Workflow Solutions

FloQast Close

FloQast Reconciliation Management

FloQast Variance Analysis

FloQast Analyze

FloQast Compliance Management

FloQast Ops

FloQast ReMind

Accounting Operations Platform

Platform Overview

Generative AI

Scalability

Trust & Security

Integrations

FloVerse Community

FloQast Studios

FloQast Blog

Controller Manifesto

FloQademy - Join / Sign In

cost allocation and management accounting

Accounting Operational Excellence eBook

How controllers can achieve a strategic mindset to benefit their teams and the business.

Chief Accounting Officer

Accounting Manager

Compliance Manager

Internal Audit Manager

By Workflow

Financial Close

Account Reconciliations

Audit Findings

Controls and Risk Management

SOX Compliance

Audit Readiness

Oracle NetSuite

Sage Intacct

FloQast Connect API

By Platform

cost allocation and management accounting

The IPO Playbook for Finance & Accounting Teams

An at-a-glance guide to going public

Success Stories

Video Testimonials

cost allocation and management accounting

PulteGroup Constructs Faster Close and Team Productivity with FloQast

Learn how FloQast helped PulteGroup reduce paper consumption, speed up its monthly Close, and streamline compliance reporting.

Closing Collaboration in a Multinational Accounting Team: How Emma Improved Team Collaboration and Internal Controls Together with FloQast

Emma's 70-person geographically distributed accounting team improved internal controls and streamlined the audit thanks to FloQast.

Qualys Modernizes SOX Compliance and Improves the Annual Audit with FloQast

Read how in just a matter of weeks, Qualys leveraged FloQast to standardize the close process and organize controls and documentation for a more simplified SOX compliance.

Partner Program

Become a Partner

cost allocation and management accounting

Take Your Business to the Next Level

FloQast’s suite of easy-to-use and quick-to-deploy solutions enhance the way accounting teams already work. Learn how a FloQast partnership will further enhance the value you provide to your clients.

All Resources

Checklists & Templates

Customer Video Testimonials

White Papers and eBooks

Customer Success Stories

cost allocation and management accounting

Month-End Close Checklist

cost allocation and management accounting

SOX RCM Template

Leverage best practices to build a SOX RCM that focuses on what’s most important for SOX compliance.

Customer Success Management

Customer Success

Global Community

Request Support

Featured Articles

The Ultimate Month-End Close Checklist

Reconciliation Excel Templates

The Definitive Guide To Effective Close Management

The FloQast Advantage

Initiatives

Diversity, Inclusion, & Community

Contact FloQast

Get In Touch

cost allocation and management accounting

Accounting automation and collaboration platform FloQast raises $110M

Read about FloQast's business model and successful round of series D funding

cost allocation and management accounting

What is Cost Allocation? Definition & Process

Jul 16, 2020 Michael Whitmire

Working with the former accountants now working at FloQast, we decided to take a look at some of the pillars of the accounting professions.

The key to running a profitable enterprise of any kind is making sure that your prices are high enough to cover all your costs — and leave at least a bit for profit. For a really simple business — like the proverbial lemonade stand that almost every kid ran — that’s pretty simple. Your costs are what you (or your parents) paid for lemons and sugar. But what if it’s a more complex business? Then you might need to brush up on cost accounting, and learn about allocation accounting . Let’s walk through this using the hypothetical company, Lisa’s Luscious Lemonade. 

What is cost allocation ?

The cost allocation definition is best described as the process of assigning costs to the things that benefit from those costs or to cost centers . For Lisa’s Luscious Lemonade, a cost center can be as granular as each jug of lemonade that’s produced, or as broad as the manufacturing plant in Houston. 

Let’s assume that the owner, Lisa, needs to know the cost of a jug of lemonade. The total cost to create that jug of lemonade isn’t just the costs of the water, lemons, sugar and the jug itself, but also includes all the allocated costs to make it. 

Let’s start by defining some terms…

Direct costs are costs that can be traced directly to the product or service itself. For manufacturers, these consist of direct materials and direct labor. They appear in the financial statements as part of the cost of goods sold .

Direct materials are those that become an integral part of the finished product. This will be the costs of the water, sugar, lemons, the plastic jug, and the label. 

Direct labor includes the labor costs that can be easily traced to the production of those finished products. Direct labor for that jug will be the payroll for the workers on the production line. 

Indirect costs are the costs that can’t be easily traced to a product or service but are clearly required for making whatever an enterprise sells. This includes materials that are used in such insignificant quantities that it’s not worth tracing them to finished products, and labor for employees who work in the factory, but not on the production line. 

Overhead costs encompass all the costs that support the enterprise that can’t be directly linked to making the items that are sold. This includes indirect costs , as well as selling, marketing, administration, and facility costs. 

Manufacturing overhead includes the overhead costs that are directly related to making the products for sale. This includes the electricity, rent, and utilities for the factory and salaries of supervisors on the factory floor. 

Product costs are all the costs in making or acquiring the product for sale. These are also known as manufacturing costs or total costs . This includes direct labor, direct materials, and allocated manufacturing overhead. 

What is the process?

The first step in any cost allocation system is to identify the cost objects to which costs need to be allocated. Here, our cost objec t is a jug of lemonade. For a more complex organization, the cost object could be a product line, a department, or a branch. 

Direct costs are the simplest to allocate. Last month, Lisa’s Luscious Lemonades produced 50,000 gallons of lemonade and had the following direct costs:

                                    Total costs     Cost per gallon Direct materials        $142,500               $2.85 Direct labor                   $37,500                   $.75

How are costs allocated?

Allocating overhead costs is a bit more complex. First, the overhead costs are split between manufacturing costs and non-manufacturing costs. Some of this is pretty straightforward: the factory floor supervisor’s salary is clearly a manufacturing cost, and the sales manager’s salary is a non-manufacturing cost. But what about the cost of human resources or other service departments that serve all parts of the organization? Or facilities costs, which might include the rent for the building, insurance, utilities, janitorial services, and general building maintenance?

Human resources and other services costs might be logically split based on the headcount of the manufacturing versus non-manufacturing parts of the business. Facilities costs might be split based on the square footage of the manufacturing space versus the administrative offices. Electricity usage might be allocated on the basis of square footage or machine hours , depending on the situation. 

Let’s say that for Lisa’s Luscious Lemonades, after we split the overhead between manufacturing and non-manufacturing costs, we have the following annual manufacturing overhead costs : 

Supervisor salary                                  $84,000 Indirect costs                                         $95,000 Facility costs                                           $150,000 Human resources                                  $54,000 Depreciation                                          $65,000 Electricity                                                $74,000 Total manufacturing overhead             $522,000

In a perfect world, it would be possible to keep an accurate running total of all overhead costs so that management would have detailed and accurate cost information. However, in practice, a predetermined overhead rate is used to allocate overhead using an allocation base . 

This overhead rate is determined by dividing the total estimated manufacturing overhead by the estimated total units in the allocation base . At the end of the year or quarter, the allocated costs are reconciled to actual costs. 

Ideally, the allocation base should be a cost driver that causes those overhead costs . For manufacturers, direct labor hours or machine-hours are commonly used. Since Lisa only makes one product — gallon jugs of lemonade — the simplest cost driver is the number of jugs produced in a year. 

If we estimate that 600,000 gallons of lemonade are produced in a year, then the overhead rate will be $522,000 / 600,000 = $.87 per gallon.

Our final cost to produce a gallon of Lisa’s Luscious Lemonade is as follows:

Direct materials                             $2.85 Direct labor                                     $0.75 Manufacturing overhead               $0.87 Total cost                                         $4.47

What is cost allocation used for?

Cost allocation is used for both external reporting and internally for decision making. Under generally accepted accounting principles (GAAP), the matching principle requires that expenses be reported in the financial statements in the same period that the related revenue is earned. 

This means that manufacturing overhead costs cannot be expensed in the period incurred, but must be allocated to inventory items, where those costs remain until the inventory is sold, when overhead is finally expensed as part of the cost of goods sold. For Lisa’s Luscious Lemonade, that means that every time a jug of lemonade is produced, another $4.47 goes into inventory. When a jug is sold, $4.47 goes to the cost of goods sold. 

However, for internal decision-making, the cost allocation systems used for GAAP financials aren’t always helpful. Cost accountants often use activity-based costing , or ABC, in parallel with the cost allocation system used for external financial reporting . 

In ABC, products are assigned all of the overhead costs that they can reasonably be assumed to have caused. This may include some — but not all — of the manufacturing overhead costs , as well as operating expenses that aren’t typically assigned to products under the costing systems used for GAAP. 

AutoRec to keep you sane

Whatever cost accounting method you use, it’s going to require spreadsheets that you have to reconcile to the GL. Combine that with the other reconciliations you have to do to close out the books, and like Lisa’s controller, you might be ready to jump into a vat of lemonade to drown your sorrows. 

Enter FloQast AutoRec. Rather than spend hours every month reconciling accounts, AutoRec leverages AI to match one-to-one, one-to-many, or many-to-many transactions in minutes. Simple set up means you can start using it in minutes because you don’t need to create or maintain rules. Try it out, and see how much time you can save this month. 

Ready to find out more about how FloQast can help you tame the beast of the close?

cost allocation and management accounting

Michael Whitmire

As CEO and Co-Founder, Mike leads FloQast’s corporate vision, strategy and execution. Prior to founding FloQast, he managed the accounting team at Cornerstone OnDemand, a SaaS company in Los Angeles. He began his career at Ernst & Young in Los Angeles where he performed public company audits, opening balance sheet audits, cash to GAAP restatements, compilation reviews, international reporting, merger and acquisition audits and SOX compliance testing. He holds a Bachelor’s degree in Accounting from Syracuse University.

Related Blog Articles

cost allocation and management accounting

Report: Accountants Want Financial Transformation, but Lack of Fulfillment and Confidence Stand in the Way

cost allocation and management accounting

Study: Compliance and Controls Processes Are Struggling

cost allocation and management accounting

Report: Analyzing Accountants’ Relationship with Technology as Stressor in the Workplace – and at Home

  • Search Search Please fill out this field.
  • Corporate Finance
  • Financial Analysis

Cost Accounting Method: Advantages and Disadvantages

cost allocation and management accounting

What Is the Cost Accounting Method?

The cost accounting method, which assesses a company's production costs, comes in a few broad styles and cost allocation practices. But these share primary advantages and disadvantages.

Cost accounting was originally developed in manufacturing firms, but financial and retail institutions have adopted it over time.

Contrasted with general accounting or financial accounting, the cost accounting method is an internally focused, firm-specific system used to estimate cost control , inventory, and profitability. Cost accounting can be much more flexible and specific, particularly when it comes to the subdivision of costs and inventory valuation. Unfortunately, this complexity-increasing auditing risk tends to be more expensive and its effectiveness is limited to the talent and accuracy of a firm's practitioners.

Key Takeaways

  • The cost accounting method is an internally focused, firm-specific system used to estimate cost control, inventory, and profitability.
  • It can be much more flexible and specific when compared to general accounting methods.
  • The complexity of cost accounting, however, means that it can be costly in a number of ways.

Advantages of Cost Accounting

The benefits of cost accounting include:

Adaptability

Managers appreciate cost accounting because it can be adapted, tinkered with, and implemented according to the changing needs of the business. Unlike the Financial Accounting Standards Board (FASB)-driven financial accounting, cost accounting need only concern itself with internal eyes and internal purposes.

Ease of Monitoring and Controlling Labor Costs

Labor costs are easier to monitor and control through cost accounting. Depending on the nature of the business, wage expenses can be taken from orders, jobs, contracts, or departments and sub-departments. This means management can pick and choose how it determines efficiency and productivity. This is very important when estimating the marginal productivity of individual employees.

Ability to View Data in Different Ways

Cost accounting can be thought of as a sort of three-dimensional puzzle. Accounts, calculations, and reports can be manipulated and viewed from different angles. Management can analyze information based on criteria that it values, which guides how prices are set, resources are distributed, capital is raised, and risks are assumed. It's a crucial element in management discussion and analysis .

Disadvantages of Cost Accounting

Cost accounting is not without drawbacks.

The benefits of cost accounting come with a price. Since costing methods differ from organization to organization, it's not clear how these costs might manifest themselves until a specific firm is examined.

Generally speaking, complex cost accounting systems require a lot of work on the front end, and constant adjustments need to be made for improvements.

Additional Steps to Verify Accuracy

Even if the rigidity of financial accounting creates some inherent disadvantages, it does remove the uncertainty and misapplication of accounting guidelines of cost accounting. Uncertainty equals risk, which always comes at a cost. This means additional—and often more vigorous— reconciliation to verify accuracy.

Reliance on Highly-Skilled Talent

Higher-skilled accountants and auditors are likely to charge more for their services. Employees have to receive extra training and must sufficiently cooperate with data input. Non-cooperation can render ineffective an otherwise beautifully constructed system.

Special Considerations

The repeated trade-off in any accounting method is accuracy versus expediency. Cost accounting reflects this more dramatically than other accounting methods because of its pliability. Every business needs to find its own balance between the two.

Costing methods are typically not useful for figuring out tax liabilities, which means that cost accounting can't provide a complete analysis of a company's true costs. It's easy enough to compensate for this by combining financial accounting with cost accounting but it, nevertheless, highlights a flaw in cost accounting.

cost allocation and management accounting

  • Terms of Service
  • Editorial Policy
  • Privacy Policy
  • Your Privacy Choices

accountingprofessor.org

The Comprehensive Guide to Cost Allocation in Accounting

Accounting is a fascinating field, and cost allocation is one of the most important concepts in accounting. Whether you’re an accounting student or an accountant just starting out, it’s important to understand how to allocate costs.

In this comprehensive guide, we’ll cover everything from what it means to its pros and cons. 

How Can Costs Be Allocated Among Departments or Product Lines When There Is No Clear Source?

Allocation is distributing costs among different departments or product lines in an organization. Trying to accurately estimate the cost of producing a good or rendering a service is a common challenge for many businesses.

This is especially true when there is no apparent source of the costs, as it requires the use of various techniques and methods to distribute the expenses fairly and reasonably.

What Is the Concept of Allocation?

Allocation (also known as “cost allocation”) is a process used to distribute the costs of a shared resource or expense among different departments, product lines, or activities within an organization.

This process is necessary to accurately determine the cost of producing a product, providing a service, or running a business. Allocation allows firms to identify the expenses incurred by each department or product line and helps make informed decisions about allocating resources.

The allocation concept has existed for centuries and is a fundamental part of modern accounting and financial management. The cost allocation process involves assigning costs to specific departments or product lines based on objective criteria, such as resource use or the benefit received from the expense.

The objective criteria used in the allocation process may vary depending on the type of business, but the goal is always to distribute the costs fairly and reasonably.

One of the main challenges of allocation is that many expenses cannot be traced directly to a specific department or product line. For example, the cost of electricity used to run a manufacturing plant cannot be directly traced to one particular product line.

In such cases, the cost of electricity must be allocated to different departments or product lines based on objective criteria, such as the number of hours each department uses the electricity or the production output of each product line.

There are different methods of allocation, each with its strengths and weaknesses. Some of the most common ways include direct allocation, step-down allocation, sequential allocation, and activity-based allocation. Each mode uses a different approach to allocating costs, but the goal is always to ensure that the costs are distributed fairly and reasonably.

What Doesn’t the Term Allocation Mean?

The term allocation” is commonly used in various contexts, such as finance, economics, project management, and resource management. However, it’s essential to understand that allocation ” doesn’t mean “equal distribution” or “uniform distribution” of resources.

Allocation refers to assigning a portion of resources, such as time, money, or labor, to specific tasks or activities. The goal of allocation is to optimize the use of resources to achieve the desired outcomes.

One of the most common misunderstandings about allocation is that it means dividing resources equally among tasks or activities. However, this is only sometimes the case. Resources are often not distributed evenly because different tasks or activities have different requirements and priorities.

For example, in project management, some jobs may require more time, money, or labor than others. In such cases, the project manager must allocate more resources to these critical tasks to ensure the project’s success.

Another misunderstanding about allocation is that it means distributing resources inflexibly and rigidly. Allocation is a flexible process that can be adjusted based on priorities or changes in resource availability. For example, in a business setting, the budget allocation may change based on market conditions or changes in customer demand. In these situations, the business must be able to reallocate its resources to respond to these changes.

The allocation also doesn’t mean that the resources are assigned once and never adjusted. Allocation is an ongoing process requiring constant monitoring and adjustments to ensure that resources are used optimally.

For example, in finance, the allocation of investments must be reviewed regularly to ensure that the portfolio is aligned with the investor’s goals and objectives.

Another misconception about allocation is that it only applies to tangible resources, such as money or equipment. However, allocation also applies to intangible resources like time and labor. These intangible resources are often more critical and limited than tangible ones. For example, allocating time is crucial in project management to ensure that projects are completed on time and within budget.

As you can see, allocation is a complex and flexible process that requires careful consideration of multiple factors, such as resource availability, priorities, and goals. It’s essential to understand that allocation doesn’t mean equal distribution or limited distribution of resources.

Instead, it’s a dynamic process that requires ongoing monitoring and adjustments to ensure the optimal use of resources. By avoiding common misconceptions about allocation, individuals and organizations can more effectively allocate their resources and achieve their desired outcomes.

Where the Term Allocation Originated From?

The word “allocation” comes from the Latin word “allocare.” The word allocation ” refers to setting aside or assigning a particular portion, amount, or portion of something for a specific purpose or recipient.

The allocation comes from the Latin prefix ad- (meaning “to”) and the noun loci (meaning “place”). The combination of these two words implies the idea of assigning a place, or portion of something, for a specific purpose.

In finance and economics, “allocation” refers to distributing resources, such as money, to different projects or initiatives based on their perceived importance and likelihood of success.

The allocation concept is ancient and can be traced back to the earliest civilizations, where resources were allocated based on the community’s needs. In early societies, central planning or direct control by the ruling class were common methods of allocation.

However, with the advent of market-based economies, the allocation has become more decentralized and is now primarily done through the market mechanism of supply and demand.

In modern economies, allocation is crucial in ensuring that resources are used efficiently and effectively. For example, in capital allocation, investors allocate their funds to different projects and businesses based on the perceived potential return on investment. This helps direct investment toward the most promising and profitable opportunities, thereby increasing the economy’s overall efficiency.

Similarly, prices play a crucial role in allocating goods and services in directing resources to where they are most needed. In a market economy, the interaction of supply and demand determines prices. When demand for a particular good or service is high, the price will increase, directing more resources toward its production. On the other hand, when demand is low, the price will decrease, reducing the allocation of resources to its production.

Government policies and regulations can also have an impact on allocation in addition to the market mechanism. For example, the government may allocate resources to specific sectors through funding or subsidies, such as education or healthcare.

Similarly, government regulations and taxes can also impact the allocation of resources by affecting the incentives for businesses and individuals to allocate their resources in a particular way.

How Allocation Relates to Accounting?

In accounting, allocation determines the cost of producing a product or providing a service. This information is then used to create accurate financial statements and make informed decisions about allocating resources in the future.

For example, a company may allocate resources to a new product line based on the expected revenue it will generate or distribute costs to specific departments based on their usage of resources.

The allocation also plays a crucial role in cost accounting . Cost accounting involves analyzing the cost of production, including direct and indirect costs, and using this information to make decisions about pricing and resource allocation.

By accurately allocating costs, a company can determine the actual cost of production and make informed decisions about pricing , production volume, and resource allocation.

In addition, allocation is used to allocate the costs of long-term assets, such as property, plant, and equipment. This is done through the process of depreciation, which is a systematic allocation of the cost of an asset over its useful life. Depreciation is used to determine the value of an investment for financial reporting purposes and the amount of tax that a company must pay.

Finally, allocation is also used in the budgeting process. In budgeting, an organization allocates resources to various departments and activities based on their priorities and goals. By accurately allocating resources, a company can ensure that it has enough resources to meet its goals and objectives while staying within its budget.

3 Examples of Allocation Being Used in Accounting Practice

Example #1 of allocation being used in accounting practice.

Allocating the Cost of Goods Sold In accounting, “cost of goods sold” (COGS) refers to the direct costs associated with producing a product or providing a service. These costs include the raw materials, labor, and overhead expenses incurred to produce the goods. COGS is crucial in determining a company’s gross profit because it represents the cost of producing and selling a product.

One example of allocation in accounting practice is when a company allocates the cost of goods sold to each product. This is done to understand the cost of producing each product and identify the most profitable products. 

The allocation process involves dividing the total COGS by the number of units sold to arrive at an average cost per unit. This average cost per unit is then applied to each unit of product sold to determine the COGS for that specific product.

This allocation process is vital because it allows the company to accurately determine the cost of producing each product. This information is then used to make informed business decisions such as pricing strategies, production decisions, and cost control measures. 

For example, suppose a company realizes that the cost of producing one product is much higher than the cost of producing another. In that case, it may choose to discontinue the higher-cost product or find ways to reduce the cost of production.

