cost allocation exercise

What Is Cost Allocation?

Table of contents.

For your business to make money, you must charge prices that not only cover your expenses, but also provide a profit. Cost allocation is the process of identifying and assigning costs to the cost objects in your business, such as products, a project, or even an entire department or individual company branch.

While a detailed cost allocation report may not be vital for extremely small businesses, such as a teen’s lawn service, more complex businesses require the process of cost allocation to ensure profitability and productivity.

In short, if you can assign a cost to any part of your business, it’s considered a cost object.

What is cost allocation?

Cost allocation is the method business owners use to calculate profitability for the purpose of financial reporting . To ensure the business’s finances are on track, costs are separated, or allocated, into different categories based on the area of the business they impact.

For instance, cost allocation for a small clothing boutique would include the costs of materials, shipping and marketing. Calculating these costs consistently would help the store owner ensure that profits from sales are higher than the costs of owning and running the store. If not, the owner could easily pinpoint where to raise prices or cut expenses .

For a larger company, this process would be applied to each department or individual location. Many companies use cost allocation to determine which areas receive bonuses annually.

Regardless of your business size, you’ll want to review and choose the best accounting software to help this process run as smoothly as possible.

Types of costs

In the boutique example above, the process of cost allocation is pretty simple. For larger businesses, however, many more costs are involved. These costs break down into seven categories.

• Direct costs: These expenses are directly related to a product or service. In your business’s financial statements, these costs can be linked to items sold. For a small clothing store, this might include the cost of inventory.
• Direct labor: This cost category includes expenses directly related to the employee production of items or services your business sells. Direct labor costs include payroll for employees involved in making the items your business sells.
• Direct materials: As the name suggests, this category includes costs related to the resources used to manufacture a finished product. Direct materials include fabric to make clothing, or the glass used in building tables.
• Indirect costs: These expenses are not directly related to a product or service, but necessary to create the product or service. Indirect costs include payroll for those who work in operations. It also lists costs for materials you use in such small quantities that their costs are easy to overlook.
• Manufacturing overhead: This category includes warehouse costs, and any other expenses directly related to manufacturing the products sold. Manufacturing overhead costs include payroll for warehouse managers, as well as warehouse expenses such as rent and utilities.
• Overhead costs: These include expenses that support the company as a whole but are not directly related to production. Some examples of overhead costs are marketing, operations and utilities for a storefront.
• Product costs: Also called “manufacturing costs” or “total costs,” this category includes expenses for making or acquiring the product you sell. All manufacturing overhead costs are also listed in this category.

Example of cost allocation

To better explain the process of cost allocation and why it’s necessary for businesses, let’s look at an example.

Dave owns a business that manufactures eyeglasses. In January, Dave’s overhead costs totaled $5,000. In the same month, he produced 3,000 eyeglasses with $2 in direct labor per product. Direct materials for each pair of eyeglasses totaled $5.

Here’s what cost allocation would look like for Dave:

Overhead: $5,000 ÷ $3,000 = $1.66 per pair

Direct costs:

• Direct materials: $5 per pair
• Direct labor: $2 per pair
• Overhead: $1.66 per pair
• Total cost: $8.66 per pair

As you can see, without cost allocation, Dave would not have made a profit from his sales. Larger companies would apply this same process to each department and product to ensure sufficient sales goals. [Read related article: How to Set Achievable Business Goals ]

How to allocate costs

Cost objects vary by business type. The cost allocation process, however, consists of the same steps regardless of what your company produces.

1. Identify cost objects.

To begin allocating costs, you’ll need to list the cost objects of your business. Remember that anything within your business that generates an expense is a cost object. Review each product line, project and department to ensure you’ve gathered all cost objects.

2. Create a cost pool.

Next, gather a detailed list of all business costs. It’s a good idea to categorize the costs based on the reason for each amount. Categories should cover utilities, insurance , square footage and any other expenses your business incurs.

3. Allocate costs.

Now that you’ve listed cost objects and created a cost pool, you’re ready to allocate costs. As demonstrated in the example above, add up the costs of each cost object. At a glance, your report should justify all expenses related to your business. If costs don’t add up correctly, use the list to determine where you can make adjustments to get back on track.

What is cost allocation used for?

Cost allocation is used for many reasons, both externally and internally. Reports created by this process are great resources for making business decisions , monitoring productivity and justifying expenses.

External reports are usually calculated based on generally accepted accounting principles (GAAP) . Under GAAP, expenses can only be reported in financial statements during the time period the associated revenue is earned. For this reason, overhead costs are divided and allocated to individual inventory items. When the inventory is sold, the overhead is expensed as a portion of the cost of goods sold (COGS) .

Internal financial data, on the other hand, is usually reported using activity-based costing (ABC). This method assigns all products to the overhead expenses they caused. This process may not include all overhead costs related to operations and manufacturing.

Cost allocation reports show which cost objects incur the most expenses for your business and which products or departments are most profitable. These findings can be a great resource to pair with employee monitoring software when evaluating productivity. If you determine that a cost object is not as profitable as it should be, you should do further evaluations on productivity. If another cost object is found to exceed expectations, you can use the report to find staff members who deserve recognition for their contributions to the company.

Recognition is one of the best ways to keep employees motivated .

What is a cost driver?

A cost driver is a variable that can change the costs related to a business activity. The number of invoices issued, the number of employee hours worked, and the total of purchase orders are all examples of cost drivers in cost accounting .

While cost objects are related to the specific process or product incurring the costs, a cost driver sheds light on the reason for the incurred cost amounts. These items can take different forms – including fixed costs, such as the initial fees during the startup phase . Cost drivers give a bird’s-eye view of the entire company and how each department operates.

It’s common for only one cost driver to be used with very small businesses , since they are focused on using minimal reporting to estimate overhead costs.

Benefits of cost allocation

• It simplifies decision-making. Cost allocation gives you a detailed overview of how your business expenses are used. From this perspective, you can determine which products and services are profitable, and which departments are most productive.
• It assists in staff evaluation. You can also use cost allocation to assess the performance of different departments. If a department is not profitable, the staff productivity may need improvement. Cost allocation can also be an indicator of departments that exceed expectations and deserve recognition. Awards and recognition are a great way to motivate staff and, in turn, increase productivity. [Read related article: Best Business Productivity Apps ]

Even if you operate a very small business, it’s a great idea to learn the process of cost allocation, especially if you anticipate expansion in the future. Since the method can be complex, it’s ideal to use accounting software as an aid. Whether you choose to start allocating costs on your own with software or hire a professional accountant , it’s a process no business owner can afford to overlook.

