How can you explain cost allocation methods to stakeholders who are unfamiliar with the concept?

1 Why use cost allocation methods?

Cost allocation methods help businesses allocate their indirect costs, which are costs that cannot be easily traced to a specific product, service, department, or activity. For example, rent, utilities, depreciation, and administrative expenses are indirect costs that are shared by multiple products or departments. Cost allocation methods help businesses distribute these costs based on some criteria, such as output, usage, or revenue. By using cost allocation methods, businesses can better understand the true cost and profitability of each product, service, department, or activity, and make informed decisions.

2 What are the main types of cost allocation methods?

Different types of cost allocation methods exist, depending on the purpose and level of detail required. The direct method is simple and easy to apply, but may ignore some important cost drivers and distort the cost allocation. The step-down method allocates indirect costs to both intermediate and final cost objects, in a sequential order, recognizing that some departments or activities provide services to other departments or activities. Activity-based costing (ABC) is more precise and comprehensive than the other methods, allocating indirect costs to multiple cost pools based on activities that cause the costs, then allocating the costs from each pool to the final cost objects based on activity drivers. However, ABC is also more complex and costly to implement.

3 How to choose the best cost allocation method?

When selecting the best cost allocation method, there is no one-size-fits-all solution. It depends on the business's nature and objectives, the data's availability and reliability, the accuracy-simplicity trade-off, and the stakeholders' expectations and preferences. Factors to consider include relevance, fairness, consistency, and transparency. Relevance means that the method should provide relevant information for decision making. Fairness implies that the costs should be distributed among cost objects based on their consumption or contribution to the costs. Consistency requires that the method be consistent over time and across different cost objects. Transparency ensures that it is easy to understand and communicate to stakeholders, so confusion and conflict can be avoided.

4 How to explain cost allocation methods with examples?

Explaining cost allocation methods to stakeholders can be made easier by using simple examples and analogies they can relate to. For instance, using the direct method can be compared to splitting a dinner bill equally, regardless of who ate more or less of each item. The step-down method is similar to splitting the dinner bill based on the individual's consumption. As for activity-based costing, it can be illustrated by taking into account both consumption and activity drivers when splitting the bill. For example, if someone ordered delivery, they would pay more than someone who didn't. This analogy helps stakeholders understand cost allocation methods in a straightforward manner.

5 How to communicate cost allocation methods to stakeholders?

Once you have explained the concept and the types of cost allocation methods, it is important to communicate them effectively to your stakeholders, such as customers, suppliers, employees, managers, or investors. When doing so, you should tailor your message to each audience, as they may have different interests and concerns. Additionally, visuals and stories can help make the cost allocation methods more understandable and memorable. Finally, it is essential to invite feedback and questions from stakeholders, listen to their opinions and suggestions, and address any concerns or objections they may have. This way you can build trust and rapport with your stakeholders while gaining their support and acceptance for your cost allocation methods.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?