Example #2 of Allocation Being Used in Accounting Practice

One example of allocation in accounting practice is allocating indirect costs to different departments or products within a company. Indirect costs, such as rent, utilities, and office supplies, cannot be directly traced to a specific product or department. These costs must be allocated among different departments or products to calculate the cost of each accurately.

For example, consider a manufacturing company with three departments: production, research and development, and administration. The company has a total indirect cost of $100,000 for the year, which includes rent, utilities, and office supplies.

The company might determine the proportion of space each department uses to allocate these costs. If production uses 40% of the total space, R&D uses 30%, and administration uses 30%, the company would allocate 40% of the indirect costs to production, 30% to R&D, and 30% to administration.

Next, the company might allocate indirect costs based on the number of employees in each department. If production has 20 employees, R&D has 15, and administration has 10, the company would allocate indirect costs based on the ratio of employees in each department.

In this example, production would receive 40% of the indirect costs, R&D would receive 30%, and administration would receive 30%.

Finally, the company might allocate indirect costs based on the number of products produced in each department. If production produces 1000 products, R&D produces 500, and administration produces none, the company would allocate indirect costs based on the ratio of products produced in each department.

In this example, production would receive 67% of the indirect costs, R&D would receive 25%, and administration would receive 8%.

Example #3 of Allocation Being Used in Accounting Practice

Suppose a manufacturing company produces two products: Product A and Product B. To determine the cost of each product, the company must allocate the factory overhead costs, including utilities, rent, maintenance, and supplies, among other expenses. The overhead costs must be assigned to each product based on the proportion of total machine hours used to produce each product.

For example, if the company uses 60% of the total machine hours to produce Product A and 40% to produce Product B, then 60% of the factory overhead costs would be allocated to Product A and 40% to Product B. The company would then use the allocated overhead costs and the direct costs of material and labor to calculate the total cost of each product.

The allocation of overhead costs to each product is critical for the company to accurately determine the cost of goods sold and price its products competitively. The company can use an allocation method to ensure a fair and accurate picture of the costs of producing each product.

How to Do Cost Allocation in Simple Steps?

Cost allocation can be complex, but it doesn’t have to be. Here are five simple steps for cost allocation:

Step 1: Identify the Costs That Need to Be Allocated

The first step in cost allocation is identifying the costs that need to be allocated. This includes both direct and indirect costs. Direct costs can be easily traced to specific products or services, while indirect costs, such as rent and utilities, cannot.

Step 2: Choose the Appropriate Method of Cost Allocation

Once you have identified the costs that need to be allocated, the next step is to choose the appropriate cost allocation method. The most common methods include direct cost allocation, step-down allocation, sequential allocation, and activity-based costing. The method chosen will depend on the nature of the costs and the objectives of the cost allocation process.

Step 3: Determine the Allocation Base

The allocation base is the basis on which the costs will be allocated. This can be the number of units produced, the number of employees, or any other relevant factor that can be used to determine the cost of goods or services.

Step 4: Allocate the Costs

Once you have determined the allocation base, the next step is to allocate the costs. This can be done by dividing the total cost by the number of units, employees, or another relevant factor and multiplying this by the number of units, employees, or another relevant factor for each product, service, or department.

Step 5: Review and Adjust the Cost Allocation

Once the costs have been allocated, the final step is to review and adjust the cost allocation as necessary. This may involve reallocating costs based on new information or changes in the business.

Which Industries Can Cost Allocation Be Applied?

With the proper guidance, cost allocation can be applied to almost any industry. It’s all about the data you have and how you use it.

Let’s take a look at some of the industries that could benefit from cost allocation:

The healthcare industry is one of the most expensive in the world. It is also one of the most heavily regulated. These factors make cost allocation a necessity for many healthcare providers.

Healthcare organizations have many different costs, but the most significant sources are labor and supplies. Labor costs can be very high in this industry because it requires highly skilled people to perform various tasks, including surgery, patient care, and patient education. Supplies like bandages and IV bags are also expensive because they have to be sterile and meet regulatory requirements.

A hospital’s supply department has much control over its budget, but it also has little control over what happens in other departments, such as surgery or patient care. This makes it difficult to allocate costs accurately when they don’t know how much they will spend on supplies or how many patients they’ll see each year.

Cost allocation helps solve these problems by allowing managers to see which departments are consuming the most resources. They can adjust accordingly without guessing what’s happening behind closed doors (or behind locked doors).

Manufacturing

The manufacturing industry is one of the most common places where cost allocation can be applied. In this industry, it is crucial to know how much it costs to make each product and how much it costs to produce goods (including materials and labor) for sale.

With this information, manufacturers can determine how much they need to charge for their products to cover all of their expenses, including overhead costs like rent or electricity bills.

Cost allocation can also help manufacturers determine which products are more profitable than others so that they can focus on those areas instead of wasting time and money on less popular lines of goods. For example, suppose a company produces clothing and electronics but finds its clothing line more popular among consumers than its electronics line.

In that case, it may want to stop producing electronics altogether because there would need to be more demand for these products for them to make any money off of them.

This is an industry that benefits from cost allocation. Energy companies have long been able to allocate costs to different projects and branches, but they often face challenges when assigning overhead expenses. That’s because overhead costs are shared among the company’s functions, making them difficult to track.

Cost allocation software can help energy companies assign overhead expenses in a way that makes sense for each project or branch. The software also allows them to better understand where their money is going and gives them more flexibility in budgeting and forecasting future expenses.

Retailers are a great example of an industry that can benefit from cost allocation.

Retailers are often sold on the idea of one-stop shopping: you go to a store and buy everything you need, from clothing to food to furniture. But in reality, there are many different types of retailers, such as grocery stores, department stores, clothing stores, etc. And each has its own distinct set of costs for running that type of business. So how do these retailers know how much each product line contributes to their overall profits? They use cost allocation.

Cost allocation is a technique for allocating overhead costs across product lines based on their relative importance to the company’s overall performance. This way, retailers can determine which products contribute most (or least) to their bottom line and make decisions accordingly.

Information Technology

Information technology (IT) is one of the most significant cost allocation areas. IT costs are often divided into two categories: direct costs and indirect costs. The former refers to those costs that can be directly attributed to a particular project or product, while the latter refers to those costs that cannot be directly attributed.

Cost allocation in IT has many benefits. It helps managers determine how much it costs to develop a new product or service and where inefficiencies lie in their IT departments.

It also allows them to understand better how much revenue they’re generating from each product or service line, which will help them make better decisions about future investments in the company’s infrastructure.

Construction

This is one of the most apparent industries to apply cost allocation. Construction projects are often massive and complex, with many different stakeholders involved in the planning, execution, and completion of a project. It’s common for construction projects to have hundreds or thousands of contracts with hundreds or thousands of different suppliers.

Cost allocation helps ensure that those involved in the project are paid what they’re owed without overpaying anyone else who participated. It’s also used to ensure that a company only spends a little money on a project by ensuring that every expense is only charged once.

Transportation

This is the industry that can benefit the most from cost allocation.

Transportation has many parts that must work in unison to transport goods or passengers. It can be difficult to determine which part of a vehicle’s operation should be allocated to specific parts, and it usually requires a lot of math.

Cost allocation can make it easier for companies in this industry to understand which parts are costing them more than they expected so that they can make changes accordingly.

Food and Beverage

Food and beverage companies can benefit significantly from cost allocation. These companies are typically comprised of many different departments that must be managed to ensure the entire business runs smoothly. Each department has specific costs that it incurs, so allocating those costs among all of the departments will help you understand where your money is going and how it can be used most effectively.

Cost allocation is also helpful when dealing with food or beverage products because it allows you to track the costs associated with each product line and make sure you profit on every product line. This way, you know what kinds of products are selling well, which ones aren’t selling as well, and how much money each product line has made for your company.

Real Estate

This is one of the most common industries to use cost allocation methods. Real estate developers often create multiple project phases, which must be accounted for separately. The costs of these phases are usually allocated to determine how much profit (or loss) will be made in each phase.

This lets developers decide which phases should be completed first and what incentives may be offered to convince buyers to purchase units from those phases.

Utilities are another excellent example of an industry where cost allocation can be used.

They must deal with various costs, including purchasing raw materials, paying for labor, and buying equipment. The type of utility and the sector it operates in determine the cost of each of these. For example, a water utility may have very high costs for purchasing raw materials but low costs for labor and employee benefits because they only need a few employees or benefit packages.

Cost allocation can help utilities determine how much money they should spend on each part of their business so that they’re not overspending on one part while underinvesting in another.

Pros of Cost Allocation

Cost allocation is a common business practice. Companies use it to help determine the profitability of individual products, services, and departments within a company. Here are the pros of cost allocation:

Improved Decision Making

Cost allocation helps businesses make informed decisions by accurately determining the cost of goods or services. Companies can make informed decisions on pricing, production, and marketing strategies with a better understanding of the costs associated with producing a product or offering a service.

Better Resource Allocation

Cost allocation helps businesses to determine the costs associated with different departments, products, or services. This information can then be used to allocate resources more efficiently and allocate more resources to more profitable areas.

Increased Profitability

By allocating costs accurately, businesses can identify less profitable areas and make changes to improve profitability. This could involve reducing costs, improving efficiency, or adjusting pricing.

Better Budget Planning

Cost allocation helps businesses to create more accurate budgets. Companies can plan their budgets more effectively as they understand the costs associated with each product, service, or department.

Improved Internal Control

Cost allocation helps businesses to maintain better internal control over their operations. By allocating costs accurately, companies can track expenses and identify improvement areas. This helps to prevent fraud and embezzlement and increases accountability within the company.

Better Understanding of Overhead Costs

Overhead costs can be challenging to understand and allocate accurately. Cost allocation helps businesses to understand these costs better and allocate them to the proper departments or products. This allows companies to make informed decisions on pricing and production.

Improved Cost Reporting

Cost allocation helps businesses to produce more accurate cost reports. This allows companies to make informed pricing, production, and marketing strategies decisions. Cost reports are also essential for tax purposes and to meet regulatory requirements.

Better Negotiations

Cost allocation helps businesses to understand their costs better, which can be used in negotiations with suppliers and customers. Companies can better understand costs and negotiate better prices, terms, and conditions with suppliers and customers. This helps businesses to maintain better relationships and increase profitability.

Cons of Cost Allocation

Cost allocation can be an excellent tool for helping you understand where your money is going and how to save it, but this method has some drawbacks.

Time-Consuming Process

Cost allocation can be time-consuming and requires significant effort from various departments within the company. This can divert resources from other important tasks and may slow down other processes.

Increased Complexity

Cost allocation can be complex, especially for large organizations with multiple departments and products. This complexity can result in errors and misunderstandings, negatively impacting the accuracy of cost reports and other important financial information.

Implementing a cost allocation system can be expensive and require a significant investment in technology, software, and training. This cost can be a barrier for smaller organizations or those with limited resources.

Unreliable Data

Cost allocation is only as accurate as the data used in the process. Poor quality data, errors in data entry, and outdated data can all result in inaccurate cost reports and inefficient resource allocation.

Resistance to Change

Some employees may resist implementing a cost allocation system, especially if they feel the process may negatively impact their department or lead to job loss.

Limited Flexibility

Cost allocation systems are often rigid and lack the flexibility to adapt to changes in business conditions. This can result in inefficiencies and limit the ability of the company to respond to new opportunities or challenges.

Potential for Misallocation

If not implemented correctly, cost allocation can misallocate costs, negatively impacting decision-making and profitability.

Dependence on Cost Allocation

Overreliance on cost allocation can lead to a lack of creativity and initiative within departments. Employees may become too focused on cost allocation and need to be more focused on driving innovation and growth for the company. This can limit the ability of the company to adapt to changing market conditions.

Frequently Asked Questions- Cost Allocation in Accounting

What are the main objectives of cost allocation.

The main objectives of cost allocation are to accurately determine the cost of goods or services, improve resource allocation, increase profitability, create more accurate budgets, improve internal control, and provide better cost reporting.

What Is Direct Cost Allocation?

Direct cost allocation refers to assigning costs directly to specific products or services. This method is used when the costs can be easily traced to specific business areas.

What Is Step-Down Allocation?

Step-down allocation refers to allocating costs from one department to another department or product. This method is used when costs cannot be directly traced to specific products or services.

What Is Sequential Allocation?

Sequential allocation refers to allocating costs based on the sequence in which they are incurred. This method is used when costs cannot be directly traced to specific products or services.

What Is Activity-Based Costing?

Activity-based costing refers to allocating costs based on the activities involved in producing a product or offering a service. This method is used when multiple activities are involved in creating a product or service.

Why Is Cost Allocation Important for Businesses?

Cost allocation is essential for businesses as it helps them understand the costs associated with each business area and make informed pricing, production, and resource allocation decisions. This leads to improved profitability and better resource allocation.

How Does Cost Allocation Impact Resource Allocation?

Cost allocation helps companies determine the costs associated with each department, product, or service, which are used to allocate resources more efficiently. By allocating resources based on accurate cost

How Does Cost Allocation Impact Pricing Decisions?

Cost allocation helps companies understand the costs associated with each product or service used to make informed pricing decisions. By accurately determining the cost of goods or services, companies can ensure that their pricing is based on a solid understanding of the costs involved.

The Comprehensive Guide to Cost Allocation in Accounting – Conclusion

Allocation of costs is a critical component of any business. By allocating costs, you can ensure that your company makes the best use of its resources and operates efficiently.

The ability to allocate costs allows you to make strategic decisions about your business’s operations and management and take appropriate actions regarding financial reporting.

The Comprehensive Guide to Cost Allocation in Accounting – Recommended Reading

Corporate Accountant: What Are the Responsibilities, Duties, & Salary of a Corporate Accountant?

How Can Business Intelligence Help with Budget Planning (in 2023)

Standard Costing- Common Problems (And How to Solve Them)

 Updated: 5/19/2023

Meet The Author

Danica De Vera

Danica De Vera

Related posts.

Ethics in Accounting: Exploring Ethical Challenges in Modern Accounting

Ethics in Accounting: Exploring Ethical Challenges in Modern Accounting

Ethics in accounting are crucial for honesty, transparency, and maintaining public trust. The profession faces evolving challenges such as technological advancements, globalization, and data privacy. Continued education and adherence to professional codes of conduct are vital for navigating these complexities.

Innovations in Accounting: What to Ask Your CFO

Innovations in Accounting: What to Ask Your CFO

The accounting and finance industry is experiencing a technological revolution with AI, blockchain, and automation reshaping financial practices. CFOs play a pivotal role in embracing these innovations and can be assessed through insightful questions about agility, automation, cybersecurity, and cultural innovation.

Automatic Matching – Automated Payable Matching Explained

Automatic Matching: Automated Payable Matching Explained

Automatic payable matching is a technological marvel revolutionizing how businesses handle payables, offering efficiency and accuracy. Different matching types, like 2-way and 3-way, suit specific needs. Benefits include error reduction, efficiency, cost savings, improved vendor relations, enhanced visibility, fraud detection, scalability, and regulatory compliance. Future trends shaping automatic matching include AI and machine learning, blockchain integration, RPA, cloud-based solutions, and enhanced data analytics. Key user groups benefiting from automated payable matching include retail, manufacturing, healthcare, financial services, hospitality, technology, government, and education. Businesses should implement automatic matching if drowning in paper, seeking efficiency, prioritizing accuracy, concerned about fraud, and experiencing growth. Factors to consider before implementing include data quality, software selection, workflow integration, and user training. Automatic payable matching provides secure handling of complex invoices with integration capabilities and comprehensive audit trails. It helps improve productivity, identify potential fraud, and duplicate payments while aiding in audit trails and compliance. As technology evolves, auto matching is set to play an increasingly crucial role in the future of finance, offering businesses efficient and automated accounts payable processes.

Subscribe to discover my secrets to success. Get 3 valuable downloads, free exclusive tips, offers, and discounts that we only share with my email subscribers.

Social media.

cost allocation and management accounting

Quick links

  • Terms of Service

Other Pages

Contact indo.

© Accounting Professor 2023. All rights reserved

Library homepage

  • school Campus Bookshelves
  • menu_book Bookshelves
  • perm_media Learning Objects
  • login Login
  • how_to_reg Request Instructor Account
  • hub Instructor Commons
  • Download Page (PDF)
  • Download Full Book (PDF)
  • Periodic Table
  • Physics Constants
  • Scientific Calculator
  • Reference & Cite
  • Tools expand_more
  • Readability

selected template will load here

This action is not available.

Business LibreTexts

3.3: Approaches to Allocating Overhead Costs

  • Last updated
  • Save as PDF
  • Page ID 846

Learning Objectives

  • Compare and contrast allocating overhead costs using a plant-wide rate, department rates, and activity-based costing.

Question : Managers at companies such as Hewlett-Packard often look for better ways to figure out the cost of their products. When Hewlett-Packard produces printers, the company has three possible methods that can be used to allocate overhead costs to products—plantwide allocation, department allocation, and activity-based allocation (called activity-based costing). How do managers decide which allocation method to use?

The choice of an allocation method depends on how managers decide to group overhead costs and the desired accuracy of product cost information. Groups of overhead costs are called cost pools 1 . For example, Hewlett Packard’s printer production division may choose to collect all factory overhead costs in one cost pool and allocate those costs from the cost pool to each product using one predetermined overhead rate. Or Hewlett Packard may choose to have several cost pools (perhaps for each department, such as assembly, packaging, and quality control) and allocate overhead costs from each department cost pool to products using a separate predetermined overhead rate for each department. In general, the more cost pools used, the more accurate the allocation process.

Plantwide Allocation

Question : Let’s look at SailRite Company, which was presented at the beginning of the chapter. The managers at SailRite like the idea of using the plantwide allocation method to allocate overhead to the two sailboat models produced by the company. How would SailRite implement the plantwide allocation method?

The plantwide allocation 2 method uses one predetermined overhead rate to allocate overhead costs.Regardless of the approach used to allocate overhead, a predetermined overhead rate is established for each cost pool. The predetermined overhead rate is calculated as follows (from Chapter 2): $$\text{Predetermined overhead rate} = \frac{\text{Estimated overhead costs}}{\text{Estimated activity in allocation base}}$$When activity-based costing is used, the denominator can also be called estimated cost driver activity. One cost pool accounts for all overhead costs, and therefore one predetermined overhead rate is used to apply overhead costs to products. You learned about this approach in Chapter 2 where one predetermined rate—typically based on direct labor hours, direct labor costs, or machine hours—was used to allocate overhead costs. (Remember, the focus here is on the allocation of overhead costs. Direct materials and direct labor are easily traced to the product and therefore are not a part of the overhead allocation process.)

Using SailRite Company as an example, assume annual overhead costs are estimated to be $8,000,000 and direct labor hours are used for the plantwide allocation base. Management estimates that a total of 250,000 direct labor hours are worked annually. These estimates are based on the previous year’s overhead costs and direct labor hours and are adjusted for expected increases in demand the coming year. The predetermined overhead rate is $32 per direct labor hour (= $8,000,000 ÷ 250,000 direct labor hours). Thus, as shown in Figure 3.1, products are charged $32 in overhead costs for each direct labor hour worked.

Figure 3.1.png

Product Costs Using the Plantwide Allocation Approach at SailRite

Question : Assume SailRite uses one plantwide rate to allocate overhead based on direct labor hours. What is SailRite’s product cost per unit and resulting profit using the plantwide approach to allocate overhead?

The calculation of a product’s cost involves three components—direct materials, direct labor, and manufacturing overhead. Assume direct materials cost $1,000 for one unit of the Basic sailboat and $1,300 for the Deluxe. Direct labor costs are $600 for one unit of the Basic sailboat and $750 for the Deluxe. This information, combined with the overhead cost per unit, gives us what we need to determine the product cost per unit for each model.

Given the predetermined overhead rate of $32 per direct labor hour calculated in the previous section, and assuming it takes 40 hours of direct labor to build one Basic sailboat and 50 hours to build one Deluxe sailboat, we can calculate the manufacturing overhead cost per unit. Manufacturing overhead cost per unit is $1,280 (= $32 × 40 direct labor hours) for the Basic boat and $1,600 (= $32 × 50 direct labor hours) for the Deluxe boat. Combine the manufacturing overhead with direct materials and direct labor, as shown in Figure 3.2, and we are able to calculate the product cost per unit.

Figure 3.2.png

*$1,280 = 40 direct labor hours per unit × $32 rate.

**$1,600 = 50 direct labor hours per unit × $32 rate.

The average sales price is $3,200 for the Basic model and $4,500 for the Deluxe. Using the product cost information in Figure 3.2 , the profit per unit is $320 (= $3,200 price – $2,880 cost) for the Basic model and $850 (= $4,500 price – $3,650 cost) for the Deluxe. Recall from the opening dialogue that SailRite’s overall profit has declined ever since it introduced the Deluxe model even though the data shows both products are profitable.

