Introduction:
Area allocation is an important concept in the field of accounting and finance. It refers to the process of dividing or allocating costs among different departments or products based on their respective usage of resources. This article aims to explain the key terms related to area allocation.
1. Cost Pool:
A cost pool is a group of individual costs that are combined for the purpose of allocating them to specific departments or products. For example, the salary of the production manager and the cost of raw materials can be combined into a single cost pool for the production department.
2. Cost Driver:
A cost driver is a factor that determines the level of activity or usage of resources by a particular department or product. For example, the number of units produced can be a cost driver for the production department.
3. Direct Costs:
Direct costs are expenses that can be easily traced to a specific department or product. For example, the wages of the employees working in the production department are direct costs.
4. Indirect Costs:
Indirect costs are expenses that cannot be directly attributed to a specific department or product. For example, the rent of the factory building is an indirect cost as it benefits all the departments equally.
5. Allocation Base:
An allocation base is a measure used to allocate indirect costs to specific departments or products. For example, the square footage of the production department can be used as an allocation base for allocating rent expenses.
6. Overhead:
Overhead refers to the indirect costs that are incurred by a business. These costs include rent, utilities, insurance, and other expenses that are necessary for running the business but cannot be directly attributed to any specific department or product.
Conclusion:
In conclusion, area allocation is an essential tool for businesses to determine the true cost of producing a product or providing a service. By understanding the key terms related to area allocation, businesses can make informed decisions about pricing, resource allocation, and profitability.