May 31, 2024

Best Practice Guide to Cost Allocation

Samuel Akinwunmi

Cost allocation is integral to calculating profitability at the lowest level and essential to budgeting and planning. Effective cost allocation allows leadership to gain visibility into expenses, understand the value of each business unit and customer, and reduce costs without compromising quality.

The Case for Cost Allocation

Most cost, quality, and operational data resides in separate asset, labor, performance, operational, and finance systems. The challenge for the finance team is to use this data to help the business make strategic decisions, as well as to report on the costs of each business unit providing their core services and capabilities to the enterprise. Additionally, very few finance teams can calculate the gross margins at a customer level.

Creating a Cost Allocation Model

Aggregating and organising data to enable deep analysis and reporting requires not only ingesting data from various sources but also developing an allocation model. An allocation model captures cost information and cost driver information, then flows that data from one logical group to another.

For example, let’s say you want to allocate marketing costs to your customers. The model would:

  1. Capture the total marketing costs.

  2. Identify the cost drivers, such as the number of leads generated or the number of marketing campaigns targeting each customer.

  3. Allocate a portion of the marketing costs to each customer based on the identified cost drivers.

  4. Finally, calculate the total cost allocated to each customer and analyse the profitability of each customer based on these allocated costs.

Cost Allocation Strategies

Most cost allocation strategies fall into five major categories. Using the example of allocating direct costs to customers, these categories are:

  1. Even Spread - Dividing all your costs evenly among all your customers.

  2. Manually Assigned Percentage - Assigning a specific percentage of costs to each of your customers manually.

  3. Manually Weighted - Similar to manual assignment but weighted by arbitrary numbers rather than adding up to 100%.

  4. Activity-Based Costing - The most accurate and fair method, where costs are weighted based on tracking actual customer activities.

  5. Multi-Dimensional - Combining different customer activities to create new cost drivers.

Next week, we’ll lay out the best practice guide for each of the above strategies for effective cost allocation and profitability management.

Which cost allocation strategies have worked for you?

Samuel Akinwunmi