What is allocation-based selection?

Allocation base selection is the process of determining the appropriate driver for allocating indirect costs to cost objects such as projects, departments, or clients. For professional service firms, common allocation bases include direct labor hours, direct labor cost, revenue, and headcount. The selected base should reasonably reflect the relationship between the cost being allocated and its consumption.

Key characteristics

• Determines how indirect costs are distributed

• Should reflect cost consumption patterns

• Common bases: hours, cost, revenue, headcount

• Different costs may use different bases

• Affects the reported project and client profitability

• Should be reviewed periodically for appropriateness

Why it matters for professional service firms

The allocation base significantly affects reported profitability. Using revenue as the base for IT costs penalizes high-revenue projects; using headcount may be more appropriate. Professional service firms should select allocation bases that reasonably reflect cost consumption and review them periodically as business changes. Inappropriate bases distort profitability analysis and decision-making.

Real-world example

Jennifer's firm allocated all overhead based on revenue. Analysis showed this penalized large projects unfairly since IT support did not vary with revenue. Revising allocation base selection: IT costs allocated by headcount (reflects actual users), rent allocated by headcount (reflects space usage), and admin allocated by revenue (reflects complexity served). Result: project profitability changed significantly. One large, previously low-margin project became profitable when IT allocation was based on headcount rather than revenue. Allocation-based selection revealed true profitability.