To illustrate further of the complexity of cost allocation, let us give an illustration as follows:
A, B, and C is having lunch together in a pizza parlor, where only A and B are paying (they are giving C a treat because today is his birthday). They order a pan of pizza, assuming that the pizza have been sliced into eight slices. Suppose that A eats 4 slices, B eats 2 slices, and C eats 2 slices.
The total cost of pizza is 800. How should that cost be divided between A and B?

There are two solution that I'm going to propose to you:

A> Each slice gets allocated 100, so A will get 400, B will get 200, and C will get 200. But since C is not paying, then his 200 will be allocated to A and B proportionally based on relative slices eaten. So A will get an additional 400 / (400+200) x 200 = 133 so he get a total of 533, and B will get an additional 200 / (400+200) x 200 = 67 so he get a total of 267.
B> Each slice gets allocated 100, so A will get 400, B will get 200, and C will get 200. But since C is not paying, then his 200 will be allocated to A and B equally. So A will get an additional of 100 so he get a total of 500, and B will get an additional of 100 so he get a total of 300.

Now which one is the most logical?

The solution B> is the most logical. Here we learn that cost allocation need not necessarily done in one go, but can be in sequences. Let us view the pizza costing 800 as a resource, and that A, B, and C are the users of that resources. We can see that C here, because he is not paying, can not be considered an end user, so the cost allocated to him must be further allocated to the real end users, in this case A and B.

In the first illustration, we allocate the cost of pizza based on the most logical resource usage, that is the slices of pizza actually consumed. Therefore in allocating the cost remaining in C toward A and B, we must do so based on the most logical way. In absent of any other information, then the most logical way is to split the cost equally, as illustrated in B>.

We can take the problem further by adding another information: C is actually the friend of A, and B have never met C before. Therefore, it become logical that A should bear the whole cost of C alone, because C is his friend. B who have never known C before should not be burdened with the cost. Unless, of course, B have agreed in advance that he will also bear the cost of C.

Cost Allocation is the foundation of all knowledge in Cost Accounting. Here we will illustrate what is Cost Allocation.

Suppose that A and B are having lunch together by ordering a pizza; a large Meat Lovers with Stuffed Crust. We shall assume that a large pizza consists of eight slices, as is common in all pizza parlors. The cost for the pizza is 800. Now, we need to allocate that cost (800) to A and B, to find out how much does A really incurs and how much does B really incurs in cost.

First of all, we can take the simplest approach, and equally divide the cost for A and B. This way A gets allocated 400, and B gets allocated 400. In the absence of any other information, then we can say that this method of allocation is reasonably accurate.

However, suppose that we get an additional information that A is consuming 5 slices of pizza, while B is consuming 3 slices of pizza, then our previous method becomes inaccurate. Our method of dividing the cost equally between A and B does not reflect the actual cost incurred by each person.

To improve our method of cost allocation, we can use the newly available information, the actual slices of pizza consumed by each person. We reason that allocating based on slices of pizza actually consumed is more reasonable and more accurate than simply dividing the cost equally. Therefore, A will be allocated 5/8 x 800 = 500, and B will be allocated 3/8 x 800 = 300.

We can go even further by finding out if the slices in a pan of pizza are of equal size. Sometimes it happened that the pizza chef did not slice the pizza exactly in the middle, so the resulting slices will be of different sizes. If the information about the size of each slices of pizza can be obtained in an economically feasible way, including the future pizza lunches they will be having together again, then we are justified in using that information to further increase the accuracy of our cost allocation method. But as we can see, it will not be easy to find out the size slices that A and B actually eat, and it will be quite difficult and inconvenient for them to measure every slice of pizza that they are going to eat, so the use of this information will not be justified.

-- to be continued --