Which of the following is considered the most accurate method in allocating overhead costs to products?

See Also:
Activity Based Costing
Standard Costing System
Cost Driver
Value Chain
Implementing Activity Based Costing
Absorption vs Variable Costing
Activity Based Management
Process Costing
Overhead
Job Costing

Activity Based Costing Costing vs Traditional Costing

In the field of accounting, activity-based costing and traditional costing are two different methods for allocating indirect (overhead) costs to products.
Both methods estimate overhead costs related to production and then assign these costs to products based on a cost-driver rate. The differences are in the accuracy and complexity of the two methods. Traditional costing is more simplistic and less accurate than ABC, and typically assigns overhead costs to products based on an arbitrary average rate. ABC is more complex and more accurate than traditional costing. This method first assigns indirect costs to activities and then assigns the costs to products based on the products’ usage of the activities.

Traditional Costing Method

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps in the traditional costing process, including the following:
1. Identify indirect costs.
2. Estimate indirect costs for the appropriate period (month, quarter, year).
3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).
4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).
5. Compute the predetermined overhead rate (see below).
6. Apply overhead to products using the predetermined overhead rate.

Predetermined Overhead Rate Calculation

Use the following formula to calculate predetermined overhead rate:

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

For example:

$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor

Activity-Based Costing Benefits

Activity based costing systems are more accurate than traditional costing systems. This is because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement. The leap from traditional costing to activity based costing is difficult.

Traditional Costing Advantages and Disadvantages

Traditional costing systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and over-costing.
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This page provides detailed guidance to help local governments in Washington State allocate indirect (overhead) costs, including key questions to consider and sample cost allocation plans and procedures.

It is part of MRSC’s Financial Policies Tool Kit, created in partnership with the State Auditor’s Office Center for Government Innovation.

What Is Cost Allocation?

Cost allocation refers to a process of accounting and recording the full costs of a government service by including its indirect costs or "overhead" in addition to its direct costs.

Direct costs are those that clearly and directly benefit a specific fund or program, such as supplies, materials, staff salaries and benefits, or consultant fees that support a single department or project.

Indirect costs, commonly referred to as "overhead costs" or central services, are for support services that are shared by multiple departments, programs and/or funds, such as accounting, payroll, administrative, or human resource salaries and benefits; information technology (IT) services for the entire municipality; or operating and maintenance costs for city hall or other buildings shared by multiple departments.

For example, the full cost of the Public Works Department includes its direct costs (wages, benefits, maintenance, and operations) plus the indirect costs/"overhead" of support services received from central services (such as accounting, payroll, and IT).

A cost allocation plan distributes these indirect costs to ensure that the respective funds are fairly and accurately paying for the services they receive.

Why Do Local Governments Allocate Costs?

There are a number of reasons that a local government should develop a cost allocation plan or system. A formal cost allocation system can help a jurisdiction:

• Identify the actual cost of services being provided to the citizens.
• Equitably share the costs of shared facilities and support services between departments, programs, and funds throughout the organization.
• Ensure accuracy of cost-based user fees for public services such as utilities, development review, parks, or any other service where the user pays a fee for service.
• Relieve pressure on the general fund by allocating certain general fund costs to enterprise or other funds that receive a benefit from support services.
• Comply with state law and minimize audit issues. RCW 43.09.210 requires that all service rendered by one department to another shall be paid for at its true and full value by the department receiving the service, and that no department shall benefit in any financial manner whatever by an appropriation or fund made for the support of another.
• Get reimbursement for allowable overhead costs from federal and state grants, to the extent that this is allowed by the grant. This usually requires a formal cost allocation plan with internal controls to assure accuracy. Federal monies require strict adherence to OMB’s Uniform Guidance (2 CFR 200).

Basic Steps of Cost Allocation

The key to successful cost allocation is to establish an allocation system that is fair, equitable, and supported by current data. In particular, a cost allocation system should:

• Identify shared facilities or support services
• Identify the costs to be allocated
• Determine the allocation factors/methodology to distribute the costs equitably
• Allocate the costs
• Update and monitor the data and methodology to ensure the allocation remains fair and equitable over time

Step 1: Identify Shared Facilities or Support Services

Your jurisdiction should allocate costs for any services, staff, facilities, or equipment that benefit other funds or departments. Identify within central services or internal service departments any specific services that support multiple funds or departments (such as payroll, accounts payable, utility billing, and facilities and grounds maintenance).