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• Exercise Set B
• Why It Matters
• 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
• 1.2 Identify Users of Accounting Information and How They Apply Information
• 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
• 1.4 Explain Why Accounting Is Important to Business Stakeholders
• 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
• Multiple Choice
• 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
• 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
• 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
• Exercise Set A
• Problem Set A
• Problem Set B
• Thought Provokers
• 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
• 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
• 3.3 Define and Describe the Initial Steps in the Accounting Cycle
• 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
• 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
• 3.6 Prepare a Trial Balance
• 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
• 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
• 4.3 Record and Post the Common Types of Adjusting Entries
• 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
• 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
• 5.1 Describe and Prepare Closing Entries for a Business
• 5.2 Prepare a Post-Closing Trial Balance
• 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
• 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
• 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
• 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
• 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
• 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
• 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
• 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
• 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
• 7.1 Define and Describe the Components of an Accounting Information System
• 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
• 7.3 Analyze and Journalize Transactions Using Special Journals
• 7.4 Prepare a Subsidiary Ledger
• 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
• 8.1 Analyze Fraud in the Accounting Workplace
• 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
• 8.3 Describe Internal Controls within an Organization
• 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
• 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
• 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
• 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
• 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
• 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
• 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
• 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
• 9.5 Apply Revenue Recognition Principles to Long-Term Projects
• 9.6 Explain How Notes Receivable and Accounts Receivable Differ
• 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
• 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
• 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
• 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
• 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
• 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
• 11.1 Distinguish between Tangible and Intangible Assets
• 11.2 Analyze and Classify Capitalized Costs versus Expenses
• 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
• 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
• 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
• 12.1 Identify and Describe Current Liabilities
• 12.2 Analyze, Journalize, and Report Current Liabilities
• 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
• 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
• 12.5 Record Transactions Incurred in Preparing Payroll
• 13.1 Explain the Pricing of Long-Term Liabilities
• 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
• 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
• 13.4 Appendix: Special Topics Related to Long-Term Liabilities
• 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
• 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
• 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
• 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
• 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
• 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
• 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
• 15.3 Compute and Allocate Partners’ Share of Income and Loss
• 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
• 15.5 Discuss and Record Entries for the Dissolution of a Partnership
• 16.1 Explain the Purpose of the Statement of Cash Flows
• 16.2 Differentiate between Operating, Investing, and Financing Activities
• 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
• 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
• 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
• 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
• A | Financial Statement Analysis
• B | Time Value of Money
• C | Suggested Resources

LO 10.1 Calculate the goods available for sale for Soros Company, in units and in $ (dollar amounts), given the following facts about their inventory for the period.

LO 10.1 X Company accepts goods on consignment from C Company, and also purchases goods from P Company during the current month. X Company plans to sell the merchandise to customers during the following month. In each of these independent situations, who owns the merchandise at the end of the current month, and should therefore include it in their company’s ending inventory? Choose X, C, or P.

• Goods ordered from P, in transit, with shipping terms FOB destination.
• Goods ordered from P, in transit, with shipping terms FOB shipping point.
• Goods ordered from P, inventory in stock, held in storage until floor space is available.
• Goods ordered from C, inventory in stock, set aside for customer pickup and payments to finalize sale.

LO 10.1 Considering the following information, and applying the lower-of-cost-or-market approach, what is the correct value that should be reported on the balance sheet for the inventory?

LO 10.2 Complete the missing piece of information involving the changes in inventory, and their relationship to goods available for sale, for the two years shown.

LO 10.2 Bleistine Company had the following transactions for the month.

Calculate the ending inventory dollar value for each of the following cost allocation methods, using periodic inventory updating. Provide your calculations.

• first-in, first-out (FIFO)
• last-in, first-out (LIFO)
• weighted average (AVG)

Calculate the gross margin for the period for each of the following cost allocation methods, using periodic inventory updating. Assume that all units were sold for $50 each. Provide your calculations.

LO 10.2 Prepare journal entries to record the following transactions, assuming periodic inventory updating and first-in, first-out (FIFO) cost allocation.

LO 10.3 Calculate the cost of goods sold dollar value for B65 Company for the month, considering the following transactions under three different cost allocation methods and using perpetual inventory updating. Provide calculations for first-in, first-out (FIFO).

LO 10.3 Calculate the cost of goods sold dollar value for B66 Company for the month, considering the following transactions under three different cost allocation methods and using perpetual inventory updating. Provide calculations for last-in, first-out (LIFO).

LO 10.3 Calculate the cost of goods sold dollar value for B67 Company for the month, considering the following transactions under three different cost allocation methods and using perpetual inventory updating. Provide calculations for weighted average (AVG).

LO 10.3 Prepare journal entries to record the following transactions, assuming perpetual inventory updating and first-in, first-out (FIFO) cost allocation. Assume no beginning inventory.

LO 10.3 Prepare journal entries to record the following transactions, assuming perpetual inventory updating and last-in, first-out (LIFO) cost allocation. Assume no beginning inventory.

LO 10.4 If a group of inventory items costing $3,200 had been double counted during the year-end inventory count, what impact would the error have on the following inventory calculations? Indicate the effect (and amount) as either (a) none, (b) understated $______, or (c) overstated $______.

LO 10.4 If Barcelona Company’s ending inventory was actually $122,000, but the cost of consigned goods, with a cost value of $20,000 were accidentally included with the company assets, when making the year-end inventory adjustment, what would be the impact on the presentation of the balance sheet and income statement for the year that the error occurred, if any?

LO 10.4 Tanke Company reported net income on the year-end financial statements of $850,200. However, errors in inventory were discovered after the reports were issued. If inventory was overstated by $21,000, how much net income did the company actually earn?

LO 10.5 Compute Westtown Company’s (A) inventory turnover ratio and (B) number of days’ sales in inventory ratio, using the following information.

LO 10.5 Complete the missing pieces of Delgado Company’s inventory calculations and ratios.

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• Publication date: Apr 11, 2019
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• Building Your Business

What Is Cost Allocation?

Cost Allocation Explained in Less Than 5 Minutes

Definition and Examples of Cost Allocation

How cost allocation works, types of cost allocation.

miodrag ignjatovic / Getty Images

Cost allocation is a method used to assign costs to cost objects for a specific department, project, program, or other area.

The methods for cost allocation involve simple calculations, which can be beneficial to small business owners who need accurate financial information to help them price their products or services and make overall decisions. Learning about these methods can help you get a handle on your expenses and positively affect your bottom line.

Cost allocation is a method used to assess the costs associated with cost objects in specific categories within a business. Cost objects might include a product or service you sell, a particular department within your company, or the costs of dealing with a supplier.

Cost allocation is not just for large corporations looking to reduce expenses. Small business owners can greatly benefit from cost allocation; you get a more detailed look into the actual costs associated with your business, which allows you to assess prices better and increase your profitability.

For example, you might want to determine the costs of dealing with one of your suppliers, so you’d add up all of the associated costs. These costs can include everything from the phone calls you make to the time spent dealing with issues caused by them. Additionally, you could count how much you pay for the supplies you get from them.

Cost allocation essentially works by assigning costs to smaller areas within the overall business so that you can view profits or losses at a more granular level. When you use cost allocation, you might discover that your true production cost per unit is higher than expected.

It’s important to remember that cost objects will vary depending on your business and industry.

That means you might consider increasing prices to maintain a specific profit margin . On the opposite end of the spectrum, you may decide to scrap a product that turned out to be a money pit.

To accurately calculate cost allocation, you must first identify the cost object, then begin to assess the actual cost.

Determining Costs

Spreading costs is not an exact science when it comes to cost objects. Some ways to allocate costs are based on units manufactured, square footage, number of hours, headcount, or usage.

Let’s say you have a building with a photography studio on the first floor and a salon on the second floor; you’ll use square footage as your cost object. The salon is 2,000 square feet, and the studio is 1,000 square feet. The total rent for the building is $6,000 per month. To allocate rent between the two spaces, you would first divide the total rent by the total square footage of the building:

$6,000 (overall rent) ÷ 3,000 sq. ft. (total space) = $2 per sq. ft.

Second, you’ll want to calculate the rent for the photography studio:

$2 (price per sq. ft.) x 1,000 (studio sq. ft.) = $2,000

Third, you can calculate the rent for the salon:

$2 (price per sq. ft.) x 2,000 (salon sq. ft.) = $4,000

Your rent per space should be $2,000 for the overhead expense of the studio and $4,000 for the overhead expense of the salon.

Other scenarios might include payroll cost allocation based on employee cost centers, or payment processing cost allocation based on transactions per location or franchise.

Cost objects can be just about anything you assign a cost to. Some examples of cost objects are jobs, payroll, departments, projects, financial systems, IT, and programs.

