The process of assigning costs to one or more cost objects when it is not possible to trace a cost directly. Indirect costs (overheads) always have to be assigned to cost objects using cost allocations. The basis on which costs are assigned to cost objects is called the allocation base or cost driver. The purposes of cost allocation can be briefly summarised as follows:
•to provide information for decisions: an example would be deciding whether or not to replace a machine;
•to set selling prices;
•to measure profits accurately (product profitability and customer profitability);
•to motivate management or employees.
Two types of systems can be used to assign indirect costs to cost objects: traditional costing systems and activity-based costing. Traditional costing systems focus on product costs and are often criticized for relying on arbitrary allocations. Activity-based costing systems use cause-and-effect allocations.