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What Is the Importance of Cost Allocation?

By Osmand Vitez
Updated May 16, 2024
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In business, nothing is free; capital expenditures are necessary to purchase the goods and items necessary to manufacture products. The importance of cost allocation is to help a company determine the amount each item produced will cost. Managerial accounting practices typically provide the tools and guidelines necessary to allocate production costs. A few features relating to the importance of cost allocation include staying on budget, costing goods to meet profit goals, and tracking inefficient or ineffective operations. Different methods are available for these processes, depending on a company’s operations.

Budgets are very common in manufacturing firms, the companies that are most likely to produce the goods purchased by consumers. Production operations often have specific budgets they must follow for each item purchased. This is a form of cost control; maintaining low costs ensures any costs allocated do not result in overpriced goods. This can severely reduce a company’s profits and produce a dangerous financial situation due to improper cost allocation. Changing allocation methods can help correct this problem.

All companies have some type of profit goals, which they can achieve through the sale of goods and services. Individually, profit is sales price less the cost of an item. Dividing this result by the sales price can give the company its gross profit margin on a per-item basis. In most cases, the only way a company can increase its profit margin is to raise the sales price or reduce costs. Without proper cost allocation practices, a company may not know how to best reduce a product’s cost.

Companies can have all manner of inefficiencies or operations that raise costs intermittently. For example, a company may use too many workers to put together a specific product. These additional workers increase the product’s costs as the hourly wages must go into the cost allocation process. If managerial accountants can determine where these and other inefficiencies exist, they can remove them from the system. This should improve the company’s operations and reduce product costs to a normal range that allows for maximization of profit.

Constant review of a company's cost allocation process should be common. This allows a company to assess how well it operates compared to other businesses in the same market. Other times, a company may try to manage its earnings by going to a different cost allocation method. These changes can move a company from a conservative income approach to an aggressive approach or vice versa.

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