. Introduction and Background

Allocations are an important part of every implementation using cost center accounting. This paper should help to make the right choice of allocation using best practices and show how to configure the SAP system. This paper primarily focuses on cost center allocations of actual costs. It is recommended that as far as possible the basis of plan allocations should be the same as for actual allocations to ensure consistency of data. In our implementation experience, the most common type of allocation is assessment. This type of allocation will be described in more detail.

2. Best Practices

Allocation is the apportionment of costs based on an estimate rather than a direct measurement. Financial accounting requires that all costs of manufacturing be included in valuing inventory and cost of sales. If the cost system is being used to value inventory for financial reporting, some allocation must be made to individual products. This allocation can be done based on units produced or inputs, such as labor or machine hours.

Allocation of overhead and other indirect costs is a necessary evil of financial accounting. For decision making purposes, though, allocated cost are often irrelevant. Allocation of overhead costs (e.g. accounting, human resources, etc.) to product line or product specific cost centers should be kept as simple as possible, if it is only an estimate to allocate costs. It is necessary to make sure there is direct relationship between additional costs and additional produced products. Any allocations could be misleading or distort decision making, if the relationship between output and overhead costs is not proportional.

If all the management accounting system is doing is taking the pool of overhead expenses and assigning it to units of output, little is accomplished. For example, overhead is often allocated based on direct labor hours. This is convenient, but does it reflect the actual relationship between activity and expenses? For companies with multiple services or products, different processes will lead to different relationships between labor and overhead. And what about other factors such as machine time, volume (short or long runs), or materials? Without the effort to uncover the true relationship between activity and cost, the time spent devising allocation formulas will succeed in spreading overhead costs, but will say nothing about what actually caused them or how you can control them.

Most companies have a large pool of expenses that do not appear directly related to the level of production or sales. In many companies this may even be the vast majority of expenses, including manufacturing overhead, such as wages for supervisors and inspectors, power, maintenance, insurance and rent. All selling, administrative, and interest expenses are also in this group. They often represent 60%, 80%, even 95% of a company's expenditures. They also are not as fixed as is often assumed. Although one additional unit of output won't change what is spent in the short term on rent, insurance, or supervisors, these expenses can change and do bear a relationship to activities. Three months, a year, or five years may pass, but all expenses become variable at some point. Since most management decisions involve some long-term commitment of resources - space, people, marketing - the impact on "fixed" costs becomes very relevant.

While the relationship maybe hard to spot, most overhead costs are driven by specific products and activities. The number of accounting clerks, purchasing agents, or warehouse personnel is often related to volume.

Because managers are allocated a portion of overhead, much of which arises in other departments and is considered beyond the line managers' control, no one is held accountable for overhead. Managers have an incentive to reduce their direct costs on which overhead expense is allocated, but no incentive to reduce overhead itself. Overhead is indeed controllable and the accounting system must reflect this. As mentioned earlier, if overhead expenses can be traced to the products or services that give rise to them, they should be. If not, recognize that not all expenses need to be allocated. If there is really no relationship between a product or service and an overhead expense, an allocation serves little purpose.

To budget and control these expenses separately is a better option, rather than create the illusion that volume or production efficiencies can change them. If the cost of the human resource department is independent of or too costly to trace to individual products, it is better to establish an operating budget and holding the department manager responsible for it. Perhaps it is possible to develop measures such as cost per applicant to measure efficiency. If costs change, the results are reported for just the department; the difference does not have to be absorbed by other departments or individual products.