uniform Guidance (2 CFR §200) USF Facilitates and Administrative Cost webpage Sponsored Research Contact List

EFFECTIVE DATE

This CCHIP is effective as of the date of revision and rescinds all previous versions pertaining to the Assignment of Indirect Costs (F&A) Rates .

ISSUED: June 1, 2020 LAST REVISION: August 17, 2021  

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