Question : The managers at SailRite like the idea of using the plantwide allocation approach, but they are concerned that this approach will not provide accurate product cost information. Although the plantwide allocation method is the simplest and least expensive approach, it also tends to be the least accurate. In spite of this weakness, why do some organizations prefer to use one plantwide overhead rate to allocate overhead to products?

Organizations that use a plantwide allocation approach typically have simple operations with a few similar products. Management may not want more accurate product cost information or may not have the resources to implement a more complex accounting system. As we move on to more complex costing systems, remember that these systems are more expensive to implement. Thus the benefits of having improved cost information must outweigh the costs of obtaining the information.

Department Allocation

Question : Assume the managers at SailRite Company prefer a more accurate approach to allocating overhead costs to its two products. As a result, they are considering using the department allocation approach. How would SailRite form cost pools for the department allocation approach?

The department allocation 3 approach is similar to the plantwide approach except that cost pools are formed for each department rather than for the entire plant, and a separate predetermined overhead rate is established for each department. Remember, total estimated overhead costs will not change. Instead, they will be broken out into various department cost pools. This approach allows for the use of different allocation bases for different departments depending on what drives overhead costs for each department. For example, the Hull Fabrication department at SailRite Company may find that overhead costs are driven more by the use of machinery than by labor, and therefore decides to use machine hours as the allocation base. The Assembly department may find that overhead costs are driven more by labor activity than by machine use and therefore decides to use labor hours or labor costs as the allocation base.

Assume that SailRite is considering using the department approach rather than the plantwide approach for allocating overhead. The cost pool in the Hull Fabrication department is estimated to be $3,000,000 for the year, and the cost pool in the Assembly department is estimated at $5,000,000. Note that total estimated overhead cost is still $8,000,000 (= $3,000,000 + $5,000,000). Machine hours (estimated at 60,000 hours) will be used as the allocation base for Hull Fabrication, and direct labor hours (estimated at 217,000 hours) will be used as the allocation base for Assembly. Thus two rates are used to allocate overhead (rounded to the nearest dollar) as follows:

  • Hull Fabrication department rate: $50 per machine hour (= $3,000,000 ÷ 60,000 hours)
  • Assembly department rate: $23 per direct labor hour (= $5,000,000 ÷ 217,000 hours)

As shown in Figure 3.3, products going through the Hull Fabrication department are charged $50 in overhead costs for each machine hour used. Products going through the Assembly department are charged $23 in overhead costs for each direct labor hour used.

Figure 3.3.png

The department allocation approach allows cost pools to be formed for each department and provides for flexibility in the selection of an allocation base. Although Figure 3.3 shows just two rates, many companies have more than two departments and therefore more than two rates. Organizations that use this approach tend to have simple operations within each department but different activities across departments. One department may use machinery, while another department may use labor, as is the case with SailRite’s two departments. This approach typically provides more accurate cost information than simply using one plantwide rate but still relies on the assumption that overhead costs are driven by direct labor hours, direct labor costs, or machine hours. This assumption of a causal relationship is increasingly less realistic as production processes become more complex.

The plantwide and department allocation methods are “traditional” approaches because both typically use direct labor hours, direct labor costs, or machine hours as the allocation base, and both were used prior to the creation of activity-based costing in the 1980s.

Key Takeaway

Regardless of the approach used to allocate overhead, a predetermined overhead rate is established for each cost pool. The plantwide allocation approach uses one cost pool to collect and apply overhead costs and therefore uses one predetermined overhead rate for the entire company. The department allocation approach uses several cost pools (one for each department) and therefore uses several predetermined overhead rates.

REVIEW PROBLEM 3.2

Kline Company expects to incur $800,000 in overhead costs this coming year—$200,000 in the Cut and Polish department and $600,000 in the Quality Control department. Total annual direct labor costs are expected to be $160,000. The Cut and Polish department expects to use 25,000 machine hours, and the Quality Control department plans to utilize 50,000 hours of direct labor time for the year.

  • Assume Kline Company allocates overhead costs with the plantwide approach, and direct labor cost is the allocation base. Calculate the rate used by the company to allocate overhead costs.
  • Assume Kline Company allocates overhead costs with the department approach. Calculate the rate used by each department to allocate overhead costs.
  • The plantwide rate is calculated as follows: $$\begin{split} \text{Predetermined overhead rate} &= \frac{\text{Estimated overhead costs}}{\text{Estimated activity in allocation base}} \\ \\ &= \frac{\$ 800,000}{\$ 160,000} \\ &= \text{\$ 5 per \$ 1 in direct labor cost} \end{split}$$
  • The department rates are calculated using the same formula as the plantwide rate. However, overhead costs and activity levels are estimated for each department rather than for the entire company, and two separate rates are calculated: $$\text{Cut and Polish department} = \frac{\$ 200,000}{25,000\; machine-hours} = \text{\$ 8 per machine-hour}$$$$\text{Quality Control department} = \frac{\$ 600,000}{50,000\; direct\; labor\; hours} = \text{\$ 12 per direct labor hour}$$

Definitions

  • A collection of overhead costs, typically organized by department or activity.
  • A method of allocating costs that uses one cost pool, and therefore one predetermined overhead rate, to allocate overhead costs.
  • A method of allocating costs that uses a separate cost pool, and therefore a separate predetermined overhead rate, for each department.

Global (USD)

Cost Accounting

Activity-Based Costing: A Modern Approach to Cost Management

Activity-Based Costing

The need for better cost management is becoming increasingly crucial for businesses to remain competitive in today's dynamic market. Traditional cost accounting methods, such as absorption costing and job costing, have limitations in providing accurate cost information for decision-making. As a result, Activity-Based Costing (ABC) has emerged as a modern approach to cost management that offers a more detailed understanding of business processes and resource allocation.

Traditional cost accounting methods vs. Activity-Based Costing

Traditional cost accounting methods allocate overhead costs to products or services based on a single cost driver, such as labor hours or machine hours. This approach can lead to inaccuracies in cost allocation, as it does not account for the complexities of business processes and the resources consumed by different activities.

Activity-Based Costing , on the other hand, assigns costs to products or services based on the activities that consume resources. This method provides a more accurate and detailed understanding of the costs associated with each product or service, enabling better decision-making and cost management.

Improve your business's financial management with Wafeq's advanced reporting tools.

What is Activity-Based Costing?

Definition and key concepts.

Activity-Based Costing (ABC) is a costing method that identifies and assigns costs to activities based on the resources they consume. It then allocates these costs to products or services based on their consumption of these activities. The main components of ABC are activities, resources, cost drivers, and cost objects.

Objectives and benefits

The primary objective of ABC is to provide accurate cost information for decision-making purposes. By understanding the true costs of products or services, businesses can make informed decisions about pricing, resource allocation, and process improvements. Some of the key benefits of ABC include improved cost accuracy, enhanced decision-making, a better understanding of business processes, and the identification of cost reduction opportunities.

 Variable Cost vs. Fixed Cost: A Comparison, Read more. 

The Process of Activity-Based Costing

Identifying activities.

The first step in implementing ABC is to identify the activities that take place within the organization. Activities are tasks or processes that consume resources, such as labor, materials, and overheads. Examples of activities include production, quality control, and order processing.

Assigning resources to activities

Once the activities are identified, the next step is to assign resources to each activity. Resources are the inputs required to perform activities, such as labor, materials, and overhead costs. The cost of each resource should be allocated to the activities that consume them.

Determining cost drivers

Cost drivers are the factors that influence the cost of activities. They can be volume-based, such as the number of units produced or the number of orders processed, or non-volume-based, such as the complexity of a product or the number of production setups. Identifying the appropriate cost drivers is essential for accurately allocating costs to activities.

Calculating activity costs

Once cost drivers have been determined, the next step is to calculate the cost of each activity. This is done by multiplying the cost driver rate (the cost per unit of the cost driver) by the quantity of the cost driver consumed by the activity.

Assigning costs to products or services

Finally, the costs of activities are assigned to products or services based on their consumption of these activities. This allocation provides a more accurate and detailed understanding of the costs associated with each product or service.

Read more: How Accounting Software Empowers Business Owners to Master Their Finances Mastering the Art of Budgeting: A Comprehensive Guide for Businesses 

Advantages of Activity-Based Costing

  • Improved cost accuracy: By allocating costs based on the activities that consume resources, ABC provides a more accurate and detailed understanding of the costs associated with each product or service. This improved cost accuracy enables better decision-making and cost management.
  • Enhanced decision-making: With a more accurate understanding of costs, businesses can make informed decisions about pricing, resource allocation, and process improvements. This can lead to increased profitability and competitiveness
  • Better understanding of business processes: ABC provides valuable insights into the organization's business processes by identifying the activities that consume resources and the cost drivers that influence these costs. This increased visibility can help identify inefficiencies and opportunities for process improvements.
  • Identification of cost reduction opportunities: By understanding the true costs of activities and the factors that drive them, businesses can identify areas for cost reduction and implement strategies to optimize resource utilization.

 Read more about the best accounting software in Saudi Arabia .

Challenges and Limitations of Activity-Based Costing

A. implementation complexity.

Implementing ABC can be complex and time-consuming, as it requires the identification of activities, resources, and cost drivers. Smaller organizations with limited resources may find it difficult to implement and maintain an ABC system.

b. Data accuracy and availability

ABC relies on accurate and up-to-date information about activities, resources, and cost drivers. Inaccurate or outdated data can lead to errors in cost allocation and decision-making.

c. Resistance to change

Organizational resistance to change can be a barrier to the successful implementation of ABC. Employees may be resistant to new processes and systems, especially if they perceive that their roles or job security may be affected.

Activity-Based Costing is a modern approach to cost management that offers numerous benefits, including improved cost accuracy, enhanced decision-making, and a better understanding of business processes. By leveraging Wafeq accounting software, businesses can efficiently implement and maintain an ABC system, leading to improved cost management and increased profitability.

Use Wafeq - an accounting system to keep track of debits and credits, manage your inventory, payroll, and more.

U.S. flag

An official website of the United States government

The .gov means it’s official. Federal government websites often end in .gov or .mil. Before sharing sensitive information, make sure you’re on a federal government site.

The site is secure. The https:// ensures that you are connecting to the official website and that any information you provide is encrypted and transmitted securely.

  • Publications
  • Account settings
  • Advanced Search
  • Journal List
  • HHS Author Manuscripts

Logo of hhspa

The Growing Importance of Cost Accounting for Hospitals

Nathan carroll.

Department of Health Services Administration University of Alabama at Birmingham USA

Justin C. Lord

Management scholars have identified several cost accounting methods that provide organizations with accurate estimates of the costs they incur in producing output. However, little is known about which of these methods are most commonly used by hospitals. This article examines the literature on the relative costs and benefits of different accounting methods and the scant literature describing which of these methods are most commonly used by hospitals. It goes on to suggest that hospitals have not adopted sophisticated cost accounting systems because characteristics of the hospital industry make the costs of doing so high and the benefits of service-level cost information relatively low. However, changes in insurance benefit design are creating incentives for patients to compare hospital prices. If these changes continue, hospitals’ patient volumes and revenues may increasingly be dictated by the decisions of individual patients shopping for low-cost services and as a result, providers could see increasing pressure to set prices at levels that reflect the costs of providing care. If these changes materialize, cost accounting information will become a much more important part of hospital management than it has been in the past.

Introduction

Recently, calls for hospitals to be more transparent in their pricing have increased. Policymakers and health care professionals have focused a great deal of attention on finding ways to present price and quality information to consumers in an accessible and comprehensible manner, so that the consumer can make better informed decisions. Hospitals’ efforts to prepare for price transparency have focused on developing systems and processes required to calculate patient and insurance-benefit-specific prices, communicating these prices to patients, and making arrangements to collect cost sharing due from patients (American Hospital Association, 2014). Ultimately, the hope is that value (price and quality) will become the basis of competition, and hospitals will be incentivized to reduce their prices by cutting their underlying costs ( Herzlinger, 2002 ).

Hospital efforts to provide patients with understandable, usable price information will go a long way towards establishing a more transparent market for hospital services. Unfortunately, these efforts will not be sufficient to create the kind of price competition that reduces hospital costs. As patients gain better information about hospital service prices, they are likely to find wide, inexplicable variation in the costs of similar services ( Newman, Parente, Barrette, & Kennedy, 2016 ; Revere, Delgado, Donderici, Krause, & Swartz, 2016 ; Tompkins, Altman, & Eilat, 2006 ). The prices that these newly-informed patients face will, in many cases, bear little relation to the underlying cost of delivering care ( Dobson, DaVanzo, Doherty, & Tanamor, 2005 ). Before price competition can incent hospitals to reduce their operating costs, hospital pricing practices must change. Hospitals will have to set prices that relate to the cost of providing individual services instead of setting prices at levels that maximize profitability under contract pricing with insurers. This is an important step in achieving the ultimate goal of creating a marketplace in which hospitals compete on the basis of price. Unfortunately, little is known about the cost accounting systems hospitals are using to collect service-level cost information and the capabilities these systems afford the hospitals using them. As a result, it is difficult to anticipate how prepared hospitals are for market changes that could make service-level prices and cost information more important bases of competition.

This article begins by offering an overview of several cost accounting systems currently in use, and identifying strengths and weaknesses of each. Next, we describe the little that is known about the cost accounting capabilities of U.S. hospitals. The scant evidence available suggests that for most hospitals, cost accounting capabilities are rather limited. We suggest that the adoption of more sophisticated cost accounting systems has been hindered by pricing processes that emphasize price negotiations at the contract, rather than the individual service level. Under these pricing processes the benefits hospitals realize by implementing systems that provide detailed cost information are relatively modest. Organizational and environmental factors specific to the hospital industry may also make the cost of implementing sophisticated cost accounting systems prohibitively high, reducing the likelihood of adoption. The paper goes on to identify recent changes in payment systems that are likely to make service-level pricing, and hence cost accounting, a more important factor in hospital management. Finally, the paper discusses alternative views of the future of hospital markets in which the importance of cost accounting is more limited.

Cost accounting methods

Cost accounting is the process of estimating and classifying costs incurred by an organization. These costs can be analyzed at the organizational or departmental level, but Gapenski and Reiter have noted that “the holy grail of cost estimation is costing at the service or individual patient level” (2016). It seems Gapenski acknowledged the increasingly important role cost accounting is likely to play in the healthcare market. The most recent update of his widely-used textbook on health care finance and accounting included much-expanded coverage of techniques for estimating costs at the product or service level.

As different industries have evolved over time so have cost accounting methods ( Wendt, 2014 ) and the management accounting research analyzing these methods ( Kaplan & Porter, 2011 ). Different approaches to managerial and cost accounting have emphasized different components of the methodologies such as, accurate cost capture or the ability to capture financial and non-financial performance measures ( Davis & Albright, 2004 ; Henri, 2006 ; Ittner, Larcker, & Meyer, 2003 ). There is a wide spectrum of costing methodologies (e.g. value-based management, benchmarking, life cycle costing, and target costing) that can help inform managers. The literature has identified various cost management accounting techniques, such as, activity-based costing (ABC), activity-based management (ABM), time-driven ABC, target costing, balanced scorecards (BSC) and ratio of cost-to-charges (RCC) ( Agbejule, 2006 ; Ax & Bjørnenak, 2005 ; Bonner, Hesford, van der Stede, & Young, 2012 ; Kaplan & Anderson, 2007 ; Zawawi & Hoque, 2010). This paper will focus on five specific cost accounting techniques seen primarily in the healthcare environment: traditional costing, activity based costing, time-driven activity based costing, performance-focused activity based costing and the ratio of costs to charges. ( Bonner et al ., 2012 ; Selto & Widener, 2004 ).

Traditional Costing is a cost accounting methodology that allocates organizational overhead to a specific output based on a predetermined cost driver or by using a pre-determined percentage rate ( Paulus, van Raak, & Keijzer, 2002 ). The traditional costing technique is easy to understand and apply. It requires minimal financial and/or managerial investment which helps explain its wide use and acceptance ( McKenzie, 1999 ). However, these costing methods have been criticized for failing to account for differences in product/service lines and marketing channels ( Velmurugan, 2010 ), and for producing inaccurate and unrealistic representations of a product or service’s true cost ( McKenzie, 1999 ).

Activity-Based Costing is a costing approach developed by Kaplan in the mid-1980s. Activity-based costing (ABC) has been the subject of numerous articles and books ( Cooper & Kaplan, 1991 ; Gapenski & Reiter, 2016 ; Kaplan & Cooper, 1998 ). This approach has been widely adopted in public and private, service and managerial organizations ( Lawson, 2005 ). Activity based costing is widely used in the preparation of budgets as it serves as a planning mechanism that shows the relationship between goal achievement and resource intensity ( Namazi, 2009 ; Turney, 2010 ). Activity based costing takes a rational approach to product and service costing, since it begins with an effort to identify the fundamental activities and resources involved in producing an output ( Namazi, 2009 ). The indirect expenses are then allocated to the activities using cost drivers that are carefully selected to reflect the use of each particular resource pool. This methodology has been found to produce accurate and rational financial management information ( Velmurugan, 2010 ), and to provide information that helps managers make accurate product mix decisions, product price calculations, and consumer profitability analyses ( Horngren et al., 2010 ).

The basis for ABC is a belief that all activities exist to support the production and delivery of goods and services and that all indirect costs can be traced and allocated to individual products and services ( Velmurugan, 2010 ). Activity based costing provides managers a more accurate view of the ‘true’ cost of their products and services. The accuracy of the ABC can lead to different evaluations of costs and profitability as compared to other simpler costing approaches ( Namazi, 2009 ). Activity based costing is designed to provide more accurate information about product costs so that management can focus its attention on value-added activities ( Velmurugan, 2010 ). Activity based costing has been found to generate information that is superior to traditional systems ( McGowan, 1998 ). The use of ABC systems has been found to help organizations make better product mix decisions, product price calculations, and consumer profitability analyses ( Horngren et al., 2010 ) The use of ABC is also associated with improved firm performance ( Banker, Potter, & Schroeder, 1995 ; Ittner et al., 2003 ) and increased manager and employee satisfaction ( Swenson, 1995 ; McGowan & Klammer, 1997 ).

However, ABC is not without its drawbacks. The ABC process has been criticized as being resource intensive for complex organizations ( Moisello, 2012 ). Identifying the appropriate cost drivers, an essential step in the ABC process, requires significant managerial time and financial investment. Moreover, significant investments are required to maintain an ABC system as the organization’s processes change ( Moisello, 2012 ). Activity based costing systems can become outdated very quickly if the assumptions regarding the cost drivers are not updated to reflect organizational changes. The selection of cost drivers is also subjective. Activity based costing may allow managers to select cost drivers that reflect their personal preferences for particular ineffient processes, under-utilized resources or unprofitable products ( Kaplan & Anderson, 2004 ).

Time-Driven Activity Based Costing (TDABC) is a managerial accounting approach introduced in 2004 by Kaplan and Anderson. Time-driven activity based costing is an attempt to overcome some of the weaknesses associated with ABC. TDABC differs from traditional ABC, in that time is used as the primary cost driver. The assumption underlying the TDABC method is that most resources (i.e. manpower, equipment, and facilities) have capacities that can be measured in terms of time ( Namazi, 2009 ). TDABC does not require the identification of ‘activities’ that the ABC method does. With TDABC no individual activities are needed because the default cost driver is time. TDABC reduces the influence of personal preferences on cost estimation by eliminating managerial discretion in cost driver selection.

Time-driven activity based costing is simpler to implement than ABC and it integrates well with available data from electronic resource planning systems. Time-driven ABC also enables fast and inexpensive cost model maintenance ( Kaplan & Anderson, 2004 , 2007 ). However, the features that make TDABC easier to implement can reduce its usefulness relative to ABC. Under the TDABC system, the activities associated with the indirect expenses are not identified. Time-driven ABC uses a single activity measure and this single cost-time relationship may not represent the actual cause-effect behavior of the costs ( Namazi, 2009 ). The identification of specific drivers can potentially help identify inefficient processes which is one of the most valued components of ABC. Using time as a measure for practical resources may be relevant for some small service firms but not suitable for other more complex enterprises with different department outputs since indirect costs cannot be tied back to the employees’ work time ( Namazi, 2009 ). This may hold especially true in a healthcare organization where different activities may require a wide range of skill sets.

Performance-Focused Activity Based Costing (PFABC) is a third iteration of ABC. PFABC is a hybrid ABC method that attempts to overcome some of the weaknesses associated with TDABC and ABC. PFABC attempts to extend the value of this managerial costing system as a means to examine organizational performance. PFABC is an intensive costing process that requires several steps to properly allocate indirect expenses. PFABC is similar to ABC in that it requires the identification of major cost activities but dissimilar to TDABC in the ways that activities’ resource use is determined. With PFABC, the actual resources for each activity can be assessed in a variety of ways, including interviews, surveys, or based on actual utilization of time, materials or other resources ( Namazi, 2009 ). This is a difference between PFABC and conventional ABC, where the cost driver is determined via specific activities or TDABC where the cost driver is time.

