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What Are the Different Types of Cost Allocation Systems?

By Osmand Vitez
Updated May 16, 2024
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Cost allocation systems are a part of managerial accounting that focus on applying production costs to manufactured goods. Many types of systems exist for this process, though many of the alterations come from a few basic setups. A few common cost allocation systems include absorption costing, variable costing, and activity-based cost allocation. Companies often select the best allocation system based on their manufacturing environments, such as job order or process production. Each costing method has its benefits and drawbacks from an accounting standpoint.

Absorption cost allocation systems are typically the preferred method for marrying management and financial accounting. Cost allocation is often an internal managerial accounting process, with the information procured not for public release. This method excludes all variable and fixed general, selling, and administrative (GSA) costs that do not affect the direct production of goods. In accounting, these costs fall under a term period expense. Period expenses go directly onto the company’s income statement, lowering net income for a given month.

Variable cost allocation systems are similar to the absorption method as they exclude GSA costs that do not affect the direct production of goods. The major difference here, however, is the exclusion of fixed manufacturing costs along with the GSA expenses. The removal of fixed manufacturing costs lowers the production costs allocated to each product. The result is lower cost of goods sold and higher gross profit. Many national accounting standard boards do not agree with this method as it creates a distorted income statement and improper costs for manufactured goods.

Activity-based costing is quite a bit different from these other two methods. These allocation systems look for activities that affect the manufacturing process. Each activity should have a cost driver, such as labor or machine hours. Under this method, accountants add together all costs associated with a manufacturing activity. The cost driver helps companies determine the per-unit costs and allocate the results accordingly.

Cost allocation systems are often under intense scrutiny by managerial accountants. Companies need to ensure the costing system properly handles all manufacturing costs and complies with any standard accounting principles that govern financial accounting. Failure to properly handle these costs can result in serious problems, from lack of profits to poor audit results to failed accounting systems. Accountants can often alter or adjust as necessary in order to create the most profitable and accurate system possible to remain in business and competitive.

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