Financial modelling terms explained

Cost Allocation

Cost allocation is the process of allocating the costs of a business activity to the related products or services. This article explains the different methods of cost allocation, and also gives examples and formulas.

What Are the Different Types of Cost Allocation?

There are three types of cost allocation: direct, indirect, and full cost. Direct cost allocation is when costs are specifically associated with a certain activity or product. Indirect cost allocation is when costs cannot be specifically associated with a certain activity or product, so they are allocated using some other method. Full cost allocation is when both direct and indirect costs are allocated.

How Do You Calculate Cost Allocation?

There are a few different ways to calculate cost allocation, but a common approach is to use a weighted average. This takes into account the relative value of each cost allocation category, and gives a more accurate estimate of the amount of money that should be allocated to each category.

Another way to calculate cost allocation is to use a flat rate. This assigns the same amount of money to each category, regardless of its relative value. This can be a good approach if the categories are all roughly equal in value, but it can lead to inaccurate results if some categories are more important than others.

Finally, some businesses use a hybrid approach that combines weighted averages and flat rates. This can be a good way to ensure that all categories are given their due consideration, while also ensuring that the overall allocation is accurate.

When Should You Use Cost Allocation?

There are a few scenarios in which cost allocation may be useful for financial modelling. One scenario is when a company is considering a new investment. In order to determine whether the investment is worth making, the company needs to know how the investment will impact its profits. Cost allocation can help to identify which costs will increase with the investment and which costs will stay the same. This information can then be used to calculate the company's net profit after the investment.

Another scenario in which cost allocation can be useful is when a company is considering a merger or acquisition. In order to determine whether the merger or acquisition is worth pursuing, the company needs to know how the deal will impact its profits. Cost allocation can help to identify which costs will increase with the deal and which costs will stay the same. This information can then be used to calculate the company's net profit after the deal.

Finally, cost allocation can be useful for budgeting and forecasting purposes. By understanding how costs are divided among different products or services, a company can make more accurate predictions about its future profits.

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