Cost allocation is based on different types of costs that fall into one of three categories, generally speaking.

Direct Costs

Direct costs are the easiest to assign to an identified cost object, because they are directly related. For example, a direct cost could be the labor required to produce a product or the materials used.

Indirect Costs

When you have an indirect cost, it is not attached to a specific cost object but still is necessary for the business to function. For example, common indirect costs could be security costs or administrative costs not related to a specific department.

Overhead Costs

Overhead costs—also called operating costs—are those costs associated with the day-to-day operations of your business. These accrue regardless of actual production, but still support productivity. Operating costs might include insurance, rent, and legal fees.

Costs can be fixed or variable depending on the type. A fixed cost is constant, while a variable cost can fluctuate depending on other factors.

The cost type factors into how you allocate the cost later. For example, if you were cost allocating rent, it would be allocated to overhead expenses. You would likely use the square-footage method to allocate the cost.

When allocating costs directly related to a product, you might use the units-produced allocation method to factor in overhead costs with the direct costs to create the product. This will allow you to determine better the price you should be asking.

Key Takeaways

• Cost allocation helps business owners identify areas of opportunity with their products or services.
• Cost objects can include anything you want to measure and assign a cost to, such as products, programs, projects, or even a customer.
• Ways to allocate costs include square footage, units produced, usage, and headcount.

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• A Nonprofit's Guide to Cost Allocations

7/19/2022 - By Emily Lalas

What is cost allocation?

Cost allocation for nonprofits is the practice of grouping all costs together in a manner that helps the user determine the actual cost of operating its programs and/or locations. To effectively develop and operate sustainable programs, nonprofit organizations should ensure that they are tracking and planning for the actual cost of each program. Many costs are easy to categorize by program. However, costs related to multiple programs such as management salaries, utilities and other shared costs may not be as easy to record directly to a program. As such, these costs are often overlooked when planning program funding, which can result in your organization not raising enough support to sustain operations or leaving funding on the table from awards that your organization has already received.

Donors use reports such as financial statements and Form 990 when evaluating an organization. One of the key pieces of information they are usually looking for is the percentage of an organization’s costs that are related to operating its programs as opposed to administrative costs. Additionally, they want to see that the cost of fundraising is generating a good return for the organization. Organizations typically want to keep the ratio of program costs to administrative costs as high as possible. Developing a strategic cost allocation plan can help organizations ensure that they are communicating the actual cost of operating their programs to users of their financial reports.

How should my organization determine a cost allocation plan?

While there are many ways to determine a cost allocation plan for your organization, it is best to keep it clear and simple. The following steps are recommended to complete your allocation plan.

• Take inventory of programs. The leadership team of your organization should meet to look at all the different services that the organization is providing to the community and should then determine significant programs. For example, you may provide food to the homeless that you fund with multiple grants each year. Instead of treating each grant as a program, consider treating the service itself as a single program, which is then funded with multiple grants. It is important to remember that the goal here is to capture the actual cost of the services you are providing, not necessarily the expenses reimbursed by a single grant.
• Determine direct program costs. These costs are anything that you can readily determine are related to a single program. For example, paying a teacher’s salary for an educational program or paying a food vendor for a meal service program. 
• Determine major indirect cost pools. Group costs for similar functions together to be allocated lump sum. For example, you may group together things like administrative salaries, fringe benefits, occupancy, marketing, general and administrative, etc. 
• Evaluate each program’s fair share of each cost pool. Evaluate each cost pool and determine the percentage of costs that go towards each program, then allocate the full amount proportionately. It is important to note that the portion of each cost pool benefiting particular programs may vary. For example, it may be determined that programs benefit from 90% of the total occupancy costs, but only 60% of total salary expense. To have a strong methodology, each cost pool should be evaluated based on an appropriate basis. This may include square footage for occupancy costs, direct costs of Program A in proportion to total direct program costs, etc. If you do not know where to start with allocating certain costs, the best thing to do is to evaluate any historical data that you have. This may include records such as timesheets of management personnel detailing how much time they spent on each program. Any costs left over after allocation to all programs and fundraising are considered administrative costs. 
• Document and use consistently. One of the most important things that you need to do after you develop a cost allocation methodology is to document the plan including your programs, cost pools, which accounts comprise each cost pool and the basis (or rationale) for allocating each cost pool. Organizations should allocate costs consistently in accordance with the established methodology. 
• Revisit and revise. As your organization evolves, it is important to reevaluate your costs and ensure that your cost allocation methodology is evolving alongside your actual activities. This may include changing the way that your costs are allocated to ensure that your organization continues to track the actual cost of each program. Any changes to the methodology throughout the year should be documented with a rational reason for doing so.

What if my organization receives grants with specific cost allocation rules?

Sometimes grantors determine the extent to which indirect costs can be charged to a specific grant. In this case, indirect costs may need to be recalculated for grant reporting and funding requests to abide by the terms of the awarding agency. 

If your organization receives federal funding, it is important to be familiar with the cost principles that apply to your organization. Most standard 501(c)3 organizations receiving federal funding will be subject to the cost principles detailed in OMB Circular No. A-122 . These rules govern what is allowable under federal programs and give guidance and examples regarding cost allocation plans .

Even in instances where cost allocations are more heavily regulated, organizations still benefit from tracking their own cost allocations to ensure programs are adequately funded and should still evaluate their costs to maximize use of grant funding while remaining compliant with terms of their awards.

Whether your organization is developing an allocation methodology for the first time or is in the process of evaluating an existing methodology, including a trusted advisor such as an accountant specializing in nonprofit accounting can give you peace of mind knowing that you are properly evaluating your organization’s finances, strategically using as much of your existing funding as possible and remaining compliant with all award terms.

If you have questions about cost allocations and would like more guidance, reach out to our Nonprofit team.

About the Author |  Emily Lalas

Emily is a senior in the Audit & Assurance Services practice of Saltmarsh, Cleaveland & Gund. Her primary areas of expertise include providing audit and assurance services to the firm’s non-profit and healthcare clients. Emily is active in serving non-profit organizations throughout Pensacola and before joining Saltmarsh, she worked in bookkeeping and office administration for a regional law firm.

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69 8. Exercises (Part 1) – Weighted average

• Contributed by No Attribution by request
• Anonymous by request
• Which types of companies use a process costing system to account for product costs? Provide at least three examples of products that would require the use of a process costing system.
• Describe the similarities between a process costing system and a job costing system.
• Describe the differences between a process costing system and a job costing system.
• Review Note 8.4 “Business in Action 8.1” What are the three stages of production at Coca-Cola, and what account is used to track production costs for each stage?
• What are transferred-in costs?
• Review Note 8.9 “Business in Action 8.2” Why is it likely that Wrigley uses a process costing system rather than a job costing system?
• Explain the difference between physical units and equivalent units.
• Explain the concept of equivalent units assuming the weighted average method is used.
• Explain why direct materials, direct labor, and overhead might be at different stages of completion at the end of a reporting period.
• Review Note 8.14 “Business in Action 8.3” Why do colleges convert the actual number of students attending school to a full-time equivalent number of students?
• Describe the four key steps shown in a production cost report assuming the weighted average method is used.
• What two important amounts are determined in step 4 of the production cost report?
• Describe the basic cost flow equation and explain how it is used to reconcile units to be accounted for with units accounted for.
• Describe the basic cost flow equation and explain how it is used to reconcile costs to be accounted for with costs accounted for.
• Review Note 8.22 “Business in Action 8.4” Describe the last two stages of the production process at Hershey.
• How does a company determine the number of production cost reports to be prepared for each reporting period?
• What is a production cost report, and how is it used by management?
• Explain how the cost per equivalent unit might be misleading to managers, particularly when a significant change in production is anticipated.

