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Internal cost allocation: definition, example & tools

Internal cost allocation offers companies many advantages, such as cost transparency, pricing and resource allocation. Read how ZEP facilitates this process & can boost your company's performance.
Internal cost allocation: definition, example & tools!

Internal cost allocation may seem like a dry and highly bureaucratic topic at first glance, but it plays a crucial role in the efficiency and competitiveness of your organisation. In this blog post, we will take an in-depth look at this important process and find out how ZEP can help you manage your business.

Table of contents - What you can expect:

Example of internal cost allocation
Why is internal cost allocation important?
Internal cost allocation: Advantages of ZEP

What does "internal cost allocation" mean?

Internal cost allocation (ICA) is a procedure for allocating services provided within a company between different departments or cost centres. The aim is to allocate the costs of these internal services transparently and in line with their origin in order to better manage and control the profitability and efficiency of the company's divisions. For example, the costs of IT services provided by the IT department for other departments or cost centres are allocated to the cost centres. Departments are allocated to these accordingly. This is done through internal postings without actual cash flows taking place.

The costs charged are calculated as follows

Allocated costs in internal activity allocation are calculated by determining and allocating direct and overhead costs to the various cost centres and cost units. Transfer prices are determined on the basis of full costs, partial costs, market or negotiated prices. These costs are then recognised in the accounts to ensure accurate and transparent cost allocation within the company.

Example of internal cost allocation: Here's how it works

An example of internal cost allocation helps to make the process easier to understand. Let's assume a company has two departments: the IT department and the production department. The IT department develops a software tool for the production department.

Step-by-step example:

1. cost type analysis IT department determines costs:

10,000 for software licences,

5,000 € for hardware,

8,000 for salaries,

2,000 € for rent.

2. cost centre accounting Total costs of the IT department: € 25,000.
3. cost unit accounting Allocation of the total costs (€ 25,000) to the production department.
4. transfer prices Transfer price on a full cost basis: € 25,000.
5. accounting entry IT department issues an internal invoice to the production department for € 25,000.

Booking: IT department -€25,000, production department +€25,000.

Result:

The production department now bears the costs for the software tool totalling € 25,000, while the IT department books these as services rendered. This ensures a transparent and causal allocation of internal costs and helps the company to better manage efficiency and profitability.

The challenge in internal cost allocation lies in the fact that cost centres can receive services from others and pass on services themselves. This requires complex mathematical procedures to correctly map simultaneous allocations. There are alternative approximation methods due to the high effort involved:

Equation method

The simultaneous calculation of the allocation rates of all auxiliary cost centres using linear equations ensures a clear solution, although formulating the equations is time-consuming. This method accurately captures interdependencies between cost centres, such as electricity deliveries to the turbine maintenance workshop, and can be facilitated by IT solutions.

Block process

The block method neglects the consideration of activity allocations from upstream cost centres and is therefore a rough method. It is recommended to avoid it as far as possible, as the result does not correspond to the actual circumstances.

Step ladder procedure

The ladder method organises activity dependencies to avoid cycles and enables planned and actual activity allocation in successive stages, but it cannot provide an exact solution for cyclical activity relationships.

Why is internal cost allocation important?

The importance of internal cost allocation in companies cannot be overlooked. After all, this process plays a central role in the management and optimisation of resources. Below, we'll take a closer look at why internal cost allocation is so important and how it can help your organisation improve performance and ensure long-term profitability.

1. performance appraisal

One of the main reasons why organisations use internal cost allocation is the ability to assess performance. By allocating costs at departmental level, you can recognise which departments or teams are working particularly efficiently and which may be inefficient. This allows you to take targeted action to improve performance and optimise the use of available resources.

2. cost transparency

Internal cost allocation creates transparency about cost structures and expenditure in different departments. This gives your management a clear overview of how resources are allocated within your organisation. This transparency is crucial for making better-informed decisions about budgets and Resource planning to meet.

3. pricing

If your company offers various products or services, internal cost allocation can help you set prices. By taking internal costs into account, you can ensure that prices are reasonable and at the same time take profit margins into account.

4. resource allocation

Companies have limited resources, be it in the form of labour, machinery or finances. Internal cost allocation helps you to ensure that these resources are utilised efficiently by showing which departments or projects use the most resources and which use fewer. This allows you to optimise the distribution of all available resources.

5. cost efficiency & budget control

Do you want to keep an eye on your costs and ensure that you stay within budget? Internal cost allocation is crucial for avoiding unnecessary expenditure and ensuring the financial stability of your company. With these clear insights into cost structures, you can manage budgets even more effectively.

6. motivation & incentives

Internal cost allocation systems can also serve as a motivational tool. Departments that save costs or work more efficiently can be rewarded, which increases motivation and leads to better performance. It creates an incentive system that encourages your employees to promote cost awareness and efficiency.

7 Compliance & Reporting

In some industries and for certain regulatory requirements, accurate internal cost allocation is required. This helps you to comply with legal requirements and prepare reports for external stakeholders. The accuracy and transparency of cost allocation is crucial for compliance.

Internal cost allocation with ZEP - these are the advantages!

Are you tired of doing your internal cost allocation manually and in confusing spreadsheets? Then you should think about using efficient software. We have something for you: ZEP! Our software makes it possible to track, allocate and control the costs of various activities, resources and services within your organisation. If your company is divided into several departments, country organisations or other structural levels, it is definitely worth purchasing specialised software. This is because it allows your employees to work cross-functionally despite structural divisions - communication channels are shortened and workflows optimised. Thanks to the internal cost allocation in ZEP, it is also clearly defined which expenses are shifted or allocated within the company. And this is how it works:

Step Description of the
1. 🧭 Departments > Call up analyses In ZEP, navigate to the "Departments" menu item and select the "Analyses" option.
2. 💰 Select cost allocation Click on "Cost allocation" to activate the corresponding function.
3. ⏳ Check internal hourly rate Before calling up the report, check the internal hourly rate of the assigned project employees, which is used for cost allocation or internal remuneration.
4. 🛠️ Adjust the hourly rate If necessary, adjust the hourly rate for each individual project and allocation period to ensure accurate cost allocation.
5. 📝 Create departments as "customers" Create the relevant departments in ZEP as "customers" to enable internal cost allocation.
6. 💵 Create fixed price invoice Create a fixed price invoice for the services provided based on the amounts stated in the evaluation.
7. 📑 Invoice the relevant department Issue the fixed price invoice to the relevant department (customer) for the services provided.
8. 📊 Use amounts from the evaluation The amounts stated in the analysis serve as the basis for internal cost allocation.

Conclusion

As you can see, internal cost allocation may seem complex, but it is of fundamental importance for the management and optimisation of company resources. It enables better performance assessment, creates cost transparency and can make a decisive contribution to employee motivation. With the right software such as ZEP, you not only increase your competitiveness, but also guarantee your long-term success. Profitability. Using ZEP makes this process much easier and provides clear insights into your company's cost structures.

Therefore: Don't see internal cost allocation as a mere bureaucratic evil, but as a strategic instrument for improving company performance. Rely on forward-looking planning and decision-making at management level to make your company more successful. That was too complex for you? No problem! All your questions about internal cost allocation with ZEP will be answered by our Support team - by mail or directly on the phone.

Tanja Hartmann CEP

Tanja Hartmann

Content Marketing Manager at ZEP

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