Cost allocation methods and applications

¶ … Allocation: An Overview

Arguments in favor of cost allocation

Cost allocation is a method of accounting used to determine the cost of services that an organization provides to the users of that service. It does not determine the price of the service, but rather determines what the service costs to the service provider. It one of the most useful methods for service-based organizations to use to determine a justifiable price, added charge, or tax for its services. It is also of particular value for nonprofits that might have to defend an additional charge for what are supposed to be 'free' services to consumers, because providing the service incurs certain necessary costs that must be met through a fee.

Cost allocation has grown increasingly useful in a world where most organizations have some service-based costs. It takes into consideration a variety of factors that contribute to costs, such as indirect costs that are generated by an outside organization associated with providing the service that contribute to overall service-based costs. In an increasingly interconnected global economy, with many hidden costs, the need for organizations to expand the services they provide, and a greater dependency upon a wider arena of providers, cost allocation can be useful and above all flexible as an accounting methodology.

Does cost allocation provide relevant information?

Cost allocation takes into consideration the direct, indirect, and incremental costs of providing a service. "Direct costs, or separable costs, are costs that are related to a single type of service...Indirect costs, or common costs, are related to more than one type of service...Incremental costs change with the level of output produced. Incremental costs measure changes in output, such as differences in staffing levels or staffing costs that may vary with production needs, such as a spike in seasonal foot traffic at a retail establishment or an airport (Fiertz & Monico, 2007).

Would a current-value approach to measurement of fixed assets be preferable? Why?

A current-value approach, or an approach that notes the current market value of an asset, is still often considered less preferable because it only records current market conditions, not future market conditions such as inflation. Also, while current-value approaches require tangible fixed assets to be measured at cost when they are initially recognized, these values may quickly change with depreciation of the fixed asset ("Tangible fixed assets," 1999, ASB). Replacement costs must eventually be taken into consideration for the fixed asset, and also the opportunity cost for replacing that asset, to gain a complete understanding of its value. Also, current values can shift seasonally, even for a fixed asset, depending on the nature of the industry and the asset.

Is a current-value approach consistent with the physical capital maintenance concept? Explain.

As a concept, physical capital maintenance and the current-value approach is controversial. If the purpose of accounting is to "make possible the periodic matching of costs (efforts) and revenues (accomplishments)...no current market price can have a general status of fairness applicable to all firms particularly where long-term strategies for periodic assets exist" (Aiken & Aden 2005: 6). To be consistent and accurate, a current-value approach requires constant reevaluation in the context of the role of the asset, the industry, and how these impact the firm's overall financial health. Also, expected maintenance or replacement costs are not always periodic and predictable, particularly if changes in technology require an unexpected update, or there is a sudden seasonal impact upon the industry, based upon climatic conditions.

Problems/limitations associated with using replacement cost for fixed assets

The fixed asset replacement cost strategy allows an organization to define how assets are depreciated, record those assets, report the asset costs, report replacement costs, and to report other costs associated with the fixed asset. but, although the principles of "economic efficiency requires that replacing assets should be valued at opportunity cost...for specialised assets whose opportunity costs are very low, setting prices on the basis of opportunity cost" alone is not always fair ("Historic vs. replacement cost approaches," 2007, MED). Some organizations have no choice but to replace certain assets.