Brief Exercises

• Product Costing at Desk Products, Inc . Refer to the dialogue presented at the beginning of the chapter.
• Why was the owner of Desk Products, Inc., concerned about the Assembly department product cost of each desk?
• What did the accountant, John Fuller, promise by the end of the week?
• Chewing gum manufacturer
• Custom automobile restorer
• Facial tissue manufacturer
• Accounting services provider
• Electrical services provider
• Pool builder
• Cereal producer
• Architectural design provider
• The Molding department requisitioned direct materials totaling $2,000 to be used in production.
• Direct labor costs totaling $3,500 were incurred in the Molding department, to be paid the next month.
• Manufacturing overhead costs applied to products in the Molding department totaled $2,500.
• The cost of goods transferred from the Molding department to the Packaging department totaled $10,000.
• Manufacturing overhead costs applied to products in the Packaging department totaled $1,800.

Prepare journal entries to record transactions 1 through 5.

• A university has 500 students enrolled in classes. Each student attends school on a part-time basis. On average, each student takes three-quarters of a full load of classes. Calculate the number of full-time equivalent students (i.e., calculate the number of equivalent units).
• A total of 10,000 units of product remain in the Assembly department at the end of the year. Direct materials are 80 percent complete and direct labor is 40 percent complete. Calculate the equivalent units in the Assembly department for direct materials and direct labor.
• A local hospital has 60 nurses working on a part-time basis. On average, each nurse works two-thirds of a full load. Calculate the number of full-time equivalent nurses (i.e., calculate the number of equivalent units).
• A total of 6,000 units of product remain in the Quality Testing department at the end of the year. Direct materials are 75 percent complete and direct labor is 20 percent complete. Calculate the equivalent units in the Quality Testing department for direct materials and direct labor.
• Calculating Cost per Equivalent Unit . The following information pertains to the Finishing department for the month of June.

Calculate the cost per equivalent unit for direct materials, direct labor, overhead, and in total. Show your calculations.

• Assigning Costs to Completed Units and to Units in Ending WIP Inventory . The following information is for the Painting department for the month of January.
• Calculate the costs assigned to units completed and transferred out of the Painting department for direct materials, direct labor, overhead, and in total.
• Calculate the costs assigned to ending WIP inventory for the Painting department for direct materials, direct labor, overhead, and in total.

Exercises: Set A

• Assigning Costs to Products: Weighted Average Method . Sydney, Inc., uses the weighted average method for its process costing system. The Assembly department at Sydney, Inc., began April with 6,000 units in work-in-process inventory, all of which were completed and transferred out during April. An additional 8,000 units were started during the month, 3,000 of which were completed and transferred out during April. A total of 5,000 units remained in work-in-process inventory at the end of April and were at varying levels of completion, as shown in the following.

The following cost information is for the Assembly department at Sydney, Inc., for the month of April.

• Determine the units to be accounted for and units accounted for; then calculate the equivalent units for direct materials, direct labor, and overhead. (Hint: This requires performing step 1 of the four-step process.)
• Calculate the cost per equivalent unit for direct materials, direct labor, and overhead. (Hint: This requires performing step 2 and step 3 of the four-step process.)
• Assign costs to units transferred out and to units in ending WIP inventory. (Hint: This requires performing step 4 of the four-step process.)
• Confirm that total costs to be accounted for (from step 2) equals total costs accounted for (from step 4). Note that minor differences may occur due to rounding the cost per equivalent unit in step 3.
• Explain the meaning of equivalent units.
• Production Cost Report : Weighted Average Method . Refer to Exercise 25. Prepare a production cost report for Sydney, Inc., for the month of April using the format shown in Figure 8.9.
• Direct materials totaling $15,000 are requisitioned and placed into production—$7,000 for the Fabrication department and $8,000 for the Packaging department.
• Products with a cost of $22,000 are transferred from the Fabrication department to the Packaging department.
• Products with a cost of $35,000 are completed and transferred from the Packaging department to the finished goods warehouse.
• Products with a cost of $31,000 are sold to customers.
• Prepare journal entries to record each of the previous transactions.
• In general, how does the process costing system used here differ from a job costing system?

Exercises: Set B

• Assigning Costs to Products: Weighted Average Method . Varian Company uses the weighted average method for its process costing system. The Molding department at Varian began the month of January with 80,000 units in work-in-process inventory, all of which were completed and transferred out during January. An additional 90,000 units were started during the month, 30,000 of which were completed and transferred out during January. A total of 60,000 units remained in work-in-process inventory at the end of January and were at varying levels of completion, as shown in the following.

The following cost information is for the Molding department at Varian Company for the month of January.

• Production Cost Report : Weighted Average Method . Refer to Exercise 28. Prepare a production cost report for Varian Company for the month of January using the format shown in Figure 8.9.
• Direct materials totaling $80,000 are requisitioned and placed into production—$60,000 for the Mixing department, $11,000 for the Testing department, and $9,000 for the Packaging department.
• Products with a cost of $55,000 are transferred from the Mixing department to the Testing department.
• Products with a cost of $86,000 are transferred from the Testing department to the Packaging department.
• Products with a cost of $100,000 are completed and transferred from the Packaging department to the finished goods warehouse.
• Products with a cost of $81,000 are sold to customers.

Cost Accounting Copyright © 2023 by William (Bill) Bonner is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License , except where otherwise noted.

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• Open access
• Published: 18 March 2020

What is the time cost of exercise? Cost of time spent on exercise in a primary health care intervention to increase physical activity

• Lars Hagberg   ORCID: orcid.org/0000-0002-4639-2324 1 ,
• Stefan Lundqvist 2 , 3 &
• Lars Lindholm 4  

Cost Effectiveness and Resource Allocation volume  18 , Article number:  14 ( 2020 ) Cite this article

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In health care interventions aimed at increased physical activity, the individual’s time spent on exercise is a substantial input. Time costs should therefore be considered in cost-effectiveness analyses. The aim of this study was to estimate the cost of time spent on exercise among 333 primary health care patients with metabolic risk factors receiving physical activity on prescription.

Based on a theoretical framework, a yardstick was constructed with experience of work (representing claim of salary as compensation) as the lower anchor-point, and experience of leisure activity forgone due to extended exercise time (no claim) as the higher anchor-point. Using this yardstick experience of exercise can be valued. Another yardstick was constructed with experience of cleaning at home in combination with willingness to pay for cleaning as the lowest anchor-point.

The estimated costs of exercise time were between 14 and 37% of net wages, with physical activity level being the most important factor in determining the cost. Among sedentary individuals, the time cost was 21–51% of net wages while among individuals performing regular exercise it was 2–10%. When estimating the cost of time spent on exercise in a cost-effectiveness analysis, experience of exercise, work, leisure activity forgone, and cleaning at home (or other household work that may be relevant to purchase) should be measured. The individual’s willingness to pay for cleaning at home and their net salary should also be measured.

Conclusions

When using a single valuation of cost of time spent on exercise in health care interventions, for employed participants 15–30% of net salary should be used. Among unemployed individuals, lower cost estimation should be applied. Better precision in cost estimations can be achieved if participants are stratified by physical activity levels.

Trial registration The study was conducted as a survey of existing clinical physical activity on prescription work, and was approved by the Regional Ethical Review Board in Gothenburg, Sweden (ref: 678-14)

Inadequate physical activity (PA) is associated with increased risk of disease and premature death [ 1 , 2 ]. Support for increased PA is often used in health care as treatment or prevention, and is generally assumed to be effective and cost-effective [ 3 ]. Cost-effectiveness analyses can be performed from different perspectives, but in general a societal perspective is recommended [ 4 , 5 ]. From this perspective, the individual’s time spent on exercise is a substantial input and should be considered in analyses. In this article, the term “exercise” is used to mean leisure time PA for enjoyment or health, rather than for useful reasons such as transportation or PA during work time.

