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cost allocation

Also called: overhead allocation, allocated costs, allocation key

Assigning shared costs (office, finance team, platform) to products, subjects or teams by some key. Useful for pricing and reporting, dangerous for decisions: allocated costs usually don't disappear when a product is dropped.

Cost allocation assigns shared costs (the office, the finance team, the platform, management) to products, subjects, teams or customers using a key such as headcount, revenue, units or hours. It is useful for pricing, for showing what a product line must cover in the long run, and for reports that add up to the company total.

It is dangerous for decisions. Allocated costs usually don't disappear when a product is dropped: the office, the platform and the managers stay, and their cost moves to the remaining products. A product can show a loss after allocation while leaving plenty of contribution, and dropping it then makes the company poorer. The result also depends on the key: the same product looks deeply loss-making by one key and nearly break-even by another.

For a keep-or-drop decision compare what the product leaves (its contribution) with the costs that would actually go away (its own marketing, staff who would leave, tools that would be cancelled). For reporting, show each product's contribution minus its own costs, and the shared costs once, for the company. Otherwise re-allocating after each closure starts a spiral in which the next product looks unprofitable too.

Example

Klasna allocates 10,088,000 UAH of shared costs by tutor headcount, 77,600 per tutor. Programming has 34 tutors:

Programming, last year
UAH
Contribution
1,118,625
Own marketing
−340,000
Allocated shared costs (34 × 77,600)
−2,638,400
Result after allocation
−1,859,775

By a lessons key the same subject shows −24,885.19. Dropping it would save only 454,000 (its 340,000 of ads and 3 coordinator-months, 114,000) while losing 1,118,625 of contribution: operating profit would fall by 664,625, from 744,174.72 to 79,549.72. And the shared costs, re-allocated over the remaining 96 tutors, would push maths to −1,264,093.67.

Common mistakes

  • Dropping a product because it's loss-making after allocation. Compare its contribution with the costs that would actually go away.
  • Treating the key as a fact. Headcount, revenue and units give very different pictures; the key is a convention.
  • Re-allocating after a closure and repeating. That's the death spiral: each step makes the next product look worse.
  • Using allocated full cost as a price floor. For a one-off decision the floor is the relevant cost, not the full cost.
  • Hiding shared costs in every line. Show them once for the company so everyone sees their real size.

Learn it in the course