Allocation base

What it means

An allocation base is the measure used to spread indirect costs, meaning overheads, over products, jobs or cost centres. It might be labour hours, machine hours, floor space, direct wages or direct materials.

While direct costs can be traced unambiguously to a specific product, overheads such as rent, energy or administration have to be divided using a key. The allocation base is that key, and its choice determines how much overhead each product carries in costing.

The ideal base has a direct causal link to how costs arise. If production overheads are driven mainly by machines, machine hours are the logical base; if by manual work, labour hours. With diverse overheads, activity-based costing with several bases gives a more accurate picture.

How it works in practice

In practice, overheads are first collected in cost centres and then allocated to outputs using the chosen base. For example, workshop overheads are divided by machine hours, administrative overheads by production cost and selling overheads by sales.

In services, such as an accounting firm, the typical base is time worked. Office overheads, software and administration are allocated to clients by hours, revealing which clients are profitable and which pay prices that do not cover actual costs.

The chosen base should be described in an internal policy and applied consistently. When valuing own-produced inventory and work in progress in the accounts, it is also a matter of correct asset valuation, not just management information.

What to watch out for

A poorly chosen base distorts costings. If the overheads of automated production are allocated by labour hours, labour-intensive products will look more expensive than they are and automated ones cheaper. The company may then set the wrong prices.

When technology or the production mix changes significantly, the base must be revisited. A key that made sense ten years ago may no longer reflect reality, and outdated costings can lead to decisions that harm the company.