Even though there is no satisfactory evidence for the time cost of exercise, it is common to simply assume a time cost and include it in the analysis. The use of exercise cost was described in a review of cost-effectiveness of PA interventions [ 6 ], but also in later articles, such as cost-effectiveness of physical activity on prescription (PAP) in a Swedish context [ 7 , 8 ]. Hatziandreu [ 9 ] was an early pioneer in this field, suggesting that exercise time should be valued at full wages for those who dislike exercise, at half wages for those who are neutral, and at no cost for those who like exercise. However, it is possible and desirable to make empirical estimates of the time cost of exercise. We have previously suggested a theoretical framework and a measurement method [ 10 ]; the framework is summarized below.

Theoretical framework

Time is usually regarded as an economic resource which everyone holds in the same fixed quantity. Individuals are assumed to allocate their time to different activities in different proportions with the aim of maximizing their utility. Time-dependent utility cannot be stored, and so can only be replaced by utility from activities that can be performed at the same moment.

The value of time is considered to be equal to the utility an individual receives from an activity [ 4 ]. Utility of activities can be divided into two parts; utility during the performance of the activity (utility in use) and utility after the activity is performed (utility in anticipation) [ 11 ]. This is important when it comes to time spent on exercise, which may be motivated by both enjoyment (utility in use) and better health (utility in anticipation).

In cost-utility analysis, health-related utility in anticipation should be expressed in terms of quality-adjusted life years (QALY) [ 12 ]. However, utility in use cannot be measured by QALY, because it is not sensitive to enjoyment, and so the only possible solution is to monetize it [ 12 ]. When health gains in anticipation are expressed in QALY, the monetized cost of time is only affected by utility in use.

As a theoretical rule, the utility in use is lower in work than in leisure activities. We accept and spend time in work because we receive salary as compensation, and the level of salary can be assumed to indicate the difference between utility in use of lost leisure activity and utility in use of work. At least in theory, we allocate time between work and leisure in order to maximize our utility, meaning that the utility of the last hour of leisure is equal to the utility of the last hour of work including salary. Based on this observation, a yardstick can be constructed with utility in use of work as the lowest anchor-point and utility in use of leisure activity forgone as the highest anchor-point. The yardstick can be monetized using the amount of salary necessary to make the two points equal with respect to utility level. The cost of the loss of utility in use when spending leisure time on exercising can thus be calculated. Another approach to creating the yardstick is based on purchase of different kind of home services, which means buying time for more leisure activities and thus gaining utility equivalent to the difference between the experience of homework and the experience of leisure activity. This second yardstick can be monetized by the willingness to pay (WTP) for home services.

This measurement method was used as a basis to gather data for estimating the cost of exercise time in an intervention in primary health care in Gothenburg, Sweden. This intervention involved the PAP in primary health care, individualized for patients with metabolic risk factors, with the main aim of the intervention being to increase these patients’ PA level.

The primary aim of this study was to estimate the cost of time spent on exercise among patients with metabolic risk factors receiving PAP. A secondary aim was to investigate individual factors associated with differences in the cost of time spent on exercise.

Study population

This study was based on an observational follow-up study of PAP treatment in primary health care, using 6-month follow-up data. The study population consisted of 444 patients from 15 primary health care centers in Gothenburg, Sweden, included during 2010–2014. The study design and medical results are presented in detail elsewhere [ 13 ]. The inclusion criteria were: being physically inactive, having at least one component of the metabolic syndrome present, receiving PAP treatment, and understanding the Swedish language.

Of the 444 patients who received the PAP intervention, 368 participated in the 6-month follow-up, and 333 of these filled in the questionnaire on experience of activities. The mean age was 58 years (range 27–84), and 54% were female. The most common reason for the PAP prescription were overweight/obesity (88%) and hypertension (79%) (Table  1 ).

Dropout was related to sex (more female), musculoskeletal disorders, diastolic blood pressure and quality of life. No significant differences between followed up and dropouts were seen for age, socioeconomic factors, tobacco, and all other risk factors/diseases [ 13 ].

Intervention

Personnel at the primary health care centers prescribed an individually tailored PAP to each patient, based on a dialogue with the patient using the principles of motivational interviewing [ 14 , 15 , 16 ]. Important factors for the content in the prescription were the patient’s preferences regarding level of PA and different kinds of PA. The patients were offered individual support for 6 months.

Measurements

Cost of time spent on exercise was measured according to a previously-developed method [ 10 ]. This consisted of two main measurements: (1) identification of the leisure activity forgone due to extended exercise time, and (2) rating of the experience of time spent on exercise, work, and the leisure activity forgone on a graphic rating scale (see Fig.  1 ). It was stressed that only the experience during the activity should be judged. In addition, experience of cleaning at home was measured. The experience of each activity was transformed to a scale running from 0 to 100, assumed to correspond to utility in use.

Rating scale for experience of exercise, leisure activity forgone, work, and cleaning

Physical activity level was measured with the Saltin–Grimby Physical Activity Level Scale (SGPALS), which assesses leisure time PA during the past year on four different levels [ 17 ].

Sedentary—mostly reading, television, computers, cinema, or other sedentary activities.

Moderate exercise—walking, cycling, or other activity for at least 4 h a week.

Regular exercise and training—running, swimming, tennis, badminton, gymnastics, or other similar exercise for at least 2–3 h a week.

Vigorous training and competition—vigorous training and competition in running, cross country skiing, swimming, or football several times a week.

These levels have been validated against measures such as metabolic risk factors [ 18 , 19 ], and the SGPALS has been published in an updated Swedish form [ 20 ].

Body weight and body height were measured by health care personnel. Body mass index (BMI) in kg/m 2 was calculated from the measured weight and height.

Estimation of costs of the time spent on exercise

In estimating costs of the time spent on exercise, the following interpretations of measurements were made:

When the experience of exercise was graded higher than the leisure activity forgone, the value of experience of exercise was set to the same as for the leisure activity forgone (no time cost).

When the experience of exercise was graded lower than both the activity forgone and work, the value of experience of exercise was set to the same as for work (time cost similar to salary).

When the experience of exercise was graded in between the experience of work and that of the leisure activity forgone, the value of experience of exercise was estimated by its position on the scale relative to the positions of work and leisure activity (with the time cost on a scale running from 0 to 100% of salary).

As an example, suppose that given a scale of 0–100, an individual valued the experience of work at 20 and that of the leisure activity forgone at 80. If experience of exercise was valued at 20 (the same as work), net salary would be needed as compensation for reaching a utility level equivalent to 80, while a valuation of exercise equal to 80 would mean that no compensation was needed and a valuation of 50 would represent a need of half net salary as compensation.

As will be shown in this article, many individuals rate their experience of work higher than their experience of leisure activity. Experience of work is therefore not always a useful lower anchor-point of the yardstick, and may lead to an overestimation of the cost of time spent on exercise. Hence experience of cleaning was also used as the lower anchor-point of the yardstick. WTP for cleaning was not measured in the actual investigation, but instead it was assumed that the WTP for 1 h of cleaning is between 0.5 and 1.0 h of net salary.

The two methods for estimating the cost of time spent on exercise can be formulated as follows.