For the purposes of this cost allocation methodology, these costs are referred to as indirect costs or "overhead."

Key questions to consider:

• What staff members or departments support multiple funds or programs? Common examples for smaller jurisdictions include finance directors, clerks/treasurers, payroll clerks, and facility maintenance staff. For larger jurisdictions, this may also include categories like city administrators, attorneys, human resources, and IT.
• What contracted services support multiple funds or departments? For instance, do you contract with a technology firm to provide IT services to your entire jurisdiction? Have you hired a company to maintain shared facilities or grounds?
• What facilities and equipment are used by multiple departments or programs? Are all of your departments and programs located in one central services or public works facility? Did you purchase a piece of equipment (such as a vehicle or a copier) that will be used by multiple departments?
• How should costs be allocated to your enterprise (utility) funds? Utility funds and other funds with restricted revenue sources should only reimburse for the actual benefit received from the services provided by other funds such as the general fund, internal service funds, motor pools, IT services, and others.
• Should you allocate costs associated with your elected officials? When considering whether to allocate these costs to restricted funds such as utilities, use extreme caution. The SAO will require documentation to support the fairness of these charges. Do the elected officials devote time every meeting to those enterprise activities? Consider using agenda items as the basis for allocating these costs.

Step 2: Identify Costs

Once you have identified these shared "overhead" functions, compile their total costs using timesheet data or other accounting of actual expenditures associated with this activity.

You can also allocate shared costs using budget projections, although in that case you should include a monitoring component at the end of the year to make sure the budget and the actual costs are within an acceptable range. If you are using projections, the cost allocation plan should define what the "acceptable range" is. For instance, the plan might state that the actual costs must be within 1% of the budgeted costs, or 5%, or somewhere in between.

For instance, below are two simple, fictional examples of cost allocation processes for payroll and facility maintenance.

Example A: Calculating Payroll Costs

The payroll department conducts payroll for all departments, so payroll costs can and should be allocated. To calculate the total cost of providing payroll services, you must calculate the number of hours that each staff member spends on payroll. The most accurate method of calculating this is to use timesheet data. Record the hours each staff member spent on the payroll function, along with their hourly pay rates and the prorated costs of benefits for those employees. Only include payroll hours - if the staff members providing payroll services also perform other duties, do not include the other duties.

If you do not have this level of timesheet data, it will be important to establish a process for hourly timesheet reporting over multiple pay periods to ensure accurate data collection. Conduct a periodic timesheet analysis to determine how the payroll staff spend their time over the course of a typical period (such as a quarter) and update this analysis at least once or twice a year.

Example B: Calculating Facility Maintenance Costs

Use the same method to calculate the maintenance costs for facilities that are shared by multiple departments. This example is for a hypothetical City Hall. Be sure to include the costs of materials and any contractors that provide janitorial or other facility maintenance services.

Step 3: Determine Allocation Factors

Next, determine a fair and equitable way to spread those costs among the various departments, funds, or programs that benefit from the shared services. Use numbers that are easy to gather or estimate and that can be easily updated in the future to keep the cost allocation plan current.

Remove any costs that should not be allocated, costs that can be assigned directly, and any other agreed upon revisions that do not diminish the "cost-basis" of the plan.

Key questions to consider:

• What allocation method makes the most sense? Allocation methods may vary depending on the type of cost. For instance, below are some common cost allocation methods:
  • Payroll and personnel: Number of full-time equivalents (FTEs) or number of hours worked within each department or fund.
  • Accounts payable/purchasing: Number of transactions for each department or fund.
  • Financial reporting and budgeting: Budget appropriation levels or year-end fiscal totals.
  • Facility operations and maintenance: Square footage or number of employees in the building for each department or fund.
  • Information technology: Number of computers, servers, databases, etc. for each department or fund
• How will you document the cost estimates? For instance, when allocating wages, salaries, and benefit costs for services such as payroll, budget development, or financial reporting, conduct a periodic timesheet analysis.

Example A (Continued): Determining Payroll Allocation Factor

Payroll costs largely depend on the number of employees your jurisdiction has, so the allocation factor is typically full-time equivalent (FTE) positions. This means that the cost of the payroll function is allocated to the different departments based on the number of FTEs within each department.