The other significant difference between PFABC and other costing approaches is that PFABC calculates the cost drivers’ standard rate (quantity) and price variances. This helps managers evaluate the true drivers of cost by separating the analysis of volume and price variances. The extra processes in the PFABC approach make PFABC more difficult to establish but enable PFABC to offer a richer and more detailed examination of the organization’s activities.

PFABC does hold several advantages over the traditional ABC and TDABC ( Namazi, 2009 ). PFABC focuses more on the implementation stage by identifying each important activity explicitly and directly mapping the resource costs to the activities. PFABC’s focus on budget variances also helps managers to identify excess capacity. PFABC offers managers more information than other accounting methods. It is a powerful planning and performance evaluation tool, as it can identify variances, such as rate, efficiency, and volume variances. It is the one costing mechanism that is used to examine the efficiency and effectiveness of an organization.

Ratio of cost to charges (RCCs) is a costing method specific to the health care industry. Hospitals participating in the Medicare program are required to file annual Medicare Cost Reports with the Centers for Medicare and Medicaid Services (CMS). The cost report uses traditional costing methods to allocate overhead costs to clinical departments, allowing hospitals to estimate the full cost of each revenue-producing department. Hospitals can pair these estimates with information about the total charges for all services provided by a clinical department to compute a department-level ratio of cost to charges (RCC). The RCC, when multiplied by the hospital’s charge for a specific service, can be used to estimate the cost of providing an individual.

Service-level costing using RCCs is a simple exercise. Using RCCs requires virtually no additional investment of managerial time or financial resources because department level costs are readily available from the Medicare Cost Report and information on total and per service charges are readily available as well. However, the service cost estimates made using this method are of questionable accuracy. For one thing, the Medicare cost reporting process may contain features that encourage hospitals to distort their true costs (Magnus & Smith, 2000 ). The RCC costing method also relies on the tenuous assumption that the charges for all the services provided by a clinical department have a common markup over costs ( Gapenski & Reiter, 2016 ). There is no reason to believe this kind of constant markup exists. As a result, many cost estimates made using RCCs are inaccurate. One estimate suggests that over 30% of the DRG cost estimates within a hospital differ from the estimates made by more sophisticated methods by greater more than 10%. (Shwartz & Young, 1995)

Observations on the state of hospitals’ cost accounting efforts

While the literature describing the features of costing systems and advocating increased use of particular systems is extensive, there is relatively little information available about what types of cost accounting systems are most frequently used in U.S. hospitals today. Overall, U.S. hospitals have been slow to adopt the more sophisticated forms of cost accounting like ABC, TDABC, PDABC or even traditional costing methods. A 2007 report from the Healthcare Financial Management Association (HFMA) reports that 73% of surveyed hospitals rely on the RCCs or Medicare cost allocation methods for product cost information ( Healthcare Financial Management Association, 2007 ). An older survey of academic medical center CFOs suggested that in 2000, 16% of surveyed CFOs were “certain” in their plans to implement ABC in their organizations ( Smith et al ., 2000 ). Unfortunately we do not know how many of the surveyed CFOs were able to successfully implement and maintain ABC systems. It is also important to remember academic medical centers are some of the largest hospitals in the U.S. and are best-able to bear the fixed costs of creating and maintaining accounting systems. It is unlikely the experience of these facilities is representative of U.S. hospitals broadly. Although there is little in the way of academic research on hospitals’ cost accounting capabilities, the consensus among industry experts seems to be that hospitals’ cost accounting capabilities are lacking. Accounting experts have gone so far as to say that “…there is an almost complete lack of understanding of how much it costs to deliver patient care…Instead of focusing on the costs of treating individual patients with specific medical conditions over their full cycle of care, providers aggregate and analyze costs at the specialty or service department level” (Robert S Kaplan & Porter, 2011 ). This begs the question, why have hospitals been slow to adopt systems that hold a great deal of theoretical promise? The answer is that, for hospitals, the costs of implementing sophisticated cost accounting systems are relatively large while traditionally the benefits to doing so have been modest.

High costs of implementing accounting systems

Hospitals are particularly costly organizations in which to implement cost accounting efforts. For one thing, they produce a staggering number of products and services ranging from 12,000 to 45,000 individual items ( Dobson et al ., 2005 ). Next, the specific services that individual patients need can vary drastically, even within the same diagnosis related group (DRG) categories that Medicare and many payers use for payment ( Taheri, Butz, Dechert, & Greenfield, 2001 ). As a result, determining the cost of an output (in this case a DRG) presents the typical cost accounting challenges associated with allocating indirect costs and an additional challenge. Even if costs are perfectly measured, the cost of providing a particular kind of care can vary from patient to patient depending on the patient’s clinical needs and the preferences of the treating physician ( Feinglass, Martin, & Sen, 1991 ). Clearly, the hospital production process is complex and even the normally simple process of defining what outcome is being costed is difficult in the context of hospital operations. All these factors make the cost of implementing and maintaining a sophisticated cost accounting system relatively high for healthcare organizations.

Another notable cost of implementing a sophisticated cost system is the potential resistance from the facility’s medical staff. To the extent that a sophisticated costing system like ABC would assist hospitals in standardizing clinical processes, individual physicians may feel that their professional judgement is being impeded and may oppose efforts to develop more sophisticated systems ( Cardinaels, Roodhooft, & Herck, 2004 ). This conflict may be reinforced by the traditional separation between payments for hospitals’ “facility fees” and “professional fee” payments made to physicians practicing in hospitals. Hospitals reimbursement is, for the most part, case-based while a significant portion of a physician’s reimbursement comes on a fee--for-service basis, so while the hospital has an incentive to reduce per-episode resource use, the physician does not.

Modest benefits of cost system implementation

The costs of implementing a cost accounting system for a hospital are significant, yet the benefits of a sophisticated cost accounting system may be low for many hospitals. The reason for this limited benefit relates to hospitals’ perceived inability to influence their prices. Many hospitals feel that their ability to improve payment rates is limited, even if they develop sophisticated cost accounting systems ( Arrendondo, 2014 ). Moreover, even hospitals that can exert influence on the prices they charge tend to ignore service-level cost information in their pricing negotiations. In fact, in setting charges (which are seldom the actual prices paid for hospital services) large urban hospitals only report using cost information about half of the time while rural hospitals only report using cost information a quarter of the time ( Dobson et al ., 2005 ). This is probably due to the traditional methods used to price and reimburse hospital services. First, most U.S. patients have traditionally been insured and had plans that kept them relatively insulated from the full cost of medical care ( Reinhardt, 2006 ). As a result, price negotiations have taken place not with individual patients purchasing single services, but with insurance companies purchasing a mix of services on behalf of their beneficiaries. For hospitals, setting the price of individual services at rational, profitable levels has not been as important as negotiating entire contracts that proved profitable ( Tompkins et al. , 2006 ). As a result hospitals have not had to profitability price (and hence accurately cost) individual inpatient services, so long as they were able to negotiate acceptable insurer contracts ( Hilsenrath, Eakin, & Fischer, 2015 ; Tompkins et al. , 2006 ). Since negotiations have taken place at the contract rather than the individual service level, hospitals have realized relatively little benefit from investing in cost accounting systems that generate accurate cost estimates at the service or patient level. However, the hospital industry is changing in important ways that may increase the benefits of having a sophisticated cost accounting system while reducing the costs of implementation.

Market changes poised to increase the importance of service-level price negotiations

Firms’ decisions to adopt or change their cost accounting methodologies result from various organizational (Abernethy & Bouwens, 2005; Cavalluzzo & Ittner, 2004; Chapman, 2005; Granlund & Mouritsen, 2003), technical (Waweru, Hoque, & Uliana, 2004), and economic factors (Lin & Yu, 2002). The functionalist view of contingency theory states that organizations will develop or adopt control of management systems to achieve a goal or outcome. However, the goals or outcomes will be influenced by the external environment, technology, organizational structure, size, culture and strategy ( Chenhall, 2003 ). The various cost accounting methodologies (ABC, TDABC, PFABC, and RCCs) and systems have emerged in response to the different information needs of organizations and industries ( Chenhall & Langfield-Smith, 2003 ; Kaplan, 1984). The type of accounting system that a hospital decides to adopt or utilize will be contingent on organizational and environmental factors of the hospital ( Tiessen & Waterhouse, 1983 ). Price transparency and changes in individuals’ insurance benefits will certainly bring important changes to the hospital marketplace and these changes are likely to affect the costs and benefits associated with hospitals’ adoption of cost accounting systems.

Despite the traditional importance of contract-level negotiations in hospital pricing, the industry is currently experiencing changes that have the potential to increase the importance of pricing individual services competitively. These changes include an increase in coinsurance and deductibles, new reference pricing benefits, and an increase in media attention directed at health care pricing structures. Each of these trends will make it more important for hospitals to establish new prices that reflect the costs of providing particular services.

In the past 10 years patients have experienced a marked increase in the proportion of health care costs they pay directly. These increases have come in the form of rising deductibles and increases in the prevalence of coinsurance. In 2016 64% of workers with employer-provided health insurance faced coinsurance requirements for inpatient hospital care. Similarly, 66% of covered workers faced coinsurance requirements for outpatient surgery. For both services the average amount of coinsurance required was 19%. ( Kaiser & HRET, 2016 ). These are dramatic increases in the number of individuals exposed to coinsurance requirements. In 2006 only 22% of covered workers faced coinsurance for inpatient hospital stays and 24% of covered workers faced coinsurance for outpatient surgery ( Kaiser & HRET, 2006 ).

Rising deductibles may also provide an incentive for individuals to seek out low-cost providers. Currently individual deductibles average $1,478 and family deductibles average $4,343. For the 29% of covered workers in high-deductible plans, deductibles are even higher, averaging $2,031 for individuals and $4,321 for families ( Kaiser & HRET, 2006 ). It is true that these deductibles are likely to be met quickly by the cost of an inpatient stay, since commercial insurance payments to hospitals average $12,361 for an inpatient stay ( Cooper et al. , 2015 ). However, rising deductibles may still influence the provider choice of individuals undergoing lower-cost outpatient or imaging procedures. 1

High coinsurance requirements and deductibles create an incentive for patients to compare prices of different providers within their insurers’ networks. Beneficiaries with high coinsurance and deductibles still benefit from the rates negotiated between insurers and hospitals, but even prices offered to commercially insured patients can have tremendous variance within a single hospital market ( Newman et al ., 2016 ; Revere et al. , 2016 ). Increasing pressure on employers to control health care costs and the (now delayed) implementation of the Cadillac Tax from the Affordable Care Act, make it likely that employers will continue to shift the cost of care to employees. If this is the case, hospitals may find it necessary to re-price services based on the cost of providing those services rather than simply pricing services by applying a standard percentage updates to prior years’ prices.

Deductibles and coinsurance requirements are undoubtedly growing. However, another strategy insurers are using to sensitize consumers to the cost of care is reference pricing. Under reference pricing arrangements, insurers limit reimbursement for a defined medical service to a predefined amount. This amount is usually sufficient to cover the cost of services at select providers. Patients that wish to use higher-cost providers are responsible for the difference between the cost they incur and the reference price. Reference pricing benefits have been employed by large employers including the California Public Employees’ Retirement System (CalPERS) (for orthopedic procedures) and Safeway (for imaging and lab tests) ( Robinson & MacPherson, 2012 ). Reference pricing benefits have been shown to affect beneficiaries’ choice of provider and to induce price decreases from high-cost providers ( Robinson & Brown, 2013 ). If reference pricing benefits become more popular, hospitals may require a greater understanding of the cost of providing individual services so that they can establish prices that attract patients without generating financial losses.

Changes in insurance benefits have the potential to make the prices, and hence the costs, of individual services a more important consideration for hospitals. However, the confusing system for pricing hospital services and the inconsistencies it creates have attracted an increasing amount of attention from government regulators and the popular media. In his popular 2013 article, Stephen Brill of Time Magazine called hospital chargemasters “the poison coursing through the health care ecosystem” ( Brill, 2013 ). Since then the Centers for Medicare and Medicaid Services (CMS) have released charge data for hospital services and these releases have prompted a number of newspaper articles commenting on the large variation in charges ( Meier, McGinty, & Creswell, 2013 ; Radnofsky & Barry, 2013 ). On another front, state legislatures continue to be active in developing legislation requiring health care providers to offer pricing information ( Report Card on State Price Transparency Laws, 2015 ). If successful, efforts may encourage service-specific shopping or at least cause providers to increase their focus on service specific pricing that can be justified by a reliable and valid estimate of the cost of producing a specific service.

Alternative future states

Increasing price transparency will likely create market pressure that pushes hospitals to alter their pricing processes so that prices reflect the costs of providing individual services. In this version of the future, it will be important that hospitals adopt new cost accounting systems so that they can better-understand their service-level costs. However, predictions about the future of the health care industry are extremely difficult to make and there are other plausible views of the future in which cost accounting efforts continue to play a minor role in hospital management. One such circumstance could occur if capitated payments become pervasive reimbursement arrangements. In a capitated payment environment, managers may shift their focus from understanding service-level costs to other strategies. Attempts to increase revenues by expanding the population being managed and to reduce costs by improving care management efforts may be preferred to strategies that emphasize operating cost reductions. This sort of strategic behavior was seen in at least one integrated delivery system operating in the late 1990s. (Robinson & Dratler, 2006).

The widespread adoption of narrow networks is another scenario in which cost accounting could continue to play a minor role in hospital markets. Narrow networks plans are insurance benefits that offer relatively low premiums but drastically limit beneficiaries’ provider choice. Many of the plans offered through the federal and state exchanges are narrow network plans. These plans employ a very different strategy of cost reduction than plans that choose to increase coinsurance or deductible amounts. Plans that choose to increases coinsurance or deductible amounts encourage beneficiaries to compare the prices offered by providers within their networks (utilization effects). This puts more pressure on providers to offer rational pricing for individual services. On the other hand, to reduce costs narrow network plans must rely on insurers’ ability to negotiate lower-cost contracts with providers. If narrow network plans dominate the marketplace, the provider contract and not the individual service will continue to be the primary level at which prices are negotiated. In this scenario hospitals may avoid the need to reform their cost accounting efforts.

In the short term, barriers to price transparency include finding ways to communicate complex information on prices, provider quality, and financial liability to consumers in ways that they can understand. If these efforts meet with even partial success, hospitals are likely to encounter new challenges. Patient volumes and revenues may increasingly be dictated by the decisions of individual patients shopping for low-cost services and as a result, providers will see increasing pressure to set prices at levels that reflect the costs of providing care. Though a seemingly straightforward objective, this would be a marked change from hospitals’ current situation in which the primary levers of financial viability are their ability to gain volume through inclusion in payer networks and their ability to negotiate profitably at the contract level. If these changes materialize, cost accounting information will become a much more important part of hospital management than it has been in the past.

1 For example, commercial reimbursement for colonoscopies averages $1,694 and for lower-limb MRIs averages $1,332.

Contributor Information

Nathan Carroll, Department of Health Services Administration University of Alabama at Birmingham USA.

Justin C. Lord, Department of Health Services Administration University of Alabama at Birmingham USA.

  • Agbejule A (2006). Motivation for activity-based costing implementation: Administrative and institutional influences . Journal of Accounting & Organizational Change , 2 ( 1 ), 42–73. [ Google Scholar ]
  • Arrendondo R (2014). Why Revisit Your Cost Accounting Strategy? Healthcare Financial Management July, 68–73. [ PubMed ] [ Google Scholar ]
  • Helathcare Financial Management Association, (2007). Reconstruting Hospital Pricing Systems: A Call to Action for Hospital Financial Leaders . Retrieved from Westchester, IL: [ Google Scholar ]
  • Ax C, & Bjørnenak T (2005). Bundling and diffusion of management accounting innovations—the case of the balanced scorecard in Sweden . Management Accounting Research , 16 ( 1 ), 1–20. [ Google Scholar ]
  • Banker RD, Potter G, & Schroeder RG (1995). An empirical analysis of manufacturing overhead cost drivers . Journal of Accounting and Economics , 19 ( 1 ), 115–137. [ Google Scholar ]
  • Bonner SE, Hesford JW, Van der Stede WA, & Young S (2012). The social structure of communication in major accounting research journals . Contemporary Accounting Research , 29 ( 3 ), 869–909. [ Google Scholar ]
  • Brill S (2013). Bitter Pill . Time , 181 ( 8 ), 16. [ PubMed ] [ Google Scholar ]
  • Cardinaels E, Roodhooft F, & Herck G. v. (2004). Drivers of cost system development in hospitals: results of a survey . Health policy , 69 ( 2 ), 239–252. doi: 10.1016/j.healthpol.2004.04.009 [ PubMed ] [ CrossRef ] [ Google Scholar ]
  • Chenhall RH (2003). Management control systems design within its organizational context: Findings from contingency-based research and directions for the future . Accounting, Organizations and Society , 28 ( 2 ), 127–168. [ Google Scholar ]
  • Cooper R, & Kaplan RS (1991). Profit priorities from activity-based costing . Harvard Business Review , 69 ( 3 ), 130–135. [ Google Scholar ]
  • Cooper Z, Craig S, Gaynor M, Van Reenen J (2015) The Price Ain’t Right? Hospital Prices and the Privately Insured . National Bureau of Economic Research working paper 21815.2015 . Retrieved from http://www.nber.org/papers/w21815 . [ Google Scholar ]
  • Davis S, & Albright T (2004). An investigation of the effect of balanced scorecard implementation on financial performance . Management Accounting Research , 15 ( 2 ), 135–153. [ Google Scholar ]
  • Dobson A, DaVanzo J, Doherty J, & Tanamor M (2005). A Study of Hospital Charge Setting Practices . Retrieved from Falls Church, VA: http://www.medpac.gov/documents/contractor-reports/Dec05_Charge_setting.pdf?sfvrsn=0 [ Google Scholar ]
  • Feinglass J, Martin GJ, & Sen A (1991). The financial effect of physician practice style on hospital resource use . Health Services Research , 26 ( 2 ), 183–205. [ PMC free article ] [ PubMed ] [ Google Scholar ]
  • Gapenski LC, & Reiter KL (2016). Healthcare Finance: An Introduction to Accounting and Financial Management (6 ed.). Chicago: Health Administration Press. [ Google Scholar ]
  • Henri J-F (2006). Management control systems and strategy: A resource-based perspective . Accounting, Organizations and Society , 31 ( 6 ), 529–558. [ Google Scholar ]
  • Herzlinger R (2002). Let’s Put Consumers in Charge of Health Care . Harvard Business Review , 80 . [ PubMed ] [ Google Scholar ]
  • Hilsenrath P, Eakin C, & Fischer K (2015). Price-Transparency and Cost Accounting: Challenges for Health Care Organizations in the Consumer-Driven Era . INQUIRY: The Journal of Health Care Organization, Provision, and Financing , 52 . doi: 10.1177/0046958015574981 [ PMC free article ] [ PubMed ] [ CrossRef ] [ Google Scholar ]
  • Horngren CT, Foster G, Datar SM, Rajan M, Ittner C, & Baldwin AA (2010). Cost accounting: A managerial emphasis . Issues in Accounting Education , 25 ( 4 ), 789–790. [ Google Scholar ]
  • Ittner CD, Larcker DF, & Meyer MW (2003). Subjectivity and the weighting of performance measures: Evidence from a balanced scorecard . The Accounting Review , 78 ( 3 ), 725–758. [ Google Scholar ]
  • Kaiser Family Foundation and Health Research & Educational Trust. (2016). Employer Health Benefits Survey: 2016 . Retrieved from http://kff.org/health-costs/report/2016-employer-health-benefits-survey/ . [ Google Scholar ]
  • Kaiser Family Foundation and Health Research & Educational Trust. (2006). Employer Health Benefits Survey: 2006 . Retrieved from https://kaiserfamilyfoundation.files.wordpress.com/2013/04/7527.pdf . [ Google Scholar ]
  • Kaplan RS, & Anderson SR (2004). Time-driven activity-based costing . Harv Bus Rev , November, 131–138. [ PubMed ] [ Google Scholar ]
  • Kaplan RS, & Anderson SR (2007). The innovation of time-driven activity-based costing . Journal of cost management , 21 ( 2 ), 5–15. [ Google Scholar ]
  • Kaplan RS, & Cooper R (1998). Cost & Effect: Using Integrated Cost Systems to Drive Profitability and Performance : Harvard Business Press. [ Google Scholar ]
  • Kaplan RS, & Porter ME (2011). The big idea: How to solve the cost crisis in health care . Harvard Business Review , 89 ( 9 ), 46–52. [ PubMed ] [ Google Scholar ]
  • Lawson RA (2005). The use of activity based costing in the healthcare industry: 1994 vs. 2004 . Research in healthcare financial management , 10 ( 1 ), 77–95. [ Google Scholar ]
  • McGowan AS (1998). Perceived benefits of ABCM implementation . Accounting horizons , 12 ( 1 ), 31. [ Google Scholar ]
  • McGowan AS, & Klammer TP (1997). Satisfaction with activity-based cost management implementation . Journal of management accounting research , 9 , 217–237. [ Google Scholar ]
  • McKenzie J (1999). Activity-based costing for beginners . Magazine for Chartered Management Accountants , 77 ( 3 ), 56–58. [ Google Scholar ]
  • Meier B, McGinty JC, & Creswell J (2013). Hospital Billing Varies Wildly, U.S. Data Shows. (cover story) . New York Times , 162 ( 56130 ), A1. [ Google Scholar ]
  • Moisello AM (2012). ABC: Evolution, problems of implementation and organizational variables . American Journal of Industrial and Business Management , 2 , 55–63. doi: 10.4236/ajibm.2012.22008 [ CrossRef ] [ Google Scholar ]
  • Namazi M (2009). Performance-focused ABC: A third generation of activity-based costing system . Cost management , 23 ( 5 ), 34–47. [ Google Scholar ]
  • Newman D, Parente ST, Barrette E, & Kennedy K (2016). Prices For Common Medical Services Vary Substantially Among The Commercially Insured . Health Affairs . doi: 10.1377/hlthaff.2015.1379 [ PubMed ] [ CrossRef ] [ Google Scholar ]
  • Nur Haiza Muhammad Z, & Hoque Z (2010). Research in management accounting innovations . Qualitative Research in Accounting and Management , 7 ( 4 ), 505–568. doi: 10.1108/11766091011094554 [ CrossRef ] [ Google Scholar ]
  • Paulus A, Van Raak A, & Keijzer F (2002). Core articles: ABC: The pathway to comparison of the costs of integrated care . Public Money and Management , 22 ( 3 ), 25–32. [ Google Scholar ]
  • Radnofsky L, & Barry R (2013, May 8 , 2013. ). Data Shine Light on Hospital Bills . Wall Street Journal (Online) . [ Google Scholar ]
  • Reinhardt UE (2006). The Pricing Of U.S. Hospital Services: Chaos Behind A Veil Of Secrecy . Health Affairs , 25 ( 1 ), 57–69. doi: 10.1377/hlthaff.25.1.57 [ PubMed ] [ CrossRef ] [ Google Scholar ]
  • Report Card on State Price Transparency Laws. (2015). Retrieved from http://www.catalyzepaymentreform.org/images/documents/2015_Report_PriceTransLaws_06.pdf
  • Revere FL, Delgado RI, Donderici EY, Krause TM, & Swartz MD (2016). Price Transparency and Healthcare Cost: An Evaluation of Commercial Price Variation for Obstetrical Services . Journal of health care finance . [ Google Scholar ]
  • Robinson JC, & Brown TT (2013). Increases In Consumer Cost Sharing Redirect Patient Volumes And Reduce Hospital Prices For Orthopedic Surgery . Health Affairs , 32 ( 8 ), 1392–1397. doi: 10.1377/hlthaff.2013.0188 [ PubMed ] [ CrossRef ] [ Google Scholar ]
  • Robinson JC, & MacPherson K (2012). Payers Test Reference Pricing And Centers Of Excellence To Steer Patients To Low-Price And High-Quality Providers . Health Affairs , 31 ( 9 ), 2028–2036. doi: 10.1377/hlthaff.2011.1313 [ PubMed ] [ CrossRef ] [ Google Scholar ]
  • Selto FH, & Widener SK (2004). New directions in management accounting research: insights from practice . Advances in Management Accounting , 12 , 1–36. [ Google Scholar ]
  • Smith D, Carli N, Adams A, Alcaraz R, Belles N, Ng A, … Tikhtman V (2000). Chief Financial Officers in Academic Medical Centers . Paper presented at the International Society for Research in Healthcare Financial Management Meetings, Baltimore, MD. [ Google Scholar ]
  • Swenson D (1995). The benefits of activity-based cost management to the manufacturing industry . Journal of management accounting research , 7 , 167. [ Google Scholar ]
  • Taheri PA, Butz DA, Dechert R, & Greenfield LJ (2001). How DRGs hurt academic health systems1 . Journal of the American College of Surgeons , 193 ( 1 ), 1–8. doi: 10.1016/S1072-7515(01)00870-5 [ PubMed ] [ CrossRef ] [ Google Scholar ]
  • Tiessen P & Waterhouse JH (1983). Towards a descriptive theory of management accounting . Accounting, Organizations and Society 8 ( 2–3 ), 251–267. [ Google Scholar ]
  • Tompkins CP, Altman SH, & Eilat E (2006). The Precarious Pricing System For Hospital Services . Health Affairs , 25 ( 1 ), 45–56. doi: 10.1377/hlthaff.25.1.45 [ PubMed ] [ CrossRef ] [ Google Scholar ]
  • Turney PB (2010). Activity based costing: An emerging foundation for performance management . Cost management , 24 ( 4 ), 33–43. [ Google Scholar ]
  • Velmurugan MS (2010). The success and failure of activity-based costing systems . Journal of Performance Management , 23 ( 2 ), 1–32. [ Google Scholar ]
  • Wendt C (2014). Changing Healthcare System Types . Social Policy and Administration , 48 ( 7 ), 864–882. doi: 10.1111/spol.12061 [ CrossRef ] [ Google Scholar ]