When using work as the lower anchor-point,

and when using cleaning at home as the lower anchor-point,

where C denotes cost of time, U utility in use, l experience of leisure activity forgone, e experience of exercise, w experience of work, c experience of cleaning, H n number of hours, NS net salary, and WTP willingness to pay for an hour of cleaning.

Statistical analysis

Results are presented as mean values and standard deviations. Spearman’s Rank Correlation was used to analyze the impact of personal factors on estimation of cost of time spent on exercise.

Experience of activities

Mean experience of exercise (74.3) was somewhat higher than mean experience of leisure activity forgone (70.8). Among employees, work was rated as the activity with highest experience (Table  2 ). The activities taken into consideration when rating experience of exercise and leisure activity forgone are listed in Table  3 .

Cost of time spent on exercise

When using the yardstick with work as the lower anchor-point, 66% of the participants had higher experience of exercise than of leisure activity forgone, 25% had experience lower than both leisure activity forgone and work, and 9% had experience in between work and leisure activity forgone. The mean time cost was 28.2% (SD: 47.1%) of net salary. When using the yardstick with cleaning as the lower anchor-point, 30% of the ratings were between cleaning and leisure activity foregone, and the estimated cost of time spent on exercise was 13.5–27.1% of net salary (Table  4 ).

Factors associated with experience of activities and cost of time spent on exercise

The impact of sex, age, education, BMI, and PA level on cost of exercise time was tested in a bivariate correlation analysis. Sex and BMI had no impact, age and education had some impact, and PA level had a strong impact (Table  5 ).

When the participants were divided into subgroups by PA level, the costs of time spent on exercise differed considerably between the subgroups (Table  6 ).

Principal findings

We used two measurement methods to estimate the cost of time spent on exercise in a health care intervention to promote PA. The estimated costs were between 14 and 37% of net wages, with a large variation between individuals. PA level was the most important factor determining the value; among sedentary individuals, the time cost was between 21 and 51% of net wages and among individuals performing regular exercise and training it was between 2 and 10%.

Strengths and weaknesses of the study

The previously-proposed method of estimating cost of the time spent on exercise seems to have shortcomings, due to higher valuation of experience of work than expected. The yardstick based on experience of work will not be adequate for many individuals, as for them, in reality, the estimation of cost of exercise time is based on a higher or lower experience of exercise than experience of leisure activity forgone. For those who rate experience of exercise just below leisure activity forgone, if full net salary is considered as the cost of time spent on exercise, there is likely to be an overestimation of the cost. When instead experience of cleaning at home is used as the lower anchor-point, most values of experience of exercise lower than leisure activity forgone will be inside the yardstick.

This work does have one weakness in that WTP for an hour of cleaning was not measured, and there is room for debate over the assumption of cost corresponding to 0.5–1.0 h of net salary for an hour of paid cleaning. Most people, at least in Sweden, do not pay an hour’s salary for an hour of cleaning. Therefore, using WTP for cleaning corresponding to half net salary seems to be most relevant. To our knowledge, there are no studies on how much people are generally willing to pay for cleaning.

The theoretical construction using experience of work as the basis for valuation does not seem to work well in practice. People’s general experience of work is positive, and experience of leisure time is not always more positive than experience of working hours. In Sweden, working conditions are in general good. How we allocate time between work and leisure time does not seem to match the theory of maximization of utility. In practical use, it seems to be more appropriate to start from the exchange of an hour of housework, such as cleaning, for leisure time. We believe that the maximal WTP to buy an hour of cleaning may be a fairly good measurement of the value of the difference in experience between cleaning and leisure activity. Therefore, in the actual work we prefer the result based on cleaning as the lower anchor-point of the yardstick.

The dropout in the study may have affected the experience of time. Larger drop-out among those with lower quality of life may have resulted in higher experience of time, but it is unclear if it affects the valuation of time spent on exercise.

One might initially think of a method that involves the demand for compensation for exercising instead of the utility in use of leisure activity forgone. However, that valuation is likely to be affected by both utility in use and utility in anticipation, and the demand for compensation will probably be too low. In fact, the participants in the study performed all their exercise without any compensation.

Valuation of time appeared to be different between employed and unemployed individuals. This is in line with an earlier study of the value of travel time, which found that the value was 22.5% lower among the unemployed [ 21 ]. The present study, like an earlier study [ 22 ], suggests that the opportunity cost (value of leisure activity forgone) may be lower for unemployed individuals. For unemployed individuals in particular, then, it should be more relevant to base the yardstick on WTP for cleaning or similar.

There was a large difference in the costs of time spent on exercise between sedentary individuals and those who regularly performed exercise and training. It is likely that there is a bi-directional causal link, with high time costs leading to less PA. It is also possible to argue that low fitness level gives a less positive experience in the beginning. When starting an exercise regime, the experience seems to be less positive during the first 3 months than after a longer period of exercise [ 23 ].

The study was conducted in daily clinical practice among patients in primary care with health problems related to physical inactivity. The cost estimates should therefore be of high relevance for cost-effectiveness analyses of intervention aimed at increased PA in health care. Those who receive PAP are motivated to implement a lifestyle change and may not be representative of the entire patient group with the need for increased PA. In intervention aimed at other sedentary patients, the cost estimation of time spent on exercise in subgroup related to exercise level can help to provide relevant cost of time spent on exercise for those who are least physical active and motivated.

Strengths and weaknesses in relation to other studies

The most important item from the literature to discuss is the work of Hatziandreu [ 9 ] assumed the cost of exercise time to correspond to net salary for those who dislike exercise, half of net salary for those who are neutral, and zero for those who like exercise. The actual study can confirm zero salary (or close to) for those who like exercise, but for those who are neutral or dislike exercise Hatziandreu’s assumption seems much too high. Another common assumption used in cost-effectiveness analyses is that the cost of time spent on exercise is 35% of net salary. This assumption has generally been used in the absence of empirical data, for instance in the analyses of PAP by Feldman [ 7 ] and Romé [ 8 ]. The assumption may be reasonable for sedentary individuals, but too high for modestly physically active persons. The most important factor making this assumption too high is that the opportunity cost (value of leisure activity forgone) is not as high as net salary.

In comparison with the previous pilot study [ 10 ], the present study found that the cost of time spent on exercise was higher despite using the same measurement method; this is probably because the actual study population had poorer health and was less physically active. However, both studies showed a clear difference in the cost of time spent on exercise for sedentary compared to modestly physically active individuals. The development of the measurement method using experience of cleaning instead of work seems to be an advantage.

When using a single valuation of cost of time spent on exercise in health care interventions, for employed participants 15–30% of net salary should be used. Better precision in cost estimations can be achieved if participants are stratified by PA levels. The results are most relevant to employed individuals. Among unemployed individuals, lower cost estimation should be applied.

For estimation of cost of time spent on exercise in a cost-effectiveness analysis, experience of exercise, work, leisure activity forgone, and cleaning at home (or other household work that may be relevant to purchase) should be measured. In addition, individuals’ WTP for cleaning at home and their net salary should be measured. This will allow estimation of the currently most accurate cost of exercise time.

Data availability statement

The study data are available from the corresponding author on reasonable request.

Abbreviations

Body mass index

• Physical activity

Physical activity on prescription

Quality-adjusted life-years

Willingness to pay

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Acknowledgements

Not applicable.

Funding was provided as economic support for Ph.D. study by Region Västra Götaland.

Author information

Authors and affiliations.

