What is Cost Allocation?
Cost allocation is the process of assigning indirect costs (overhead) to cost objects such as products, services, departments, or projects using rational and consistent cost drivers. It enables more accurate product costing, pricing, performance measurement, and inventory valuation under IFRS.
How It Works
- Pool indirect costs into homogeneous categories (e.g., utilities, maintenance, depreciation).
- Identify a cost driver for each pool that best reflects causation (e.g., machine hours, square meters).
- Compute an allocation rate: pool cost / total driver units.
- Apply the rate to each cost object based on its driver usage.
- Refine using activity-based costing (ABC) for greater accuracy.
Saudi Context
Saudi manufacturers, hospitals, and shared-service centers allocate large overhead pools across business units. ZATCA’s transfer pricing rules require Saudi entities transacting with foreign affiliates to use defensible allocation methods, often documented in transfer pricing local files and master files.
Example
A factory has SAR 600,000 of monthly overhead and operates 30,000 machine hours per month, giving an allocation rate of SAR 20 per machine hour. A product requiring 4 machine hours absorbs SAR 80 of overhead, which is added to its direct material and labor costs for full product costing.