Redistributed cost, also known as cost allocation or cost redistribution, refers to the process of distributing indirect costs across multiple departments, products, projects, or activities. These indirect costs are not directly traceable to a specific product or department but are necessary for the overall functioning of an organization. Therefore, they are proportionately allocated to various cost objects based on a logical and systematic method.
The aim of cost redistribution is to:
- Achieve accurate product costing: By allocating indirect costs, businesses can more accurately determine the total cost and, consequently, the profitability of each product, service, or department.
- Enhance decision-making: Managers can make informed decisions regarding pricing, resource allocation, and performance evaluation when they have a clear understanding of total costs.
- Budgeting and Forecasting: Understanding the full costs helps organizations in budgeting, forecasting, and planning.
- Justify costs and expenses: Especially in service industries, cost redistribution can help in justifying the costs charged to clients.
Methods of Cost Redistribution:
Different methods can be used to allocate costs based on the nature of the costs and the business’s specific requirements. Some common methods include:
- Direct Method: Costs from each support department are directly allocated to the operating departments without considering the services rendered between support departments.
- Step-down Method: Also known as the sequential method, costs from one support department are allocated to other support and operating departments in a sequential manner. Once a support department’s costs are allocated, no other costs are allocated back to it.
- Reciprocal Method: This method recognizes mutual services rendered between support departments and allocates costs on that basis. It’s the most accurate but also the most complex method.
Example of Redistributed Cost
Let’s explore a more detailed example of redistributed cost involving a university allocating its facility maintenance costs across various departments.
Example: University Facility Maintenance Cost Redistribution
Background: Suppose “GreenField University” wants to allocate its central Facility Maintenance Department’s costs across its various academic departments. The university believes the fairest way to allocate these costs is based on the square footage each department occupies.
For the current fiscal year:
- Total Facility Maintenance Department costs: $500,000.
- Total university square footage: 500,000 sq. ft.
Details of Departmental Space:
- Science Department: 200,000 sq. ft.
- Arts Department: 100,000 sq. ft.
- Engineering Department: 150,000 sq. ft.
- Business Department: 50,000 sq. ft.
Cost Allocation Process:
First, determine the cost per square foot: = Total Maintenance Costs / Total square footage = $500,000 / 500,000 sq. ft. = $1 per sq. ft.
Next, redistribute costs based on departmental square footage:
- Science Department: = $1 x 200,000 sq. ft. = $200,000
- Arts Department: = $1 x 100,000 sq. ft. = $100,000
- Engineering Department: = $1 x 150,000 sq. ft. = $150,000
- Business Department: = $1 x 50,000 sq. ft. = $50,000
Outcome: Upon redistribution, each department receives an allocated cost that reflects its proportionate use of the university’s facilities. Departments can then include these allocated costs in their annual budgets, ensuring that each department shares the overall maintenance cost burden in proportion to their space usage.
This systematic approach helps the university in budgeting and provides a fair method for distributing central costs. Departments also get a clearer picture of their total operating expenses, including shared institutional costs.