Question

Any number of cost allocation methods can be used for shared costs. Generally they have a basis in cause-and-effect, benefits received, fairness, or ability to bear. Discuss the validity of the selection of a cost allocation methodology. Why is choice of allocation method important?

Answer 1

Valid

Because cost allocation focuses on how an organization charges its funding sources, it provides managers with more visibility into their organization than simply which department is spending what on a particular service. Cost allocation can be used to analyze performance across different business units, providing insight into the true value drivers within an organization. Management can utilize this information to make decisions about products, investments, and operations simply by having a clearer understanding of how expenditures are broken down. Cost allocation can also help improve forecast accuracy and adds a layer of detail to financial reporting.

Managing a detailed cost allocation strategy helps an organization

• Identify the actual cost of services being provided within each business segment
• Share the costs of facilities and support services between departments or groups
• Ensure accuracy of cost-based user fees
• Comply with state law and minimizing audit issues
• Ensure reimbursement for allowable overhead costs is received

Not only does cost allocation provide insight into how services are used within an organization, but the information also helps financial analysts and others interpret financial data to determine profitability. Knowing how much a department is spending over how much revenue it’s generating can create a telling picture as to the level of efficiency within a specific business segment. It can also demonstrate which products or services are proving to be a good financial investment, and which should be more closely evaluated.