In financial reporting, allocation of expenses means spreading the common expenses into different expense categories reported in the financial statements.
In the income statement, expenses are categorized into a few major classifications (for e.g., cost of goods sold, admin expenses, selling expenses etc.) and totals of all expenses incurred in a particular period are reported in the income statement. However, some expenses are related to more than one category of classification. Therefore, they cannot be categorized wholly in any of the categories. In such cases, the expense is allocated to different categories or types of expenses to be reported in the income statement.
For instance, depreciation is a common example of an expense that often needs allocation into cost of sales and general administrative expenses. Similarly, if an employee is working in the factory as well as in the administrative department, or the senior management is involved in various activities of the business, then the human resource expenses related to such employees need to be allocated into relevant cost classifications.
Question arises that how should we allocate the common expenses into different types? There is no hard and fast rule, but the allocation should be based on a reasonable basis. A good accountant will try to allocate the common expenses in such a way that the presentation of expenses is as close to actual activities as possible.
Let’s take a look at the following example of allocation of expenses.
Example – Allocation of expenses
A manufacturing company is preparing its financial statements for the year ended 31 December 20X0. The accountant is confused on how to allocate the depreciation expense into cost of sales, admin expenses and selling expenses.
Following is the detail of depreciation expense for the year:
- Plant and machinery: $11,000
- Office equipment: $5,000
- Furniture and fixture: $7,000
- Vehicles: $12,000
Plant and machinery is only related to the factory. Data of office equipment and furniture and fixture is not separately maintained for each department, so it is not possible to calculate department wise depreciation. Vehicles are also used for all operations of the company and cannot be linked to any specific type of activity.
Before depreciation, the breakup of expenses for the year is as follows:
- Cost of sales: $100,000
- Administrative expenses: $35,000
- Selling expenses: $12,000
How should the depreciation expense be allocated into above types of expenses?
Depreciation of plant and machinery is not a common expense and therefore will be fully allocated to cost of sales, as plant and machinery is only used in factory for production of goods. Depreciation of other categories ($24,000) is a common expense and needs to be allocated on some reasonable basis.
If we had some sort of data that showed us the time spent by each category of asset on each activity, then we could have allocated the depreciation on relative time spent basis. However, in the absence of such data, we can allocate the depreciation on the basis of relative expenses of each category.
Allocation of depreciation expense is shown below.