1.5 Cost Allocation Methods
Once you’ve applied a costing procedure to determine the costs of a project, the next step in making a good budget is to allocate those costs into appropriate categories. This can be done in many ways, but two common approaches are function-based costing and activity-based costing. This section will introduce you to using both of these approaches.
1.5.1 Function-Based Costing
Function-based costing works by using production drivers (e.g. machine hours, labour hours) to assign costs to various departments (e.g. sales, marketing, manufacturing). This is the method that businesses have traditionally used to track their costs, since it provides a straightforward breakdown of where money is spent within the company, and it provides good information about a business’s function for external investors. We can think of function-based costing as a three step process:
- Identify Unit-Level Drivers
Function-based costing is highly dependent on the concept of units and unit costs, where the unit is the basic quantity of the good or service being produced. For a shoe factory the unit would be a pair of shoes, and for a tour company a unit might be a single 1-hour helicopter tour. The cost drivers used in this costing method are exclusively “unit-level drivers”; that is, they are variable costs, highly correlated to the number of units produced. All overhead costs which are variables costs (e.g. utilities) are assigned using driver tracing . Any overhead costs which are fixed costs, or are not correlated to unit production (e.g. building lease, equipment depreciation), must be allocated on a different basis .
In order to determine accurate unit costs , the first step must be identifying the unit-level drivers of those costs. As examples, these drivers could include machine-hours, labour hours, or simply the number of units produced.
- Estimate Driver Capacity
Once you have identified the unit-level drivers for each department , you must estimate its capacity, or number of units that you expect to be produced over a certain period . You might find it useful to consider various types of estimates, as illustrated here with the example of a gas station :
Expected Capacity: On any given day, the gas station expects to sell about 12,000 litres of gasoline, based on an average from the last full year of sales. The expected capacity is a short term estimate of capacity.
Normal Capacity: If gas prices are unusually low this year, the gas station might expect gas consumption to dip again if prices rise back to their typical levels. Therefore, they might expect to sell about 11,000 litres of gasoline per day over the next 5 years. The normal capacity is a longer term estimate of capacity.
Theoretical Capacity: Suppose the city was hit with a hurricane warning, and every car in the city rushed to the station to fuel up so that they could leave town. From opening to close, every pump in the gas station would be occupied, and they could sell every