The Ultimate Guide to Project Cost Management with Templates

By Kate Eby | April 25, 2017

  • Share on Facebook
  • Share on Twitter
  • Share on LinkedIn

Link copied

Your organization’s projects are critical to its future. Sound cost management enables you to make optimal use of your resources (time, personnel, equipment, and materials), make data-driven decisions about projects and their risks, measure financial performance, and provide key metrics to senior management.   This definitive guide to project cost management includes templates for key activities like cost estimating and creating a cost management plan. You’ll learn important terms, best practices, and subtle distinctions (such as the difference between cost management and strategic cost management), as well as how cost management works in specialized cases, like construction and IT projects.

What Is Project Cost Management?

Whether you are developing a new product, designing a facility, or changing a key process, it’s challenging to forecast and manage project costs effectively.   In fact, the job is so challenging that half of all large IT projects massively blow their budgets , running on average 45 percent over budget and seven percent over time, according to consultants McKinsey & Co. and the University of Oxford. For projects in other sectors, the news is no better. The Project Management Institute (PMI) reported in 2016 that companies were completing only 53 percent of projects within their original budget. However, strong cost management helps you avoid that fate. So what exactly is cost management?   Cost management refers to the activities concerning planning and controlling a project’s budget. Effective cost management ensures that a project is completed on budget and according to its planned scope. Since you assess the success of a project at least in part by its cost performance, cost management is a prime determinant of project outcome.   Cost management activities are conducted throughout the project life cycle, from planning and budget allocation to controlling costs during project execution and assessing a project’s cost performance upon completion.   Although cost management includes a whole ensemble of activities, it is sometimes referred to in terms of more specific functions, such as spend management, cost accounting, and cost transparency. Cost managers sometimes use these terms as loose synonyms for the broad cost management function.

Cost Management: Four Major Steps

The Project Management Body of Knowledge (PMBOK), the bible of project management theory, says cost management is made up of four processes. These generally adhere to the sequence that follows — as a project goes from the planning board to reality.

Diagram-of-Project-Cost-Management-Phases

  • Resource Planning: Part of the initiation stage of a project, resource planning uses a work breakdown structure — a hierarchical representation of all project deliverables and the work required to complete them — to calculate the full cost of resources needed to complete a project successfully. Managers typically determine required resources for each work breakdown structure component and then add them to create a total resource cost estimate for all project deliverables.
  • Cost Estimating: Cost estimating is an iterative process that uses a variety of estimating techniques to determine the total cost of completing a project. Cost estimating techniques vary widely in their approaches to computing project costs, and stretch from conceptual techniques that draw mainly from historical experience and expert judgment to determinative techniques that estimate costs on a component-by-component basis. We will discuss these techniques in detail later, as they vary in their levels of accuracy. Determinative techniques are the most accurate; however, while the estimator’s job is always to create the most accurate estimate possible, determinative estimating techniques are only an option if you’ve reasonably finalized a project’s scope and deliverables. As such, you use the less accurate estimating techniques during the earliest stages of project planning, and then revise and update estimates as the project continues to be defined. To learn more about cost estimating, read The Ultimate Guide to Project Cost Estimating . 
  • Cost Budgeting: Once you’ve created satisfactory estimates, you can finalize and approve the project’s budget. Cost managers typically release budgeted amounts in stages according to the level of a project’s progress. These allocations include contingencies and reserves.
  • Cost Control: Cost control is the practice of measuring a project’s cost performance according to cost and schedule baselines that provide points of comparison throughout the project life cycle. The specific requirements for effective cost control are set out in the project management plan. The individual in charge of cost management investigates the reasons for cost variations - if they deem cost variations unacceptable, corrective action is likely. Cost control also includes other related responsibilities, such as ensuring that updated project budgets reflect changes to a project’s scope.

Key Components of the Cost Management Plan

The cost management plan guides these four processes. Created during the project planning phase, the cost management plan is a document that defines how you manage, control, and communicate a project’s costs in order to complete the project on budget.   Among other things, a cost management plan identifies the individual or group responsible for cost management, details how you will assess a project’s cost performance, and sets rules for how to communicate cost performance to project shareholders. It also establishes the methodologies by which you will control project cost variations.   While you can customize a cost management plan to fit your organization’s needs, they generally follow a standard format. Sections often include the cost variance plan, the cost management approach, information on cost estimation, the cost baseline, cost control, and reporting processes, the change control process, the project budget, and approvals. You may also want to include the spending authority levels for key project personnel, specifying which roles can approve costs up to specific thresholds.   Let’s look at the sections in greater depth:

  • Cost Variance Plan: Cost variance is when the actual amount differs from the budgeted amount. In your cost management plan, you’ll need a section that details the actions you should take, including who is held responsible in the case of a cost variance. The size of the variance usually necessitates different action: a cost variance of less than five percent might result in an explanation of that variance, while a 95-percent-or-greater variance could force the project to be abandoned. To learn how to calculate cost variance, read Hacking the PMP: Studying Cost Variance . For a more detailed template on tracking schedule and budget variances, see this template:
  • Cost Management Approach: This section outlines the approach a manager uses for cost management. The level of rigor can vary, but this describes how to establish a cost baseline and how to compare actual costs. You usually track and report costs through control accounts, where you roll up costs of subtasks. This often occurs at the third level of the work breakdown structure, a tool that breaks a project into small components or chunks of work to determine the resources needed to complete a job or project. However, the point at which you track and report depends on the scope of the project.
  • Cost Estimation: Here you will define the methods used for estimating project costs, the levels of variation, and the expected precision, accuracy, and risk.
  • Cost Baseline: This has a specialized meaning in project management and represents the authorized, time-phased spending plan against which you measure cost performance. It’s the sum of the estimated project cost and contingency reserves. 
  • Cost Control and Reporting Process: This section establishes how you measure costs and their key metrics during the project. We’ll provide greater detail on this later.
  • Change Control Process: This describes the process for making changes to the cost baseline and how to approve those proposed changes.
  • Project Budget: The budget builds on the cost baseline by totalling the cost of executing the project (including contingencies for possible risks). It also adds in management reserves, which is an amount to cover unanticipated risks or unidentified events that may arise. An organization will usually set a policy for this, and the amount is often five to 15 percent of the total budget.

Cost Management Activities: Essential Functions at Each Phase

Cost management includes a number of activities conducted at different phases during the project life cycle. It’s important to include the cost management function while developing project plans so that you build solid financial controls into the project structure. Here are some key terms and stages relevant to cost management:   Planning: Using the work breakdown structure to determine the resources needed to complete a job or project.   Estimating: The act of calculating or predicting the expected total cost of completing a project.   Budgeting: The authorization of a budget based on a cost estimate to complete the project. You typically authorize budgets in tandem with schedules, so you can assess cost performance at specific points.   Financing and Funding: The process of requesting, authorizing, and receiving money for a project.   Cost Management: The general practice of overseeing project expenditures and making cost-related decisions throughout the project life cycle.   Controlling: Addressing cost variations to avoid cost overruns.   Job Control: Controlling project expenditure by comparing costs predicted by the cost estimate and costs actually being incurred.   Scheduling: You can determine a project’s cost performance by using a schedule that compares the expected expenditure to the actual costs the project is incurring at any point in time.   Accounting: The practice of recording expenditures and reconciling transactions.

How Accurate Project Cost Estimating Aids Cost Management Efforts

The first step towards robust cost management is having a clear idea of your project’s likely costs. However, it’s futile to track and control costs if you base your spending on unrealistic estimates.   Project estimating considers several variables, including the method you use to create the estimate, the stage at which you build your estimate, and the types of cost you include.     The first variable is the method you employ. You can produce cost estimates using a variety of estimating techniques, depending on the extent to which you define a project and the type of information you have access to. Here are some common estimation techniques:

Analogous Estimating: This uses historical data from similar past projects to create estimates for new projects. This method works if you have experience with projects of the same type.

Parametric Estimating: This method estimates time and cost by multiplying per unit or per task amounts by the total number expected in the project. The rates are often standard or publicly published rates and can be expressed in hours of work, amount of data entered, or the number of units of a product manufactured. This technique has a reputation for good reliability, but it’s less relevant when output isn’t uniform, such as when writing computer code. Some projects have widely varying or unprecedented tasks, so they do not lend themselves to this method.

Bottom-Up Estimating: This is a determinative estimating technique that estimates costs for work breakdown structure components and adds them together to create a cost estimate for an entire project. The project team members help create the estimate. Since the people who are going to be doing the work are engaged in estimating, professionals consider this method highly accurate, as well as a team commitment builder.

Three-Point Estimating: This is a PERT -related statistical method that uses the optimistic (lowest), pessimistic (highest), and most likely cost estimates to create expected values and standard deviations for project expenditures.

Software-Based Estimating: You can use software-based estimating techniques, such as Monte Carlo simulation, to model the effects of risk events on project costs.   Another factor influencing the cost estimating is the stage at which you build your cost estimate. As a project progresses, you discover more variables and actual costs, so project estimates become more refined. You can classify cost estimates based on how well you define the project scope at the time of estimation and on the type of estimation technique you use - the latter generally determines the accuracy of an estimate. In order of accuracy, the main classes of cost estimates are:   Order of Magnitude Estimates: These are very rough cost estimates based on expert judgment and on adjusting the costs of the current project to reflect the costs of similar, past projects. Created before fully defining projects, they are only used in high-level project screening.   Preliminary Estimates: A preliminary estimate uses somewhat-detailed scope information to form estimates based on unit costs. These estimates are accurate enough to use as the basis for budgeting.   Definitive Estimates: Created when you’ve fully defined a project’s scope, a definitive estimate uses deterministic estimating techniques, such as bottom-up estimating. Experts agree that definitive estimates are the most accurate and reliable.   The final variable affecting project estimation is the type of cost included. Of course, your project budget must include all the relevant costs for labor and materials, but whether you include a portion of your organization’s indirect costs depends on the policies of your organization and the type of project. Here are the terms experts use to distinguish between various types of costs:   Direct Costs: Direct costs are those which you can directly associate with a specific cost object. They are billable to specific projects.

Indirect Costs: You cannot associate indirect costs with a specific cost object, and you typically incur indirect costs by a number of projects at the same time. They are not billable to specific projects.

Fixed Costs: Fixed costs are costs you incur during manufacturing that are not associated with the volume of produced output.

Variable Costs: Variable costs are costs you incur during manufacturing that are directly associated with the volume of produced output.

Sunk Cost: A sunk cost is an expense you cannot recoup once it is incurred.

Opportunity Cost: When selecting a course of action, its opportunity cost is the loss of potential benefits from all alternative courses of action.

Costing Techniques Determine How to Account for Project Costs

A costing technique is the way in which you compute the total cost of producing a product or performing a task. Depending on the activity or activities being costed, you may use a variety of techniques. Here are some commons ones:   Job Costing: Managers use job costing, also called job-order costing, to determine the cost of a product that is unique or dissimilar to other products. In industries such as construction, it’s extremely rare for two jobs to be identical. Job-order costing uses a unique job-cost record that compiles total labor and resource costs, as well as applicable overheads, for each task or activity completed as part of a task to determine total expenditures for the job. The job-cost record includes both direct and indirect costs.   Process Costing: You use process costing to determine costs for products or tasks that are identical. Unlike job costing, it does not compute the total cost of a product by summing up the costs of all tasks and activities that go into creating the product. Instead, process costing looks at the processes included in the mass production that creates products. By dividing the total cost of a process by the number of units output, it is possible to determine the cost per unit of each process. After this, you may total the costs per unit of every process involved in the eventual manufacturing of the product. In this way, you compute the cost per unit of each product on a process-by-process basis.   Activity-Based Costing: Activity-based costing (ABC) is an approach to assigning overhead costs to products. Since overhead cost allocation based simply on the number of machine hours needed may be misleading, this costing technique looks at the activities focused on creating a product — testing, machine setup, etc. — and then assigns portions of their costs to all products created using these activities. Products that were not created via these activities do not have shares of these activities’ costs added on.   Direct Costing: Direct costing, also called contribution costing or variable costing, is a technique that only assigns variable manufacturing costs to the cost of a product. You do not add fixed manufacturing costs to the cost of creating a product but instead associate those costs with the time period during which you incur them.   Life-Cycle Costing: Life-cycle costing is a comparative analysis technique that involves summing the total costs incurred during the life cycles of project options in order to choose the best option. Since starting capital costs may not be an accurate representation of how much a project will eventually cost, life-cycle costing includes all costs associated with ownership — including maintenance and disposal costs — to enable better decision making. 

Measuring Project Performance With Cost Management KPIs

Once your budget is approved and your project is under way, you’ll want to benchmark your progress relative to your cost management plan. First, there are some key metrics and performance indicators to understand:     Project Cost Performance: A project’s cost performance is an assessment of how actual expenditure on a project compares with planned expenditure as detailed in the project budget. The project manager communicates a project’s cost performance to the project stakeholders, and it may serve as the basis for preventative or corrective actions to avoid cost overruns.   Earned Value: Earned value is a method of measuring project cost performance. It is based on the use of planned value (where you allot specific portions of a project’s budget to the project tasks), and earned value (where you measure progress in terms of the planned value that is earned upon completion of tasks). You may contrast the earned value with the actual cost -  the expenditure you actually incur up to a certain point in the project schedule - to see how actual project costs compare to expected project costs.   Cost Performance Index (CPI): This is a measurement of how earned value compares to actual cost. This ratio measures a project’s cost efficiency at a given point in time by expressing earned value in proportion to actual cost. To calculate CPI, divide earned value by actual cost. A result of 1 means the project is exactly on budget; a number above 1 means it is under budget.

To learn more about KPIs in project management, read All About KPI Dashboards .

How to Control Costs

Effective cost control means performing a number of related activities that all begin by monitoring costs — since you can’t know if costs are greater than planned unless you are tracking actual expenses. Then, project managers need to decide how to respond to cost variances. Here are some key steps and concepts that inform the cost control process:   Monitoring Cost Performance: A project manager routinely monitors a project’s cost performance by creating performance reports that summarize current performance and forecast whether you will complete the project on budget. You provide project stakeholders with information about a project’s cost performance.   Reviewing Changes: You must amend the cost baseline to reflect all cost-related changes, and you should inform the project shareholders about all changes.   Actual Costs versus Budgeted Costs: Upon milestone and entire project completion, you examine the variances between actual costs and budgeted costs. Responses to the cost management plan will depend on the magnitude of the variance and the stage of the plan - this could range from a discussion to changes in the project scope that reduce costs.   Reserve Analysis: Use reserve analyses to allocate contingency reserves to projects based on the likelihoods and magnitudes of risk.   Cash-Flow Analysis: Used in financial reporting, cash-flow analyses detail cash inflows and outflows over a given period of time, and provide starting and ending balances.   Learning-Curve Theory: The learning-curve theory applies to the relationship between the time spent producing a unit and the number of units produced. According to the theory, the time spent on each unit should decrease as workers gain experience and therefore produce units faster.   