Centre for Health Care Science, Faculty of Medicine and Health, Örebro University, P.O.Box 1324, 701 13, Örebro, Sweden

Lars Hagberg

Department of Health and Rehabilitation, Unit of Physiotherapy, Institute of Neuroscience and Physiology, Sahlgrenska Academy, University of Gothenburg, Gothenburg, Sweden

Stefan Lundqvist

Centrum för Fysisk Aktivitet Göteborg, Svangatan 2B, Region Västra Götaland, 416 68, Göteborg, Sweden

Unit of Epidemiology and Global Health, Umeå University, 901 87, Umeå, Sweden

Lars Lindholm

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Contributions

LH and LL developed the measurement method. SL and LH designed the study. SL administrated the project and did the data management. LH performed the analysis and drafted the manuscript. All authors participated in the revision of the manuscript. All authors read and approved the final manuscript.

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Correspondence to Lars Hagberg .

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Hagberg, L., Lundqvist, S. & Lindholm, L. What is the time cost of exercise? Cost of time spent on exercise in a primary health care intervention to increase physical activity. Cost Eff Resour Alloc 18 , 14 (2020). https://doi.org/10.1186/s12962-020-00209-9

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DOI : https://doi.org/10.1186/s12962-020-00209-9

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The CFO'S Perspective

Best practices in nonprofit cost allocation methodologies.

by Todd Kimball , on Mar 28, 2022

One of the most complicated elements of managing a non-profit organization's finances is allocating administrative-related expenses. These are expenses that cannot be specifically assignable to the areas benefited – commonly referred to as Indirect Costs. The methodologies of allocating indirect costs are often complex and situational. Additionally, many funders of non-profits have their own rules, exceptions and limits, creating a spider web of regulations.

When a non-profit organization cannot effectively manage indirect costs, they may inaccurately quantify and report a business unit or award's (contract/grant) sustainability and profitability. The organization may also find itself out of compliance with a funding agreement or federal and state regulations. Lastly and most significantly, the non-profit may under-recover its administrative costs from particular funding sources and be forced to use unrestricted donations to cover any losses.

Why allocate costs?

There are two primary reasons an organization may be interested in allocating indirect costs to individual projects or activities.

• To determine the total costs and profitability of a business unit, department, location, activity, award, etc. Many non-profit organizations may not be required to allocate costs for compliance purposes but may still want to allocate indirect costs to assess performance.
• To comply with contract or grant requirements associated with a particular funding agreement. Most non-profit funders articulate the terms of applying indirect costs in the agreement, even if only to put a percentage cap. At the far end of compliance regulations tend to be government agencies – local, State & Federal.

What are direct and indirect costs?

Direct costs:.

Direct expenses are explicitly incurred to further the grant program objective. These include items specified in the approved grant budget line items.

• 2 Code of Federal Regulations (CFR) Section §200.413 : "Direct costs are those costs that can be identified specifically with a particular final cost objective, such as a Federal award, or other internally or externally funded activity, or that can be directly assigned to such activities relatively easily with a high degree of accuracy."

Indirect Costs:

Indirect expenses incurred for common or shared objectives cannot be readily identified with a particular final cost objective. Example: Administrative and overhead are indirect costs.

• 2 CFR Section §200.56: "Indirect costs mean those costs incurred for a common or joint purpose benefitting more than one cost objective, and not readily assignable to the cost objectives specifically benefitted, without effort disproportionate to the results achieved."
• Indirect rates result from a ratio (whereby an indirect cost pool is divided by a direct cost base), which is then expressed as a percentage.

Example costs and cost drivers:

Recommended Best Practices

Keep it simple.

Cost allocation methodologies can become extremely complicated to track, implement, account, and explain. And just because a policy is complex does not make it better. Federal guidelines within 2 CFR Part §200:403-405 state that costs must be allowable, reasonable, and allocable, but there is no universal rule for classifying costs as direct or indirect (§200.412).

When developing a cost allocation methodology, consider that costs should equal the benefits derived and consider whether you can defend an allocation using logic and reason.

Perfection isn't required – it must just be considered reasonable.

As a way of example, consider rent expense. A common methodology is to allocate rent expense as an indirect cost, using square feet as the basis. To implement this method, an organization would need to measure the square feet each employee, department, or program utilizes as a percentage of the total occupied space. This in itself is cumbersome. However, some may go so far as to attempt to update the square feet monthly to account for staffing changes.

Alternatively, it may be reasonable to update the square footage calculation annually instead of monthly for simplicity. Or rather, consider using FTE counts monthly or even annually instead of square feet. If total costs correspond to a reasonable proportion of rent expense, it might also be possible to use total direct expenses as the basis.

Evaluate the most advantageous methodology

Organizations need to evaluate several factors to determine the most advantageous methodology of cost allocation - as in - should an expense be charged as direct or indirect.

Compliance requirements:

When determining whether to charge an expense as direct vs. indirect, the organization's compliance requirement arrangements are first considered. For a grant or contact-dependent organization, funders may place artificial indirect rate caps or apply other prescriptive rules on what may or may not be considered direct. Sometimes funders refer to federal regulations like 2 CFR Part 200, and other times, funders create their own rules.

Financial advantages:

Next, organizations should consider the best financial outcome of charging an expense as direct vs. indirect. When funders place restrictive caps on the allowable percentage of indirect, it is often to the organization's benefit to allocate as many costs as possible directly to the funder, thereby reducing indirect costs and the indirect rate. This technique will often maximize the reimbursable costs of the organization and reduce grant, contract, or programmatic losses.

Cost-Benefit:

Lastly, organizations should determine whether analyzing, tracking, and allocating costs are worth the effort involved. It is possible to determine a direct application for many costs, but an organization must consider whether that's the right decision. For example, printing costs can often be directly charged to a particular award, department, or program by utilizing a key code for each print job. However, the benefit of charging printing directly may outweigh the staff time used to accomplish this.

Document policy & procedure

Documentation of a cost allocation methodology is a crucial best practice to ensure consistent application and explanation to auditors, funders, and management teams. Once developed, it will likely be one of your organization's most commonly referred policies.

Automate if possible

If cost allocations are an essential and ongoing process for your organization, consider utilizing an existing tool within the accounting system or developing a tool using Excel templates to effectively and consistently apply the policy.

Other points of emphasis:

• Costs must be expensed as direct or indirect and not applied situationally to both. Once classed as indirect, the same expense should generally not be charged as direct. For example, an Executive Director's wages should generally not be charged as direct on some awards or indirect on others. There may be minor exceptions, but they should be small and justifiable.
• All programs/awards should be allocated their fair share of direct and indirect costs, even if a funder won't pay for it or can not afford the allocation. This shortcut will distort the profitability of both the program/award not applied AND all remaining programs/awards that did receive an allocation. This practice is also not in compliance with federal regulations.

The potential impact of poor cost allocation

• Management may incorrectly assess profitability by business unit, department, location, activity, award, etc. This could result in expanding or closing a particular activity while using inaccurate data.
• Non-profit organizations have one or more grants or contracts that stipulate cost allocation requirements. Failure to follow these rules could result in a breach of contract, repayment to funders, and audit findings.
• Poor cost allocation methodology may result in unrecovered costs from funders, which forces an organization to use unrestricted funds to make up the shortfall or result in net losses to the organization.

Conclusion:

While developing and implementing a cost allocation methodology may seem daunting, it may be beneficial to break down each type of organizational expense individually and consider the best approach based on compliance, financial impact, and cost-benefit. A non-profit organization can build upon these principles to develop a comprehensive approach and policy with this backdrop.

CFO Selections has created strong connections with non-profit organizations throughout our regions and in Oregon through our partnership with the Nonprofit Association of Oregon (NAO).

If you are looking for assistance with non-profit cost allocation, please reach out to us! CFO Selections' mission is to provide non-profit organizations of any size with high-quality, customized strategic consulting services.

Contact us for additional information .

