An allocation is the process of shifting overhead costs throughout an organization. One company might want to distribute costs across business units or departments. Another might want to assign costs to individual products or projects. Fundamentally, the smartest approach to allocations is about properly assigning costs to the areas that benefit from those costs.
When organizations allocate costs, they benefit from more accurate financial reports that show a greater level of detail. By properly allocating the costs, we can see true profitability results and make strategic decisions based on those results.
These detailed results give organizations the ability to answer questions such as:
Are we making money on this project?
Should we stop selling this product?
What personnel changes should we make?
Four key phrases in the allocation process
There are four key phrases associated with allocations. These are:
Source – The source is simply the original value. This is the value that will be allocated or moved somewhere.
Driver – This is the basis for allocation calculations. Drivers can be dollars, units sold, headcount, etc. These are tangible items that are used to determine how to spread the source costs.
Target – The target is where you want to move the cost to. The source is where you start from, the target is where you move it.
Offset – An offset is typically a negative value associated with that target. This is used to create a balanced accounting entry and ensure that your end result is the same as your starting value.
How do you perform an allocation? First, you calculate the allocation amount. We use the driver to help determine a percentage to spread the cost. For example, a company has an office with two different departments. A very simple allocation takes the overall office costs, splits them in two, and allocates a piece to each department. In this example, the allocation percentage is half. Once the amount is defined, we post a journal entry to both move the allocated amount into the target and remove the amount from the source.
This is a very simple explanation of allocations. In the real world, some companies take a complex approach to allocations.
A complex approach to allocating product costs
One Revelwood client in the healthcare industry asked us to create an allocation model for their IBM Planning Analytics environment. They wanted to allocate a series of product costs by territory and customer combinations. The organization has multiple product categories such as commercial products, Medicare products and Medicaid products.
We tackled this challenge by designing an allocation model that could be added into their existing planning and reporting model. The new model allows the company to calculate allocation percentages by utilizing a series of methods. These methods included:
Using a standard allocation approach to calculate percentages via drivers that could be easily redefined
Defining a fixed percentage for a single product, then allocating the remaining percentage to all other products
Defining fixed percentages to existing subsets of products and then allocating those percentages into the specific products within each subset
Defining a percentage to an ad-hoc subset of products and allocating only to those products
Incorporating various combinations of these methods
This Planning Analytics allocation model uses a two-step process. First, it calculates the allocation percentages. Next, it uses the calculated percentages to allocate costs by entity, customer, product, territory and more. The model offers the financial team the flexibility to use an allocated series of independent expenses using a variety of drivers and approaches. This unique approach allows the team to separate the allocations into pieces and analyze the details throughout the process.
This approach saved the business a significant amount of time. Before Planning Analytics, the company spent days creating allocation calculations in Excel. With Planning Analytics, the company can now complete this process in approximately four minutes.