Cost Management vs. Strategic Cost Management

While cost management reduces expenses regardless of their cause or purpose, strategic cost management is a sub-discipline that strives to manage cost while also making the organization stronger.    Robin Cooper, Professor of Management at Claremont’s Peter F. Drucker Graduate Management Center and Regine Slagmulder, Professor of Management Accounting at Tilberg University in the Netherlands, define strategic cost management as the “application of cost management techniques so that they simultaneously improve the strategic position of a firm and reduce costs.”   Strategic cost management centers on the idea that cost reduction initiatives can affect an organization’s strategic position. Strategic cost management emphasizes considering the strategic and financial impact of cost management techniques.   Cooper and Slagmulder classify cost management initiatives as one of three types based on how the initiative affects the organization:   Strengthen: An example of an initiative that strengthens competitive positioning is a taxi service that replaces its phone booking system and team of booking agents with an app that allows people to book taxis using their mobile devices. An initiative like this both reduces costs and gives a company a strategic advantage, as it makes it easier to book taxis on short notice.   No effect: An initiative that has no effect on competitiveness might concern a publishing house that outsources proofreading tasks to international freelancers who accept lower wages. While this increases the company’s profitability, it does not affect its strategic positioning.   Weaken: Finally, an initiative that actively harms competitive positioning might involve the taxi company decreasing the frequency of regular vehicle maintenance, a move which, while saving costs initially, will result in cars breaking down more often.   Strategic cost management also comprises a number of important strategies:   Relevant Cost Strategies: Use relevant cost strategies to compare and decide between alternative courses of action. Relevant costs are costs you can reduce by adopting a particular course of action. They are different from sunk costs (which you cannot recoup once spent) and fixed overhead costs (which are the same for all potential courses of action). When you make decisions, a relevant costs strategy focuses only on costs that vary among options.   Evaluating Opportunity Costs: Evaluating opportunity costs is a more holistic approach to decision making that considers not only all the monetary aspects of alternative courses of action, but also all the intangible aspects. For example, a company providing vehicle repair services might have to decide between two qualities of engine oil, taking into account both that one is more expensive than the other and that the more expensive engine oil also preserves engine health in the long term.   Balanced Scorecard Strategy: A balanced scorecard strategy allows businesses to assess the impact of cost management initiatives across four key areas: financial results, customer impact, internal business processes, and employee growth and development. It provides a framework for thorough consideration of the impacts of cost management initiatives. 

Getting Into the Details: Cost Accounting in Project Cost Management

Cost accounting involves the recording and classification of costs associated with a project. It is an internal practice that supports managerial decision making and is a primary discipline concerning cost management.

Cost accounting is different than general financial accounting. Financial accounting concerns  reporting an organization’s past financial performance and does not delve into extensive detail. Since you carry out cost accounting for a specific area of activity within a company — such as a particular project or geographical region — it focuses on more granular aspects and may include projections of future costs.   Cost accounting involves preparing reports for an organization’s management (these reports are not distributed externally). By contrast, financial accounting deals with standardized reports that may be distributed to a variety of stakeholders and regulators.   As such, you typically perform cost accounting on an as-needed basis, such as during a strategic project, and it does not follow a mandated format. Financial accounting, on the other hand, is a mandated and regulated formal process, and you must create financial reports according to international financial reporting standards.   There are a few commonly used cost accounting approaches:   Standard Cost Accounting: This is based on the concept of efficiencies , or ratios that compare the time and resource costs of actually completing an activity with the costs of completing the activity under standard conditions. Variance analysis is a core element of standard cost accounting. However, since the idea of efficiencies is based on a paradigm in which labor costs contribute substantially to manufacturing — which is no longer the case — standard cost accounting is somewhat outdated.   Activity-Based Costing: This is an approach to assigning overhead costs that examines activities that provide a service, execute a task, or create a product, and then assigns portions of their costs to output.   Resource Consumption Accounting (RCA): This approach emerged around 2000, and assigns costs based on the consumption of resources. It uses a German cost management system known as GPK and activity-based costing, a cost allocation method.     Throughput Accounting: This is an accounting approach that aims to maximize profitability by increasing the rate of production of goal units and minimizing operating expenses and investment costs.   Life-Cycle Costing: This is a method of analyzing project alternatives that focuses on total costs of ownership and selecting the most cost-effective option based on more than simple capital costs.   Environmental Accounting: Reporting the environmental costs incurred by a company or project’s activities.   Target Costing: This uses a predetermined market price and preferred profit margin to determine how much money can be used to create a product or service. The target cost is the maximum amount you can spend on production without affecting the profit margin.    Cost Coding: To make cost accounting easier, most organizations have adopted a method of identifying costs with a code, usually a number. The root of the code usually represents the type of expense, cost center, or business unit involved. This makes it easier to group and find related expenses in financial reports. Individual projects may be assigned their own code.   A common structure in an enterprise or very large organization is a top-level, four-digit code that relates to the accounting entity (for example, a subsidiary company). The next numbers pertain to department, followed by a number for the cost, which can be a cost center, profit center, work-breakdown-structure element, fund, or internal order. This facilitates the cost management process by aligning the cost codes with the work breakdown structure, which makes it easier to calculate financial performance.   In addition, costs in cost accounting may be classified by:  

  • Traceability: Direct and indirect costs
  • Behavior: Fixed or variable costs
  • Controllability: Controllable or uncontrollable costs
  • Time Incurred: Historical or predetermined costs
  • Normality: Normal or abnormal costs
  • Functions: The organizational function by which you incur a cost

  Cost accounts make it easy to identify cost overruns in specific sectors that might otherwise be lost in a budget overview. However, managing a large number of cost accounts — up to several hundred accounts and sub-accounts on larger projects — comes with its own challenges. It demands a higher degree of organization in accounting, for one, and classifying costs becomes more time consuming.   In addition, the system of categorization you use for a project’s cost accounts may not match up with the system of categorization you use for an organization’s cost accounts. This complicates the creation of a project budget from a final cost estimate, and is likely to happen when you create cost accounts using a system of categorization different than the performing organization uses.

Aside from recording historical expenditure, project managers must also forecast expected activity costs to ensure that they remain under control. Managers can do this through the use of tables that classify costs for individual cost accounts and cost modeling techniques that indicate whether work associated with a particular activity is due to be completed on budget.

Software’s Role in Project Cost Management

Cost management software simplifies and expedites project cost management activities. This can ease the burden on project cost managers and make it easier to extract insights, such as the cost performance index. Some of the common functionalities include:   Project-Tree Building: A visual representation of a work breakdown structure. This can be useful when employing deterministic estimating techniques.

Cost Estimation: Cost management software can provide powerful estimation capabilities such as using project trees to record activity costs, or running regression analyses to determine cost-estimate relationships in historical data.   Project Cost Management Templates: For projects that are similar, cost management ]templates can expedite cost management activities.   Budgeting: Cost management software can make it easier for project managers to conduct budget planning activities and allocate funding. 

Keep Projects On-Budget Using a Cost Management Template

One tool that can help with project cost management is Smartsheet, a collaborative work management and automation platform. As a cloud-based platform, you can share and collaborate on your cost management activities with internal and external stakeholders, and access the information from anywhere, on any device. 

Plus, with a pre-built, customizable template in Smartsheet, you can get started faster than ever. Track project and budget performance all in one sheet. Use symbols to quickly identify tasks that may be at risk of going over budget, and bring visibility to status of estimated versus actual labor, materials, and other costs. Set up alerts and reminders to notify you as costs change, and attach documents like invoices and purchase orders directly to tasks, to keep details in context.

Try one or all of the following templates to help ensure your next project stays on budget: 

Project Budget Template

Project Budgeting Template

‌ Download Project Budget Template

Excel | Smartsheet

Cost Management Plan Template

Project Cost Management Template

Download Project Cost Management Template

Activity Cost Estimate Template

Activity Cost Estimate Template

Download Activity Cost Estimate Template

‌ Smartsheet Project with Schedule & Budget Variance Template

Cost Management for IT Projects

IT project costs are notorious for going over budget, mainly because of development approaches that allow scope creep during the product development life cycle. There is also a tendency for IT cost estimates to be less fixed than those of hard projects in fields such as construction and engineering, where maturity in planning and estimating is higher. In Information Technology Project Management , Kathy Schwalbe suggests that the people creating cost estimates for IT projects lack experience compared to specialist cost surveyors who create cost estimates for construction projects.   Furthermore, given how multifaceted these projects tend to be and how quickly IT evolves, IT projects often suffer from the “first-time, first-use penalty,” which means that it is hard to form accurate estimates when a project or project elements have not been attempted before. This makes documenting lessons learned crucial for IT projects.   The U.S. research and advisory firm Gartner creates a research report for the project and portfolio management market that categorizes vendors into four categories based on their ability to understand market needs and to drive the acceptance of new technologies. These are graphed on axes labeled “completeness of vision” and “ability to execute,” respectively. The “magic quadrant” is the upper right of this graph in which leaders in both areas cluster.  

Cost Management in Construction Projects

Construction project cost managers, or quantity surveyors, oversee cost estimation and cost control while maintaining a project’s profitability. They are responsible for ensuring that a project remains within budget while meeting its scope, quality, and performance requirements.   Though the majority of construction projects are not subject to the “first-time, first-use penalty,” they are still highly complex. And as hard projects, their design, scope, and budgetary requirements must be planned before work begins. Experience and formal training are essential for quantity surveyors.   The evaluation and recommendation of bids is one of the quantity surveyor’s primary responsibilities, though they may be engaged in a project from inception to conclusion. In fact, quantity surveyors get their name from the bill of quantities , a cost estimate prepared by the surveyor and by which contractors’ tenders are assessed.

To aid cost management for large, complex projects, quantity surveyors or project managers may use cost codes discussed earlier to set up multiple cost accounts. These accounts are essentially portions of budget marked for specific expenses such as labor, construction materials, architectural design, etc.

Home Construction Budget Template

Home Construction Budget Template

Download Construction Budget Template

Excel |  Smartsheet

Construction Estimator Template

Construction Estimator Template

Download Construction Estimator Template

Excel  ‌| Word | PDF |  Smartsheet    

Exploring Cost Management as a Career

Professional cost managers, sometimes called quantity surveyors, work on large projects (such as construction). But project managers also need an understanding of cost management strategies and techniques to perform their duties.   Cost management requires creative problem-solving skills and a thorough understanding of the factors that affect project costs. As such, cost managers are in high demand and have opportunities to progress to lead project managers.   One popular cost management profession is cost accounting, which is determining the costs focused on creating a product or providing a service. Cost accountants deal with budget preparation and profitability analysis, and their main responsibilities include collecting and communicating cost-related data to aid management decision-making and create financial transparency.   Cost accountants typically study accounting or finance at the undergraduate level, and many pursue master’s degrees in business administration or finance with a specialization in accounting. They typically need a license to advance their careers, which can be obtained after meeting some combination of work and educational requirements.

How Smartsheet Can Help with Cost Management Across Your Projects

The best marketing teams know the importance of effective campaign management, consistent creative operations, and powerful event logistics -- and Smartsheet helps you deliver on all three so you can be more effective and achieve more. 

The Smartsheet platform makes it easy to plan, capture, manage, and report on work from anywhere, helping your team be more effective and get more done. Report on key metrics and get real-time visibility into work as it happens with roll-up reports, dashboards, and automated workflows built to keep your team connected and informed.

When teams have clarity into the work getting done, there’s no telling how much more they can accomplish in the same amount of time. Try Smartsheet for free, today.

Improve your marketing efforts and deliver best-in-class campaigns.

Inspired Economist

Cost Accounting: An In-Depth Analysis of Managing Business Expenses

✅ All InspiredEconomist articles and guides have been fact-checked and reviewed for accuracy. Please refer to our editorial policy for additional information.

cost accounting

Cost Accounting Definition

Cost accounting is a specialized sector of accounting that deals with recording, analyzing, summarizing, and allocating all costs associated with a business’s production processes or services. The main objective is to inform a business’s management on how cost efficiency and financial performance can be improved to maintain a profitable operation.

Types of Cost Accounting Systems

Job order cost accounting.

The job order cost accounting system is commonly used in industries where products or services are custom-tailored to the specific requirements of a client. For example, a construction company building a custom home would use job order costing to track all the direct materials, direct labor, and overhead costs associated with that specific project.

In job order costing, each job is accounted separately and treated as a unique cost object. This allows for a detailed analysis of cost control, profitability, and operational efficiency on a job-per-job basis. It is particularly valuable in cases where jobs vary greatly in terms of raw materials, labor requirements, and production processes.

Process Cost Accounting

Process cost accounting, on the other hand, is suited for companies that produce homogeneous products in continuous flows or batches. Examples of such companies include oil refineries, breweries, and manufacturers of consumer goods like toiletries or food items.

In process costing, costs are accumulated for a "process" and then assigned equally to each unit produced during the period. This method doesn't scrutinize individual costs of specific jobs or batches. Instead, it averages out the cost over the number of units produced within a specific period. This system is valuable for companies that aim to analyze the efficiency of whole processes rather than individual jobs.

Standard Cost Accounting

Standard cost accounting is a system where costs are assigned to products based on predetermined or "standard" costs. These predetermined costs are what it should theoretically cost to manufacture a product or deliver a service under normal conditions.

In standard costing, management establishes the standard costs through careful analysis of each element of cost – material, labor, and overheads. These standards are then compared with the actual costs incurred to measure the performance of an organization: favorable if actual costs are lower than the standard costs and unfavorable if it's the other way around. Standard costs are useful for budgeting and control, as well as in setting product price, as business decisions can be made based on standard costs before actual costs are known.

These different types of cost accounting systems each play unique roles depending on the structure and needs of the business. Understanding the specific needs of your business and aligning it with the appropriate cost accounting system can greatly influence its efficiency, profitability, and overall success.

Benefits of Cost Accounting

Cost accounting has several advantages that can significantly enhance a company's financial management process, and here are some of the primary benefits:

Aids Decision Making

One of the main advantages is that it supports an organization's decision-making process. The data gathered through cost accounting can inform both tactical and strategic decisions. For example, information on the actual cost of manufacturing a product can help managers decide whether to continue production or seek alternatives. Similarly, understanding the overhead costs can lead to strategic decisions about outsourcing or investing in new equipment.

Enhances Price Setting

Another vital benefit of cost accounting is its role in price setting. A company must know how much it costs to produce its goods or services to set prices effectively. Cost accounting provides detailed cost information, allowing for an accurate calculation of profitability and a strategic approach to price setting. This way, the company can ensure it both covers its costs and remains competitive in the market.

Ensures Cost Control

Cost accounting also plays a crucial role in cost control. Regular tracking and categorizing of costs make it possible to observe trends, identify inefficiencies, and act accordingly. It allows for implementing effective cost reduction strategies and ensuring resources are used efficiently.

Provides Valuable Financial Information for Strategy Building

Finally, cost accounting provides detailed financial information that can form the base of an organization's strategy. With an accurate understanding of costs, a company can identify profitable lines of business, spotlight underperforming ones, and analyze the implications of potential strategic decisions. This makes cost accounting a vital tool for long-term business planning and strategy development.

In sum, the advantages of cost accounting make it a vital tool within an organization, offering valuable insights for decision-making, price setting, cost control, and business strategy building.

Challenges in Cost Accounting

While cost accounting can prove invaluable to a firm when used strategically, the practice is not without its set of challenges. It is crucial to consider these issues and work diligently to address them effectively.

Difficulty Allocating Overheads

Struggles in the allocation of overhead costs are one of the frequent issues faced in cost accounting. Overhead costs, such as rent, utilities, or management salaries, are general expenses that do not directly tie into production but are necessary for overall operations. These costs need to be distributed among various products or services offered by the company. However, determining just how to divide these costs can be complex.

A common method is to distribute overheads based on direct labor hours, but this might not always accurately reflect the consumption of resources. For instance, a high-tech product that takes little direct labor but a lot of machine use might become undercosted, leading to inaccurate profitability analysis. Thus, practitioners must regularly review and adjust their overhead allocation bases to ensure they reflect the changing reality of the business.

Managing Indirect Costs

Handling indirect costs presents another challenge. Unlike direct costs, indirect costs, such as utilities, rent, and administrative expenses, do not have a straightforward relationship with a product or service. Tracking these costs can be complicated and time-consuming as they are often spread across different departments or activities.

Traditional cost accounting methods might pool these costs based on certain cost drivers, but this may lead to cost distortions. As such, the management could resort to activity-based costing to allocate indirect costs based on each activity's consumption. However, this approach requires a more detailed analysis and data collection process, which might burden the accounting team.

System-Related Issues

Keeping up with technological advancements can offer its own set of challenges. On the one hand, failing to modernize cost accounting systems can result in inefficiencies and inaccuracies. On the other hand, further complexities might arise when implementing more sophisticated systems.

Outdated systems may not match the demands of complex and fast-paced business environments, leading to flawed data and consequential decision-making errors. However, transitioning to advanced systems can also be challenging as it usually requires significant financial investment and staff training, a hurdle especially for small to medium-sized companies. Once a new system is in place, there can also be difficulties in managing the complex functionalities and ensuring data accuracy.

To overcome these challenges, it is crucial that management carefully analyses the pros and cons of different systems, ensuring they fit the company’s needs and capabilities. Furthermore, effective training programs to familiarize staff with new systems is an essential step towards a successful transition.

Role of Cost Accounting in Management Decision Making

Cost accounting plays an integral role in various aspects of management decision-making, often providing the primary data that leaders need to make informed business choices.

Through the lens of cost accounting, managers can draw out comprehensive and efficient budgets. It facilitates in identifying the different costs associated with business operations, including direct materials, direct labor, and overhead costs. Furthermore, cost accounting allows for the analysis of variances resulting from the difference between actual costs and budgeted costs. This analysis forms the basis for corrective action and future budgeting.

Product Pricing

The pricing of products is another area where cost accounting is indispensable. It takes into account the cost of production, administration, and distribution to determine the price of a particular product. By accurately grasping the total production cost, managers can set competitive prices that ensure profit margins are maintained.

Cost Control

Cost accounting doesn't just play a role in setting prices, but also in controlling costs. By distinguishing between controllable and uncontrollable costs, and between efficiency and inefficiency, it supports cost reduction and optimal resource utilization. The use of standard costing and variance analysis helps the management to identify the areas of inefficiencies and take corrective actions accordingly.

Performance Measurement

Cost accounting is also instrumental in performance measurement. By attributing costs to the responsible department or individual, it enables the assessment of their performance. The comparison of actual results with standards reveals efficiencies and identifies the need for improvements.

Profitability Analysis

Lastly, cost accounting provides deep insights into profitability analysis. It helps determine the profitability of each product, operation, department, and project by calculating and comparing the cost and revenue associated with each. This analysis forms a crucial part of strategic decision making, supporting leaders in deciding which activities should be continued, expanded, curtailed, or eliminated.

Cost Allocation in Cost Accounting

Allocating costs forms an integral component in cost accounting. Diverse methods are adopted to achieve this task and assessing them provides an incisive input to comprehend the complete picture.

Traditional Costing

Traditional costing method, being the simplest, assigns production costs based on a single, volume-based cost driver. The calculus involves calculating the total production costs and dividing by total units of the production cost driver. While it is straightforward, over-simplified allocation can result in inaccuracies in financial reporting.

Activity-Based Costing

On the other hand, activity-based costing (ABC) assigns multiple cost pools to multiple cost drivers. The calculus is complex but more accurate. It allocates cost based on the consumption of activities, considering that various activities consume resources differently. ABC surfaces both operational and financial details supporting strategic decision-making processes, optimizing costs, and improving performance management.

Job Order Costing

Job order costing allocates costs for each job (order or batch) separately. The calculus counts actual material, labor, and overhead cost for each job. This method serves specific industries like publishing or customization well.

Process Costing

Differing from job order costing, process costing assigns costs according to processes. Each operation or stage of production is assigned a cost, and the costs are averaged over units produced. It is advantageous in continuous production environments like oil refining or flour milling.

Joint and By-Product Costing

In industries producing more than one product from the same input, joint and by-product costing allocates costs based on estimated sales value, physical measures, or other logical bases.

Cost allocation has profound implications for financial reporting and performance management. Appropriate cost allocation practices provide more accurate cost data, ensuing in reliable financial statements. Performance management uses this data for operational budgeting, variance analysis, and profitability analysis of product lines, territories, or other segments of a business.

Despite the importance of cost allocation, it remains a subject of debate and controversy. Firstly, fairness can be subjective. How costs are allocated can affect different departments or products differently, leading to internal disputes. Secondly, simplicity versus accuracy is always a subject of tension. Lastly, exact cost allocation often belongs to the realm of educated guesses rather than accurate calculations, especially with overhead costs.

The method of cost allocation used depends largely upon an entity's operations and reporting needs. Regardless, open communication about how costs are being allocated can help mitigate controversies and contribute to better overall performance in an organization.

Cost Accounting and Sustainability

The intersection of cost accounting and sustainability is an increasingly important area of focus for businesses. Both concepts deal with the optimal use of resources, but they do it from different perspectives. Cost accounting is concerned with the economic side of operations, striving to minimize costs and maximize profits. Sustainability, on the other hand, prioritizes environmental preservation, social equity, and economic development.

A key method that links these two concepts together is life-cycle costing (LCC). LCC considers all costs associated with an item throughout its lifetime, from initial purchase and maintenance to disposal or recycling.