Example B (Continued): Determining Facility Maintenance Allocation Factor

Facility maintenance costs depend in large part on the size of the facility, so the allocation factor for facilities maintenance is typically square footage (SF). This means that the facility maintenance costs for City Hall are allocated based on the number of square feet that each department occupies.

Step 4: Allocate Costs

Next, allocate the costs by applying the allocation factors to each department, program, or fund based on their proportionate share (a "one-step" methodology). Again, be sure to thoroughly and consistently document your calculations.

Larger or more complex organizations would typically use either a "two-step" methodology (allocating overhead costs to direct users and to those departments that use the services of the direct users) or reciprocal allocation methodology (allowing for overhead to be allocated back and forth between departments).

Example A (Continued): Allocating Payroll Costs

The payroll overhead costs are being allocated on the basis of FTEs per department. The following chart shows what that might look like based on the size of the departments in this example.

Note that the Finance and Payroll Department cannot allocate all of the payroll costs to other departments and must retain some of those costs internally, because some of the time is spent on payroll for employees within the department.

In this example, Finance and Payroll would retain $1,270 of the payroll costs and allocate the remaining costs to the other departments.

Example B (Continued): Allocating Facility Maintenance Costs

The facility maintenance costs for City Hall are being allocated on the basis of square footage per department. The following chart shows what that might look like based on the how much space each department occupies within City Hall.

Step 5: Update and Monitor the Data and Methodology

You should periodically review your cost allocation formulas and data to make sure they continue to accurately reflect costs. Incorporating an annual review as a pre-budget development step will help enhance your budget forecasting numbers and update your cost methodology.

Key Questions to Consider:

• What are your internal controls to ensure data accuracy and reviews? Incorporating internal control measures into the cost allocation plan demonstrates a commitment to accurate and reliable data.
• Did you use estimates or budget projections (as opposed to actual costs) in your allocation process? If so, you should include a monitoring component at the end of the year to make sure that the estimated and actual costs are within the acceptable range as defined by your cost allocation plan. Any variances outside of the acceptable range will require adjustment.
• How often will you update your calculations? You should review and update your data at least once a year, and perhaps more frequently for some figures such as public works timesheet information.

Examples of Cost Allocation Plans and Documents

Below are examples of cost allocation plans, studies, and related documents that may be useful, focusing in particular on small to mid-size jurisdictions.

Cost Allocation Plans, Policies, and Studies

• Arlington Cost Allocation Policy (2017) - on pages 31-32 of the comprehensive financial policies
• Bainbridge Island Cost Allocation Manual (2017) - Detailed goals, background, and methodology for the city’s cost allocation plan.
• Bremerton Overhead Cost Allocation Memo (2012) - Recommendations from the city auditor on how to improve the city's cost allocation process
• Monroe Cost Allocation Plan (2014) - Short, three-page cost allocation plan, changes city’s cost allocation method from estimated costs to a two-year "look back" method. Includes adopting resolution.
• Napavine Draft Central Services Cost Allocation Plan (2016) - Includes descriptions of central services and cost allocation methodology.
• Poulsbo Indirect Cost Allocation Plan (2012) - Easy-to-understand cost allocation methodology for all city departments and functions
• Skagit County Central Services Cost Allocation Plan (2021) - Includes summary and detail components, financial information for internal funds, and reconciliation of net position.
• Stevenson Cost Allocation Plan (2016) - Short, four-page cost allocation plan.

Cost Allocation RFPs

• Kennewick RFP for cost allocation plan/comprehensive rate study (2010) - RFP for the development of a full cost allocation plan and a comprehensive fee and rate study for development-related services

Recommended Resources

Below are some useful resources from the State Auditor's Office (SAO) and Government Finance Officers Association (GFOA) to help you create an effective cost allocation system.

• SAO Resources Database: Cost Allocation - Simple, three-page overview, including common cost allocation mistakes
• SAO BARS GAAP Manual: 3.9.5 Overhead Cost Allocation
• SAO BARS Cash Basis Manual: 3.9.5 Overhead Cost Allocation
• GFOA: Indirect Cost Allocation (2014) - GFOA best practices
• GFOA: Pricing Internal Services (2013) - GFOA best practices for cost allocation for internal services such as IT, payroll, legal, and HR
• GFOA: Cost Analysis and Activity-Based Costing for Government (2004) - For-purchase publication

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