About the Author

Todd is a senior accounting professional with over 15 years of expertise in the non-profit and government sectors. He has a proven track record at tackling the most challenging not-for-profit accounting issues and finding solutions that work and move organizations forward.  He excels at creating process efficiencies, motivating and utilizing staff to their full potential, implementing internal controls and providing sound technical expertise.   Learn more about Todd here .

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Benefits of Cost Allocation for Businesses: Make Informed Decisions with Accurate Cost Tracking

By henry sheykin, what methods are used to allocate costs.

Cost allocation is the process of assigning costs incurred to one or more cost objects. Cost objects are activities, products, departments, projects or other items to which costs are assigned or allocated. There are three commonly used methods to allocate costs: direct, step, and reciprocal.

• Direct Method: This method assigns costs directly to cost objects on a one-to-one basis. This can be done manually or by using an automated system. For example, in the manufacturing industry, companies can assign the costs associated with producing an item directly to that item.
• Step Method: The Step method allocates costs to cost objects through a series of predetermined steps and assigns costs based on an estimated measure of activity or volume. This method is usually used when costs are difficult to be assigned on a direct basis. For example, allocating the electricity costs to multiple products manufactured by the company.
• Reciprocal Method: This method compares relative usage of the shared resource by each cost object and allocates costs to those cost objects accordingly. For example, the cost of maintenance of a common resource can be allocated between two departments or divisions using the reciprocal method.

It is important to consider the accuracy and consistency of the chosen cost-allocation method and the amount of effort required when selecting a method. Cost allocation should be carried out on a regular basis in order to ensure that costs are properly assigned and tracked.

Key Takeaways:

• Accurate measurement of resources used
• Consistent methodologies should be applied
• Costs should be allocated in the same accounting period
• Allocation of resources helps to evaluate expenses
• Improved accuracy in tracking expenses and budgeting
• Enables decision-making to prioritize activities and investments

How do companies allocate costs to products?

Cost allocation is a critical process for businesses and organizations of all types. It involves identifying, gathering and assigning costs to different products or services. Cost allocation is important because the costs of producing or providing a product or service determines how much the company can sell it for and how much profit they can make.

There are several methods companies use to allocate costs, including direct tracing, step allocation, and activity-based costing. Depending on the nature of the business, one or more of these methods may be used.

Here is an overview of the three main methods for allocating costs:

• Direct Tracing: This method traces costs directly to products in a one-to-one relationship. For example, the cost of a specific raw material to create a certain product can be traced directly to that product.
• Step Allocation: This method divides costs into categories with each category allocated to a number of products. For instance, indirect labor may be allocated among different products based on the number of labor hours used producing each product.
• Activity-Based Costing: This method assigns costs to products based on the activities necessary to produce the product. It can produce more precise cost allocation than other methods, but it can also be more complex and expensive to implement.

It is important to note that the method used to allocate costs will depend on the specific circumstances of the business, such as the type of products being produced, the complexity of the production process, and the accuracy required for cost accounting.

What is the Purpose of Cost Allocation?

Cost allocation is the process of identifying, aggregating and assigning indirect costs to different cost objects such as products, services and activities. Cost allocation is important for businesses to accurately assess the cost of producing goods and services, as well as to understand how overhead costs are distributed.

For example, in a large manufacturing firm, the cost of utilities, building maintenance and property taxes must be allocated to different buildings and departments. Allocation of these costs, in combination with properly allocating direct costs, provides the company with the true cost of doing business.

Below are some tips to help you perform cost allocation:

• Accurately measure resources used: An accurate understanding of the resources used is necessary in order to allocate the costs effectively.
• Make sure to use consistent methodologies: Different cost allocation methods might be applied and having a set of consistent methodologies will help ensure accurate cost allocations.
• Ensure that costs are allocated in the same accounting period: Allocating costs to the same period ensures that all the costs associated with that period are accounted for.

What are the Benefits of Cost Allocation?

1. Allocation of Resources Cost allocation allows organizations to allocate resources more effectively and efficiently. By assigning costs to individual cost centers, managers can assess the cost of each activity and determine the areas where cost reductions should be made.

2. Improved Accuracy Cost allocation can help organizations track different expense categories and make sure that the costs are being allocated fairly and accurately. This enables organizations to determine actual costs and ensure that cost savings are being achieved.

3. More Accurate Budgeting Cost allocation makes budgeting more accurate and allows managers to better forecast costs. By assigning costs accurately, organizations can assess the current budget and identify areas where additional funds may be needed.

4. Enables Decision-Making Cost allocation can help organizations make more informed decisions when it comes to activities and investments. By tracking costs and expenses accurately, organizations can analyze which activities are generating the highest ROI and prioritize those activities.

To maximize the benefits of cost allocation, organizations should establish a clear allocation methodology that is detailed and documented. This helps ensure that the costs are being allocated accurately and efficiently and that each cost center is being allocated its fair share. Organizations should also review their cost allocation regularly to make sure that it remains accurate and up-to-date.

What is the difference between direct and indirect cost allocation?

Direct Cost Allocation

Indirect Cost Allocation

Tips for Direct and Indirect Costs Allocation

• Make a list of all costs that need to be allocated and separated them into direct and indirect.
• Develop a system for assigning costs as accurately as possible to their respective products or activities.
• Analyze each cost to determine if it is fixed or variable, and if it is strictly assignable to a product or activity.
• Determine the cost allocation method that best applies to each cost and activity.
• Allocate the costs accurately in order to provide an accurate financial picture.

How do You Ensure Accurate Cost Allocation?

• Make sure that each cost is properly categorized and classified. This includes making sure that each cost is assigned to the correct cost object and that their costs are not split across multiple objects.
• Identify any fixed and variable costs, as well as any indirect or overhead costs. This allows for a more comprehensive understanding of cost behavior, which is essential for accurate cost allocation.
• Develop a formal budgeting process that takes into account the potential for cost overruns and other fluctuations in expenses. This helps to ensure that costs are allocated within the allocated budget interims.
• Perform periodic reviews of cost allocations to ensure that expenses are being distributed correctly. Reviewing allocations on an ongoing basis can help to identify any discrepancies or issues that may affect cost allocation accuracy.
• Analyze historical and current cost trends to help anticipate any future cost fluctuations. This can help to ensure that cost allocations accurately reflect the current cost picture.

How does cost allocation affect budgeting?

Cost allocation is the process of assigning costs to one or more cost objects, such as a project, department, or service. Cost allocation affects budgeting because it helps to provide a better understanding of the total cost of a project or service, allowing for better budget planning and management. In addition, cost allocation can help to identify areas where an organization can reduce costs or increase efficiency.

The following are examples of how cost allocation affects budgeting:

• Cost allocation can provide insights into how much money is spent on specific activities and allows budget planners to allocate resources accordingly.
• Cost allocation can help organizations identify suppliers or vendors with lower costs and determine the pricing structure for products and services.
• It can help organizations plan for future investments and forecast expenses more accurately.
• It can provide a more accurate projection of an organization’s income and expenses, allowing for shorter and more detailed budget cycles.

To ensure cost allocation affects your budgeting process positively, it is important to have a thorough understanding of the cost structure of your organization. It is also important to make sure that cost allocation is done in a timely manner, and that all stakeholders in the budgeting process are involved in the process. Furthermore, accurate records should be kept for all transactions that are allocated to specific cost objects.

Conclusion:

Cost allocation is an important process for businesses and organizations of all types, as it helps to track overhead costs, improve accuracy and efficiency, and make better decisions. It is important to identify and use a cost allocation methodology that is detailed and documented, so that the costs are allocated accurately and each cost center is allocated its fair share. Organizations should also review cost allocation regularly to ensure accuracy and stay up-to-date.

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