Life-Cycle Costing takes into account acquisition, operation, maintenance and disposal costs. By considering all these costs, businesses can make more accurate and holistic determinations about the total economic impact of a product or service. This in turn allows for better cost-management and more sustainable decisions.

It's worth noting that this method extends beyond simply calculating financial costs. It also considers the environmental cost of products or services – what resources are needed, how much waste is produced, what's the energy consumption, etc. Therefore, LCC can be a tool not only for cost control but also for boosting a company's sustainability efforts.

Understanding and managing costs can directly contribute to a company's sustainability. When a business has a clear understanding of where its money is going, it can identify areas where costs can be reduced – often through more sustainable practices.

For example, energy-efficient equipment may have higher upfront costs, but the savings in electricity usage will often outweigh the initial expense over the lifetime of the equipment. Cost accounting in this case can help decision-makers to see the long-term financial benefits of investing in more sustainable options.

Similarly, identifying areas of waste can lead to cost savings. If a production process has high material waste, a business might find ways of reducing, reusing or recycling materials to both cut costs and lessen its environmental impact.

Overall, integrating cost accounting and sustainability can lead to both improved financial performance and more environmentally-friendly practices. It allows businesses to make informed choices that simultaneously consider economic, environmental, and social values.

Auditing in Cost Accounting

One significant component of cost accounting is auditing. In essence, auditing ensures that the financial information of a company is accurate and the company is in compliance with applicable laws and regulations.

Role of Auditing in Cost Accounting

The role of auditing in cost accounting largely revolves around verifying the accuracy of financial statements, as well as ensuring compliance with financial rules and regulations. Auditors critically review a company's financial statements to identify any discrepancies, errors, or manipulation of data. By doing so, they provide assurance to the stakeholders, such as investors, lenders, and regulatory bodies, that the financial information provided by the company is reliable.

Techniques and Methods Used by Auditors

In conducting their tasks, auditors use a variety of techniques and methods. The selection of these tactics largely depends on the nature of the business and the complexity of the financial transactions involved.

One common method is the vouching, where auditors trace transactions from the financial statements back to the original documents such as invoices and receipts. Another common method is the verification of assets and liabilities, achieved by inspecting assets physically and checking supporting documents for liabilities.

In cost accounting, auditors may also make use of standard cost variance analysis, which involves comparing actual costs with standard costs to identify and explain variances. Auditors might further employ trend analysis or ratio analysis to understand more about certain cost behaviors or relationships.

How Auditing Ensures Accuracy and Compliance

Auditing plays a vital role in ensuring the accuracy of financial information. Auditors meticulously examine the recorded transactions, check original documentation, and verify the existence of assets and liabilities. In doing so, they can vouch for the reliability of the financial statements.

Moreover, auditing also guarantees the compliance with laws and regulations. Auditors conduct a comprehensive review to ensure that a company’s financial practices are in line with relevant legislation. They also ensure that the company is complying with taxation laws and other financial obligations. If any non-compliance is identified, auditors will recommend corrective measures.

In essence, auditing in cost accounting serves as a checkpoint and validation mechanism. It guarantees that cost records and financial statements are free from any material misstatement, and the company's financial operations are being carried out within the bounds of the law.

Future of Cost Accounting

The future of cost accounting could be significantly influenced by the ongoing tide of technological advancements. One can expect alterations and refinements in practices as technology streamlines, simplifies, and enhances the sector.

Impact of Data Analysis

Data analysis is one such technological development which could notably transform cost accounting landscape. An increased amount of granular data can be harvested and processed with the evolving capabilities of data analysis tools. These make it easier to break down complex financial figures into manageable data points, helping to identify cost trends and anomalies.

Predictive modeling and advanced analytics might become commonplace, giving cost accountants the ability to forecast probable fiscal outcomes based on a comprehensive understanding of past and present data patterns. This could have a profound impact not only on the accuracy of the budgeting and cost control, but on strategic decision-making processes as well.

Influence of Artificial Intelligence

Artificial Intelligence (AI) is another innovation that has the potential to revolutionize cost accounting. Technologies such as Machine Learning and Robotic Process Automation could automate many labor intensive processes, freeing up accountants to concentrate on high-value tasks. Recurrent jobs such as data collection, calculations, and basic reporting could be executed by AI systems. This not only enhances efficiency and productivity, but might also serve to reduce the likelihood of human error in data preparation.

AI algorithms can spot outliers, trends, and patterns in vast datasets that may go unnoticed by humans, this makes for more informed decision-making processes. However, accountants must be adept enough to interpret, validate, and apply findings from AI tools.

Required Skills for Future Cost Accountants

As the field of cost accounting adjusts to these technological progressions, the blend of skills required by future cost accountants may incline more towards technology savvy and analytical acumen, alongside a solid understanding of cost accounting principles. They need to be ready to embrace digital tools, data analysis, and AI in their work and possess the skills to work with these systems effectively.

Ability to work alongside AI, to validate and interpret its output, may set apart the future cost accountant. Sophisticated analytical skills to interpret and use the data will also be essential.

Moreover, as automation undertakes routine tasks, accountants may spend more of their time on strategic analysis and interpretation, making sound communication, presenting skills and business acumen indispensable.

In a nutshell, technology could push cost accounting towards becoming a more strategic and analytical field, and future cost accountants might need to adapt and grow their skillset accordingly.

Share this article with a friend:

About the author.

Avatar photo

Inspired Economist

Related posts.

accounting close

Accounting Close Explained: A Comprehensive Guide to the Process

accounts payable

Accounts Payable Essentials: From Invoice Processing to Payment

operating profit margin

Operating Profit Margin: Understanding Corporate Earnings Power

capital rationing

Capital Rationing: How Companies Manage Limited Resources

licensing revenue model

Licensing Revenue Model: An In-Depth Look at Profit Generation

operating income

Operating Income: Understanding its Significance in Business Finance

cash flow statement

Cash Flow Statement: Breaking Down Its Importance and Analysis in Finance

human capital management

Human Capital Management: Understanding the Value of Your Workforce

Leave a comment cancel reply.

Your email address will not be published. Required fields are marked *

Save my name, email, and website in this browser for the next time I comment.

Start typing and press enter to search

Cost Allocation: Definition, and Example on How the Cost Allocation Works

To run a profitable business, you have to make sure that your prices are high enough to cover all your expenses and give you profits at the same time. Most business and company owners use cost allocation to allocate the costs of specific items.

That includes products, departments, materials, overhead costs, etc. Cost allocation is significant for businesses of any kind. However, it is mostly used by manufacturing businesses that carry a variety of costs. 

The cost allocation process becomes important when some costs can not be attributed to a particular cost object. These expenses are spent on different items in simple words, and then the sum is divided into multiple cost objects. These expenses are basically indirect costs. In this article, we are going to discuss cost allocation, its different aspects, and how does it actually work:

Definition of Cost Allocation:

Cost allocation is the process that plays a major role in identifying, assigning, and aggregating the expenses to cost objects. A cost object is anything that requires you to measure the costs separately. Here are some examples of cost objects: products, services, departments, activities, customers, etc. 

Cost Allocation is mostly used for reporting the financial details of a business or company. It helps to distribute the costs between departments and inventory items. Cost allocation can also be used for calculating the profits at a departmental or subsidiary level. And that can be used as a basis of bonuses or for the fundings for extra activities. 

Types of Costs:

Most running businesses carry a variety of costs while doing projects and deals. And the list of costs can be very long, from the material needed to make an item to the direct labor payroll cost for the employees who ran the machines and assembled the product. 

There are three main types of costs that a business or company must define before allocating the costs to their specified cost objects: 

1. Direct Costs:

Direct costs are anything that can be directly connected to cost objects. Tied to direct production, direct costs are the only expenses that do not require any allocation. Instead, they are used while calculating the costs of sold products and services.

Here are some of the most common direct costs of a business or company: Direct Labor, Direct Materials, and Production Supplies.

Direct Labor Costs : It includes the costs for employees who are responsible for manufacturing and assembling the product. Direct labor costs are basically payrolls.

Direct Materials Costs: It includes the costs of materials that were used for making the products, such as wood, cement, and bricks for construction companies. 

Production Supplies Costs: It includes any delivery cost. 

2. Indirect Costs:

Indirect costs are the expenses that are not directly related to cost objects such as production, department, activities, etc. These are the expenses that are necessary for running a healthy business or company.

Some of the common examples of indirect costs are security, electricity, administration, etc. Indirect costs should be identified first and then should be executed. And lastly, they should be allocated to other cost objects within the business. 

Indirect costs are divided into two parts: Fixed Costs and Variable Costs

Fixed Costs: Fixed costs are costs that are allocated to a specific product or department. An example would be a supervisor who is assigned to a specific department or project.

Variable Costs: The other category of indirect costs is variable costs. Common examples for variable costs would be goods sold, raw materials and inputs to production, packaging, wages, commissions, and certain utilities like electricity, gas, etc.

3. Overhead Costs: 

Overhead costs are the expenses that are used daily to run a business or company. Overhead costs are never directly or indirectly linked to production. But instead, these are the costs that a business carries, no matter if it is selling products or services or not.

Rent, insurance, office supplies, maintenance, etc., can be considered as overhead costs. These are some of the costs that a business or company carries regardless of its production quantity.

Overhead costs such as supplies can be variable. But on the other hand, costs such as insurance, payrolls, rents are some of the fixed costs that don’t change every month.

Similar to indirect costs, overhead costs must be allocated regularly to justify the production cost.

Importance of Cost Allocation:

Here are some of the benefits of Cost Allocation:

  • Cost allocation is important for financial reporting. It helps in assigning the cost of cost objects accurately
  • Cost allocation helps businesses and companies to calculate the real profitability of particular or different departments. This profitability report helps businesses to make decisions in favor of the development of the department
  • If the cost allocation is executed accurately, it will help the business to identify and understand the costs at each stage and their impact on the profit and loss. Similarly, if somehow the allocation is turned out to be incorrect, the business might make incorrect decisions regarding the allocation of the valuable resources among the various cost objects
  • It also works in favor of customers to get a better understanding of the product or service rates
  • It helps businesses and companies to make better decisions whether they should accept a new order or not
  • Cost allocation can also be used to increase the performance of your employees
  • It is also useful for finding the transfer price when there is a transaction between two or more subsidiaries
  • Cost allocation also helps businesses and companies to determine where their money is going and in what quantity. It helps businesses to use their resources responsibly. If the money is not distributed accurately, it can affect the business’s production as well as performance

How does Cost Allocation work?

Now let’s see how does cost allocation actually work:

Identify the Costs:

As we discussed earlier, there are three types of cost: Direct Cost, Indirect Costs, and Overhead costs. Direct costs are directly related to the production process, such as labor costs, material costs, etc.

Indirect costs are the costs that are partially related to the production costs and are necessary to run a business. And lastly, overhead costs are the costs used regardless of the production of a business, such as rents, insurance, office supplies, etc. 

Identify the Cost Objects:

It is necessary to identify the cost objects before executing cost allocation. This is really important because we can not set a price for a product if we don’t have any information about it. Here are some examples of cost objects: products, services, departments, activities, customers, etc. 

Identify the Allocation Base:

Alongside the cost object, a company must identify a basis to allocate the costs. The basis could be the headcount, insurance, rent, number of hours, etc. 

Collect the Costs into a Cost Pool:

Once you have identified the costs, cost objects, and the allocation basis, not it’s time to categorize them into cost pools. This is the account head where the costs should be accumulated before being distributed to the cost objects. 

Example of Cost Allocation:

Here is an example of Cost Allocation:

Let’s assume A owns a manufacturing business and has an administrative office. The main office is 3,000 square feet, and the administrative office is 1,500 square feet.

The rent for the entire office is $10,000 each month. The rent must be allocated based on these two departments. 

Let’s start the calculation:

The total area would be: 

3,000 square feet + 1,500 square feet = 4,500 square feet

So the rent per square feet would be around: 

$10,000 ÷ 4,500 = $2.2

Now we have to calculate the main office rent:

$2.2 x 3000 = $6,600

Now we have to calculate the administrative office rent:

$2.2 x 1,500 = $3,300

So now the total cost that should be allocated for the rental cost would be: 

$6,600 + $3,300 = $9,900

Why should you consider using Cost Allocation?

Cost allocation is important for businesses of any size. If you have zero ideas of how much it costs to produce a product or service, how will you set a price for your products or services?

A proper cost allocation is very important for accurate financial reporting. Most business owners depend on financial reports to make decisions. If the reports are incorrect, it might affect the business negatively. So proper cost allocation is very important to run a healthy business. 

So, in this article, we discussed cost allocation and how it actually works. Cost allocation is an important process that keeps businesses in profit by allocating the costs to cost objects.

It also helps businesses find profitable gaps and areas where businesses can make a significant profit. It also helps owners make good decisions regarding the costs. 

Related Posts

4 best account payable books of all time – recommended, what are the purposes of budgeting, just-in-time: history, objective, productions, and purchasing, absorption costing: definition, formula, calculation, and example.

cost allocation and management accounting

Book cover

Cost and Management Accounting

  • Jill Collis ,
  • Roger Hussey

You can also search for this author in PubMed   Google Scholar

  • Clear no-jargon approach using simple techniques and procedures Includes sample questions from CIMA papers 

Part of the book series: Professional Masters (Business) (PMB)

2796 Accesses

1 Citations

  • Table of contents

About this book

About the authors, bibliographic information.

  • Publish with us

This is a preview of subscription content, log in via an institution to check for access.

Table of contents (22 chapters)

Front matter, cost and management accounting in context.

  • Jill Collis, Roger Hussey

Cost Classification

Costing for materials, costing for labour, integrated and interlocking accounts, allocation and apportionment of overheads, overhead absorption, job and batch costing, contract costing, continuous-operation costing, process costing, by-product costing and joint product costing, marginal costing, marginal costing and decision-making, break-even analysis, absorption costing and marginal costing compared, budgetary control, standard costing — materials and labour.

  • management accounting

Book Title : Cost and Management Accounting

Authors : Jill Collis, Roger Hussey

Series Title : Professional Masters (Business)

DOI : https://doi.org/10.1007/978-1-349-90655-0

Publisher : Red Globe Press London

eBook Packages : Palgrave Business & Management Collection , Business and Management (R0)

Copyright Information : The Editor(s) (if applicable) and The Author(s) 1999

Edition Number : 2

Number of Pages : 256

Additional Information : Previously published under the imprint Palgrave

Topics : Accounting/Auditing

Policies and ethics

  • Find a journal
  • Track your research

Finance Strategists Logo

Cost Allocation Base

cost allocation and management accounting

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on February 27, 2023

Fact Checked

Why Trust Finance Strategists?

Table of Contents

Cost allocation base can be defined as a factor that is the common denominator for systematically linking a cost or group of costs to a cost object such as a department or an activity.

Where cost object is a product, the narrower term cost application base is often used.

Cost Allocation Base FAQs

What is a cost allocation base.

A cost allocation base is the unit, activity, or item that allocates costs in an organization. It can be used to measure and assign expenses to departments and activities accurately.

How does a cost allocation base work?

Costs are assigned to the appropriate department or activity based on the number of units of a resource consumed by each respective department or activity, such as labor hours or machine hours. The total amount of expenses for the period is then divided among the various departments and activities based on their usage patterns.

What types of costs can be allocated using a cost allocation base?

Most variable costs associated with production processes can be allocated using a cost allocation base, such as direct materials, wages and salaries, utilities, machinery, and equipment rental costs.

What are the benefits of using a cost allocation base?

Using a cost allocation base enables organizations to identify areas where costs can be reduced or controlled more efficiently. It also helps allocate accurate costs for each department or activity and provides the necessary data for pricing products and services accurately.

How often should a cost allocation base be updated?

Organizations should review their cost allocation bases regularly to ensure accuracy in allocating expenses. The frequency will depend on the size of the organization and how quickly resource consumption patterns change within that organization. Generally speaking, it is recommended to update your cost allocation base at least once a year.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

Our Services

  • Financial Advisor
  • Estate Planning Lawyer
  • Insurance Broker
  • Mortgage Broker
  • Retirement Planning
  • Tax Services
  • Wealth Management

Ask a Financial Professional Any Question

We use cookies to ensure that we give you the best experience on our website. If you continue to use this site we will assume that you are happy with it.

At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content.

Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications.

They regularly contribute to top tier financial publications, such as The Wall Street Journal, U.S. News & World Report, Reuters, Morning Star, Yahoo Finance, Bloomberg, Marketwatch, Investopedia, TheStreet.com, Motley Fool, CNBC, and many others.

This team of experts helps Finance Strategists maintain the highest level of accuracy and professionalism possible.

Why You Can Trust Finance Strategists

Finance Strategists is a leading financial education organization that connects people with financial professionals, priding itself on providing accurate and reliable financial information to millions of readers each year.

We follow strict ethical journalism practices, which includes presenting unbiased information and citing reliable, attributed resources.

Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos.

Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others.

Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs.

How It Works

Step 1 of 3, create a free account and ask any financial question.

Ask a question about your financial situation providing as much detail as possible. Your information is kept secure and not shared unless you specify.

cost allocation and management accounting

Step 2 of 3

Our team will connect you with a vetted, trusted professional.

Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise.

cost allocation and management accounting

Step 3 of 3

Get your questions answered and book a free call if necessary.

A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation.

cost allocation and management accounting

Ask Any Financial Question

Where should we send your answer.

cost allocation and management accounting

Question Submitted

We need just a bit more info from you to direct your question to the right person.

Tell Us More About Yourself

Is there any other context you can provide.

Pro tip: Professionals are more likely to answer questions when background and context is given. The more details you provide, the faster and more thorough reply you'll receive.

What is your age?

Are you married, do you own your home.

  • Owned outright
  • Owned with a mortgage

Do you have any children under 18?

  • Yes, 3 or more

What is the approximate value of your cash savings and other investments?

  • $50k - $250k
  • $250k - $1m

Pro tip: A portfolio often becomes more complicated when it has more investable assets. Please answer this question to help us connect you with the right professional.

Would you prefer to work with a financial professional remotely or in-person?

  • I would prefer remote (video call, etc.)
  • I would prefer in-person
  • I don't mind, either are fine

What's your zip code?

  • I'm not in the U.S.

cost allocation and management accounting

Almost Done!

Finish your free account setup.

Your privacy is a top priority. We never sell your information or disclose it to 3rd parties.

Submit to get your retirement-readiness report.

A financial professional will be in touch to help you shortly.

cost allocation and management accounting

Part 1: Tell Us More About Yourself

Do you own a business, which activity is most important to you during retirement.

  • Giving back / charity
  • Spending time with family and friends
  • Pursuing hobbies

Part 2: Your Current Nest Egg

Part 3: confidence going into retirement, how comfortable are you with investing.

  • Very comfortable
  • Somewhat comfortable
  • Not comfortable at all

How confident are you in your long term financial plan?

  • Very confident
  • Somewhat confident
  • Not confident / I don't have a plan

What is your risk tolerance?

How much are you saving for retirement each month.

  • None currently
  • Minimal: $50 - $200
  • Steady Saver: $200 - $500
  • Serious Planner: $500 - $1,000
  • Aggressive Saver: $1,000+

How much will you need each month during retirement?

  • Bare Necessities: $1,500 - $2,500
  • Moderate Comfort: $2,500 - $3,500
  • Comfortable Lifestyle: $3,500 - $5,500
  • Affluent Living: $5,500 - $8,000
  • Luxury Lifestyle: $8,000+

Part 4: Getting Your Retirement Ready

What is your current financial priority.

  • Getting out of debt
  • Growing my wealth
  • Protecting my wealth

Do you already work with a financial advisor?

Which of these is most important for your financial advisor to have.

  • Tax planning expertise
  • Investment management expertise
  • Estate planning expertise
  • None of the above

Get In Touch With

Great the financial professional will get back to you soon., where should we send the downloadable file, great your downloadable file should be in your email soon..

In the meantime, here are a few articles that might be of interest to you:

cost allocation and management accounting

pubads

You are using an outdated browser. Please upgrade your browser or activate Google Chrome Frame to improve your experience.

You are running an unsupported version of Internet Explorer, please upgrade.

