Definition:
In accounting, allocation refers to the process of distributing costs or benefits among different products, departments, or other units within an organization. It’s used to assign costs to specific items or areas for decision-making and financial reporting purposes.
Common types of allocation:
- Overhead allocation: Distributing overhead costs, such as rent, utilities, and administrative salaries, to products or services based on a predetermined allocation method.
- Cost allocation to departments: Assigning costs to different departments or divisions within an organization.
- Profit allocation: Distributing profits among different business units or partners based on a predetermined allocation method.
Why is allocation important?
- Decision-making: Allocation provides information that is used for decision-making, such as pricing, product mix, and resource allocation.
- Financial reporting: Allocation is essential for preparing accurate financial statements, as it helps to determine the cost of products or services and the profitability of different business units.
- Performance evaluation: Allocation can be used to evaluate the performance of different departments or business units.
There are various methods for allocation, including:
- Direct labor hours: Allocating costs based on the amount of direct labor hours used by each product or department.
- Machine hours: Allocating costs based on the amount of machine time used by each product or department.
- Direct materials costs: Allocating costs based on the amount of direct materials used by each product or department.
- Activity-based costing (ABC): A more sophisticated method that allocates costs based on the activities that consume those costs.
The choice of allocation method depends on the specific circumstances of the organization and the desired level of accuracy.