  • 804.673.5700

Cherry Bekaert logo

  • Financial Services
  • Not-for-Profit
  • State & Local Government
  • Government Contractors
  • Hospitality & Retail
  • Industrial Manufacturing
  • Private Client Services
  • Private Equity
  • Professional Services
  • Real Estate & Construction

Risk Management Consulting Services for the Financial Services Industry

Cybersecurity Maturity Model Certification (CMMC

GASB 96, Subscription-Based IT Arrangements: A New Challenge the Year after Leases

  • Strategic Alliances
  • Collateral Review Services
  • Cybersecurity Maturity Model Certification (CMMC)
  • Business Intelligence & Data Analytics
  • Digital Platforms
  • Digital Strategy & Transformation
  • IT Due Diligence
  • Managed IT Security Services
  • Optimization & Workflow
  • Government & Public Sector Advisory
  • SBA 8(a) Business Development Program Consulting Services
  • Fractional CxO Services
  • Recruiting & Staffing Services
  • Accounting Advisory Services
  • Enterprise Technology Solutions
  • Financial Services Regulatory Compliance
  • Internal Audit Services
  • Information Technology Audit & Consulting
  • Risk Advisory Services
  • Strategic Growth & Innovation
  • Sustainability and ESG Services
  • Deal Advisory
  • Forensics & Dispute Advisory Services
  • Transaction Tax Services
  • Valuation Services

View all of our Advisory services

  • IFRS Reporting
  • Lease Accounting Services
  • Revenue Recognition
  • Employee Benefit Plan Audit
  • SOC Reporting Services

View all of our Assurance services

  • Accounting Methods
  • Compensation & Benefits Consulting
  • Corporate Tax Planning Strategies
  • Employee Retention Credit
  • Estates & Trusts
  • Cross-Border Tax Consulting Services
  • International Tax Compliance Services
  • Transfer Pricing Services
  • Community Development Consulting
  • Management Services
  • Project Financing
  • New Markets Tax Credits
  • The Innovate Fund
  • Nonprofit Tax
  • Sales Tax Nexus & Registration Services
  • Outsourced Sales Tax Compliance and Managed Services
  • Reverse Audit Services
  • Sales Tax Training
  • Income & Franchise Tax
  • Property Tax Outsourcing Services
  • Tax Controversy & Dispute Resolution
  • Cost Segregation Services
  • Energy Tax Credits & Incentives
  • Fixed Asset Services
  • R&D Tax Credits
  • State Credits & Incentives
  • Opportunity Zones
  • Section 199A

View all of our Tax services

Enterprise-Wide Technology Solutions

Project-Based ERP Management

Financial & ERP Offering

  • Sage Intacct

Energy Solutions

  • PXiSE Energy Solutions

Wealth Advisory Management

View all of our Strategic Alliances services

Digital Advisory Services

Learn more about our digital advisory services and how we can help guide your middle market company forward on your path to digital transformation.

PPP Loan Forgiveness Assistance

Guidance through the loan forgiveness documentation process.

Employee Retention Credit Tax Services

Expanded Employee Retention Credit (ERC) & how our professionals can assist you.

Client Portal

How can we guide you, cherry bekaert.

Home » Guidance » Cost Allocation and Indirect Cost Rate Frequently Asked Questions

Cost Allocation and Indirect Cost Rate Frequently Asked Questions

calendar icon

Economic uncertainty and constraints are recurring challenges that State, Local, Tribal and Not-for-Profit organizations face. Cherry Bekaert and our team of subject matter experts (many of whom have walked in your shoes serving the public) are here to help you better understand your true cost, revealing insights that will help you plan for a sustainable economic future, and save you time so that you can stay focused on the bigger picture. To guide you forward, we’ve put together this FAQ document in the spirit of spreading information and understanding on the Cost Allocation Plan and Indirect Cost Rate concepts.

Q: When should an agency obtain a cost allocation plan?

A: All agencies that have multiple service lines should always have a cost allocation plan.

Q: How is the cognizant agency determined?

A: The cognizant agency is the agency providing the largest sum of funding. Note that your cognizant agency remains the same until funding from another agency is greater for five years, at which point your cognizant would change.

Q: Once you have a Negotiated Indirect Cost Rate Agreement (NICRA) approved with your cognizant agency, does it apply to grants from other federal agencies?

A: Yes, once you’ve received a NICRA, all other federal and state agencies must accept it, even if you are a subrecipient. See 2 CFR Part 200 Subpart E (200.414) .

Q: What’s the difference between an “Admin Cap” and the use of a NICRA?

A: The NICRA represents agency-wide indirect cost, such as finance, HR, etc., whereas the Admin Cap is defined as overhead to programs, e.g., supervisors overseeing a program(s). For example, a finance analyst that is responsible for overseeing a few grants (20% of their time) but spends the rest of their time (80%) processing payroll, 20% falls under the Admin Cap, and the remaining 80% would be part of the NICRA.

When an Admin Cap is present, refer to the Notice of Funding Availability (NOFA) to determine if a NICRA can be used in addition to the Admin Cap. If not specifically and implicitly stated that a NICRA can’t be used/is unallowed, then a NICRA is allowable in addition to the Admin Cap (i.e., it has to spell it out).

Q: Can you go back two years to claim indirect cost on past grants if you didn’t claim indirect cost to begin with?

A: Yes, and if you didn’t have a NICRA for those two years, you can still calculate one and apply it.

Q: Can your NICRA be used as the grants’ match component?

A: Yes, per OMB guidelines: 2CFR Part 200, 306.7 (C) Unrecovered indirect costs, including indirect costs on cost sharing or matching may be included as part of cost sharing or matching only with the prior approval* of the Federal awarding agency. Unrecovered indirect cost means the difference between the amount charged to the Federal award and the amount which could have been charged to the Federal award under the non-Federal entity’s approved negotiated indirect cost rate.

*Note: in order to use your NICRA as your match, it is required to notify the funder. The funder does not have the authority to deny use for match based on the guidelines.

Even if your grant disallows indirect cost, your NICRA can still be used as match.

Q: What if my cognizant says they don’t have to negotiate because I have less than $35M in direct federal funding?

A: If you have less than $35M in direct federal funding as a government agency or $10M as a nonprofit, you are not required to submit an Indirect Cost Rate Proposal (ICRP) to your cognizant. However, you are required to prepare the submission packet, including your rate, and it can be “kept on the shelf.” If a funder requires a negotiated rate, they must negotiate directly with you or accept the existing submission packet. They cannot force you to use de minimis; they must negotiate.

Q: Will application of the NICRA take funding away from the program?

A: This is a common concern and misconception. Indirect cost is incurred to run a program regardless from where that cost is funded. For most agencies, these indirect costs are subsidized by the General Fund (taxpayer dollars). It’s important to understand that indirect cost exists and may be covered by program funding or the General Fund. An agency can choose to apply the full NICRA or any percentage up to that rate, which allows the agency to make the strategic decision to fully apply the NICRA to the grant or knowingly subsidize from the General Fund.

Q: How long does the negotiation process typically take?

A: Three to six months, but the cognizant is required to negotiate within six months.

Q: Can your rate change year over year?

A: The indirect cost rate should be fairly consistent without the carry forward adjustment. The carry forward is what brings variance.

Q: How often do you have to negotiate a rate?

A: Annually, however OMB guidelines allow for a one-time extension of a current NICRA for a period of up to four years. The extension will be subject to review and approval of the cognizant agency.

Q: Can a cognizant tell me my rate seems too high?

A: No, the rate is based on audited financial statements, and they don’t have the authority to change the rate. They must accept the rate calculated as long as indirect costs included in the pool are deemed allowable by 2 CFR Part 200.

Often, perceptions are that a high rate is an indication of poor management and efficiency, therefore agencies are less inclined to negotiate the rate out of fear that the cognizant won’t approve. This is a common misconception. The rate is based on audited financials and the cognizant is more likely to approve because the agency has demonstrated an understanding of their true cost.

Q: Does having a NICRA make us more likely to win awards?

A: Yes, because it demonstrates awareness of direct and indirect cost so that you are more likely to utilize a grant to its fullest potential and have a successful program outcome. Even if your full indirect cost is not reimbursable due to grant restrictions, it informs the grantor you are aware of the subsidy necessary to fulfill the expectations of the grant.

Q: What is the most common area of the cost plan where organizations “leave money on the table”?

A: Bank Fees—many agencies do not include them. In many cases banking fees are offset from interest earned in the bank accounts so there is never an actual payment to the bank for these fees, resulting in the absence of a line-item cost in the budget. However, this cost is allowable and should be added to the cost that is spread. Also, agencies often aren’t aware that they can include the interest charged on loans/bonds or the attorney fees charged when setting up these loans.

Q: For smaller organizations, is it better for them to just get the 10% de minimis instead of doing a cost plan when you factor in time and cost of creating a cost plan?

A: It is our opinion that it is NEVER better to get the 10% de minimis. Smaller agencies can calculate a cost plan fairly simply without a lot of effort and realize a 30% to 50% indirect cost rate.

Q: Please explain matching/cost sharing.

A: Simply put, “match” is the non-federal share of costs that the grantee or the grantee’s partners are required to contribute to accomplish the purposes of the grant.

Funders have various reasons to require match. The primary reason is to share the costs of various government programs across jurisdictions or with the private sector. Funders sometimes structure match requirements to promote sustainability of projects past the life of the grant program.

Matching funds include:

  • Non-federal public or private funds
  • Funds that are not used as match for any other federal program
  • Unrecovered indirect costs
  • Match can be either an actual expenditure (cash) or a virtual cost (in-kind contribution).

We are here to help and your guide forward, so if you have additional questions or need advice and expertise, please reach out to [email protected] .

Questions? Contact Us

  • Key Differences

Know the Differences & Comparisons

Difference Between Cost Accounting and Management Accounting

Cost vs management accounting

The two accounting system plays a significant role, as the users are the internal management of the organization. While cost accounting has a quantitative approach, i.e. it records data which is related to money, management accounting gives emphasis on both quantitative and qualitative data. Now, let’s understand the difference between cost accounting and management accounting, with the help of given article.

Content: Cost Accounting Vs Management Accounting

Comparison chart, similarities, definition of cost accounting.

Cost Accounting is a method of collecting, recording, classifying and analyzing the information related to cost. The information provided by it is helpful in the decision-making process of managers. There are three major elements of cost which are material (direct & indirect), labor (direct & indirect) and overhead (Production, Office & Administration, Selling & Distribution, etc.).

The main aim of the cost accounting is to track the cost of production and fixed costs of the company. This information is useful in reducing and controlling various costs. It is very similar to financial accounting, but it is not reported at the end of the financial year.

Definition of Management Accounting

Management Accounting refers to the preparation of financial and non-financial information for the use of management of the company. It is also termed as managerial accounting. The information provided by it is helpful in making policies and strategies, budgeting, forecasting plans, making comparisons and evaluating the performance of the management.

The reports produced by management accounting are used by the internal management (managers and employees) of the organisation, and so they are not reported at the end of the financial year.

Key Differences Between Cost Accounting and Management Accounting

  • The accounting related to the recording and analysing of cost data is cost accounting. The accounting related to the producing information which is used by the management of the company is management accounting.
  • Cost Accounting provides quantitative information only. On the contrary, Management Accounting provides both quantitative and qualitative information.
  • Cost Accounting is a part of Management Accounting as the information is used by the managers for making decisions.
  • The primary objective of the Cost Accounting is the ascertainment of cost of producing a product, but the main objective of the management accounting is to provide information to managers for setting goals and future activity.
  • There are specific rules and procedure for preparing cost accounting information while there is no specific rules and procedures in case of management accounting information.
  • The scope of Cost Accounting is limited to cost data however the Management Accounting has a wider area of operation like tax, budgeting, planning and forecasting, analysis, etc.
  • Cost accounting is related to ascertainment, allocation, distribution and accounting face of cost. On the flip side, management accounting is associated with impact and effect aspect of cost.
  • Cost accounting stresses on short-range planning, but management accounting focuses on long and short range planning, for which it uses high level techniques such as probability structure, sensitivity analysis etc.
  • While management accounting can’t be installed in the absence of cost accounting, cost accounting has no such requirement, it can be installed without management accounting.
  • Branch of Accounting
  • Helpful in decision-making
  • Prepared for a particular period.
  • Not reported at the end of the financial year.

Both the cost accounting and management accounting are a part of accounting. They are helpful in for ensuring the smooth and efficient running of the business. On the basis of the information provided by the two entities various analysis are conducted. Cost accounting aims at reducing extra expenditure, eliminating unnecessary costs and controlling various costs. On the other hand management accounting aims at the planning of policies, strategy formulation setting goals, etc.

You Might Also Like:

cost centre vs cost unit

July 6, 2015 at 8:01 am

This answer is very useful for us

Ninsiima Scovia says

July 21, 2021 at 7:42 pm

Waoo the conclusion is well presented. Thanks for the information

February 15, 2016 at 11:47 am

Very helpful. Thank you

November 12, 2016 at 9:48 am

thanks. really helpful and simple to understand !

November 20, 2016 at 4:58 pm

Thanks for such a Informative articles .

Sreekanth says

March 15, 2021 at 7:15 pm

Very useful to us

February 14, 2019 at 8:28 pm

Thanks.great work👌

Ravina says

January 18, 2021 at 8:41 pm

Thank you for posting an answer on this site …..it is in easy n simple manner 😊

October 3, 2021 at 6:38 pm

THE PRESENTATION OF THE ARTICLE IS GREAT. SIMPLE AND EASY TO UNDERSTAND THE CONTENT. EXPECTING MORE WRITE-UPS.

Patricia says

October 7, 2021 at 12:17 pm

I loved my question were answered …straight to the main/key point thanks alot

Caroline says

December 10, 2021 at 6:26 pm

This information has been so helpful to me during my assignment and also, the way the different accounting systems are explained are very clear making it easy for one to understand. thank you

semambo ronald says

April 7, 2023 at 5:40 pm

it really flows just like how i wanted it. so helpful and more so when it comes to the conclusion. thanks alot. just made my assignment easier though i dont know which references to give.

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Save my name, email, and website in this browser for the next time I comment.

IMAGES

  1. Cost Allocation

    cost allocation and management accounting

  2. What is a Cost Accounting System?

    cost allocation and management accounting

  3. Cost Allocation Methods For Accurate Costing to Maximize Profits

    cost allocation and management accounting

  4. Compare Cost Vs Management Accounting : 10 Differences (Table)

    cost allocation and management accounting

  5. Cost accounting and management accounting: Meaning, Differences

    cost allocation and management accounting

  6. Cost Allocation

    cost allocation and management accounting

VIDEO

  1. Cost Accounting Part 5 Normal Costing

  2. DIFFERENCES BETWEEN FINANCIAL, COST & MANAGEMENT ACCOUNTING

  3. Cost Accounting: Allocation of Support Department Cost ( Class 4)

  4. 5) Cost Accounting: Allocation..... ( Class 5)

  5. Cost Accounting workshop 2

  6. MANAGEMENT ACCOUNTING

COMMENTS

  1. Cost Allocation

    Cost allocation is the process of identifying, accumulating, and assigning costs to costs objects such as departments, products, programs, or a branch of a company. It involves identifying the cost objects in a company, identifying the costs incurred by the cost objects, and then assigning the costs to the cost objects based on specific criteria.

  2. Cost allocation definition

    Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you want to separately measure costs. Examples of cost objects are a product, a research project, a customer, a sales region, and a department.

  3. Cost Accounting: Definition and Types With Examples

    Cost accounting is a form of managerial accounting that aims to capture a company's total cost of production by assessing the variable costs of each step of production as well as fixed...

  4. Cost allocation methods

    November 05, 2023 How to Allocate Costs Various cost allocation methods are used to allocate factory overhead costs to units of production. Allocations are performed in order to create financial statements that are in compliance with the applicable accounting framework.

  5. Cost Allocation in Accounting: An In-Depth Look

    The cost allocation definition is best described as the process of assigning costs to the things that benefit from those costs or to cost centers. For Lisa's Luscious Lemonade, a cost center can be as granular as each jug of lemonade that's produced, or as broad as the manufacturing plant in Houston.

  6. What Is Cost Allocation? (+ Types of Costs & Examples)

    3 types of costs Most businesses incur a variety of costs while doing business. These costs can range from the cost of materials needed to produce a finished product, to the direct labor...

  7. Cost Structure: Direct vs. Indirect Costs & Cost Allocation

    Cost structure refers to the various types of expenses a business incurs and is typically composed of fixed and variable costs, or direct and indirect costs. Fixed costs are incurred regularly and are unlikely to fluctuate over time. Variable costs are expenses that vary with production output.

  8. PDF Cost Allocation and Activity-Based Costing Systems

    A cost accounting sys- tem collects and classifies costs and assigns them to cost objects. The goal of a cost accounting system is to measure the cost of designing, developing, producing (or purchasing), selling, distributing, and servicing particular products or services.

  9. Cost Accounting Method: Advantages and Disadvantages

    The cost accounting method, which assesses a company's production costs, comes in a few broad styles and cost allocation practices. But these share primary advantages and disadvantages....

  10. Management accounting and efficiency in health services: the

    Rising health care costs, driven by population growth, demographic shifts and advances in medical technology, put the focus on cost analysis and management because cost information underpins decisions on resource allocation and effectiveness at system and organizational levels for providers, purchasers and regulators globally.

  11. The Comprehensive Guide to Cost Allocation in Accounting

    Allocation (also known as "cost allocation") is a process used to distribute the costs of a shared resource or expense among different departments, product lines, or activities within an organization. This process is necessary to accurately determine the cost of producing a product, providing a service, or running a business.

  12. What Is Cost Allocation? (Definition, Method and Examples)

    Cost allocation is the process of identifying, accumulating and assigning costs to specific cost objects. A cost object can be a specific product or product line, a particular service you offer, a production-related activity or a department or division in your company.

  13. 3.3: Approaches to Allocating Overhead Costs

    Kline Company expects to incur $800,000 in overhead costs this coming year—$200,000 in the Cut and Polish department and $600,000 in the Quality Control department. Total annual direct labor costs are expected to be $160,000. The Cut and Polish department expects to use 25,000 machine hours, and the Quality Control department plans to utilize ...

  14. Activity-Based Costing: A Modern Approach to Cost Management

    Traditional cost accounting methods allocate overhead costs to products or services based on a single cost driver, such as labor hours or machine hours. This approach can lead to inaccuracies in cost allocation, as it does not account for the complexities of business processes and the resources consumed by different activities.

  15. Cost Accounting: What It Is And When To Use It

    Cost accounting is a type of managerial accounting that focuses on the cost structure of a business. It assigns costs to products, services, processes, projects and related activities.

  16. The Growing Importance of Cost Accounting for Hospitals

    Time-Driven Activity Based Costing (TDABC) is a managerial accounting approach introduced in 2004 by Kaplan and Anderson. Time-driven activity based costing is an attempt to overcome some of the weaknesses associated with ABC. TDABC differs from traditional ABC, in that time is used as the primary cost driver.

  17. Costing Practices in Healthcare Organizations: A Look at ...

    Emergence of ABC. First appearing on the management accounting scene in the mid-1980s, ABC promised to revolutionize the way costs were allocated to the products produced and services performed by organizations. Numerous articles have appeared since its introduction, detailing the effectiveness of this technique for a variety of purposes.

  18. The Ultimate Guide to Cost Management

    Cost management refers to the activities concerning planning and controlling a project's budget. Effective cost management ensures that a project is completed on budget and according to its planned scope. Since you assess the success of a project at least in part by its cost performance, cost management is a prime determinant of project outcome.

  19. Cost Accounting: An In-Depth Analysis of Managing Business Expenses

    Cost Accounting Definition. Cost accounting is a specialized sector of accounting that deals with recording, analyzing, summarizing, and allocating all costs associated with a business's production processes or services. The main objective is to inform a business's management on how cost efficiency and financial performance can be improved ...

  20. Cost Allocation: Definition, and Example on How the Cost Allocation

    Cost allocation is the process that plays a major role in identifying, assigning, and aggregating the expenses to cost objects. A cost object is anything that requires you to measure the costs separately. Here are some examples of cost objects: products, services, departments, activities, customers, etc.

  21. Cost and Management Accounting

    The purpose of cost and management accounting is to provide managers with information which helps them to control, plan and make decisions. The second edition of this popular book, covers the principles and techniques of this subject area including the basic methods and procedures.

  22. Cost Allocation Base

    Table of Contents. Cost allocation base can be defined as a factor that is the common denominator for systematically linking a cost or group of costs to a cost object such as a department or an activity. Where cost object is a product, the narrower term cost application base is often used.

  23. Revenue Recognition Under ASC 606: Best Practices for ...

    When Accounting Standards Codification Topic 606 (ASC 606), Revenue from Contracts with Customers, took effect in 2019 for private companies, many government contractors lacked clarity on the new standard and struggled to understand how the requirements applied to their contracts — even after subsequent guidance from the FASB. Following implementation, BDO has identified best practices and ...

  24. Cost Allocation and Indirect Costs: FAQs and Answers: Cherry Bekaert

    A: This is a common concern and misconception. Indirect cost is incurred to run a program regardless from where that cost is funded. For most agencies, these indirect costs are subsidized by the General Fund (taxpayer dollars). It's important to understand that indirect cost exists and may be covered by program funding or the General Fund.

  25. Difference Between Cost Accounting and Management Accounting

    The scope of Cost Accounting is limited to cost data however the Management Accounting has a wider area of operation like tax, budgeting, planning and forecasting, analysis, etc. Cost accounting is related to ascertainment, allocation, distribution and accounting face of cost.