McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Cost Allocation: Theory Chapter Seven

7-2 Connection of Cost Allocation to Other Chapters in this Book Chapter 2 (costing for decision making): Cost allocations might be used as proxies for opportunity costs. Chapter 4 (organizational architecture): Cost allocations are a form of transfer pricing and are useful for control. Chapter 5 (responsibility centers): Cost allocations influence decision rights and performance measurement. Chapter 6 (budgeting): Cost allocations influence how resources are allocated within the firm. Chapter 8 discusses practical problems of cost allocation. Chapters 9 through 13 (product costing): Indirect manufacturing costs are allocated to products.

7-3 Definitions and Glossary Cost object is a product, process, department, or program that managers wish to cost. Common cost is a cost shared by two or more cost objects. Examples: Accounting, building maintenance, supervisors. Cost allocation is the assignment of indirect, common, or joint costs to cost objects. Allocation base is the measure of activity used to allocate costs. Examples: hours, floor space, sales dollars.

7-4 Steps of Cost Allocation 1. Defining the cost objects. Decide what departments, products, or processes to cost. 2. Accumulating the common costs to be assigned to the cost objects. (Also known as indirect cost pools.) 3. Allocating the accumulated costs to cost objects using an allocation base. (Also known as cost assignment, apportionment, or distribution.) Usually the allocation base approximates how the cost objects consume common resources. See Self-Study Problem.

7-5 Surveys of Cost Allocation Practices by Large Corporations What corporate-level costs are allocated to profit centers? Most often: selling and distribution expenses Least often: income taxes What allocation bases are used? Meter: measure actual use Negotiate: estimate usage Prorate: based on relative proportions of sales, profits, or assets

7-6 External Cost-based Contracts Usage: Some organizations purchased goods and services with cost-based contracts. Suppliers were paid for their reported costs plus a stated profit percentage. Examples: Military aircraft, hospital services, university research grants. Incentives: Contractors maximize the indirect costs allocated to cost-based contracts. Responses: 1.Tighter regulation of cost allocation practices. 2.Abandon cost-based contracts in favor of fixed-price contracts.

7-7 External Reasons for Cost Allocation External financial reports:  Allocate production costs between expenses (expired costs, such as cost of goods sold) and assets (unexpired costs, such as ending inventory. Income taxes:  Uniform capitalization (“Unicap”) rules of the tax law prescribe when product costs can be deducted. Cost-based reimbursement:  Some government contracts and regulated industries use cost-plus contracts. Bookkeeping costs are reduced if the same costs are used for external and internal reporting.

7-8 Internal Reasons for Cost Allocation Decision Making  Managers will try to reduce their use of common resources that have relatively high cost allocation rates Decision Control  Central executives can control behavior of operating managers with cost allocation policy  Allocating more costs to a center constrains that center from using other resources

7-9 Cost Allocations are a Tax System Cost allocations are economically equivalent to taxes on resource factors. Increasing cost allocation rates (or taxes) decrease profits reported by the center bearing the allocated costs. Increasing the cost allocation rate (or taxes) motivates profit-maximizing managers to use less of the cost allocation base. Example shows imposing an overhead rate R on salespersons decreases the number of salespersons. This is economically equivalent to a payroll tax on salesperson compensation.

7-10 Even in the Federal Reserve System … The Fed reportedly shifted the allocation of costs from competitive services and markets to less competitive services. This allowed the Fed to “justify” charging lower prices in its competitive services and higher prices for its less competitive services. Who was best served by this process?

7-11 Microeconomic Analysis of Cost Allocation (Figures 7-1 – 7-2) Manager’s decision problem: Minimize cost to produce sales level Q by choosing levels for two inputs: advertising (A) and salespersons (S). With no cost allocation: Costs = PaA + PsS With cost allocation, overhead rate R is added to salesperson costs: Costs = PaA + (Ps+R)S Since R makes sales persons more expensive, the optimum level of salespersons decreases from SY to SZ. Some advertising is substituted for salespersons, and the optimum level of advertising increases from AY to AZ.

7-12 Allocation Proxies for Externalities Positive externalities are benefits imposed on other individuals without their participation in the decision and without compensation for the benefits imposed on them. Negative externalities are costs imposed on other individuals without their participation in the decision and without compensation for the costs imposed on them. When costs are allocated, the overhead rate is a proxy for externalities that are hard to measure.

7-13 Average Overhead Rate as a Proxy for Marginal Opportunity Costs Externality: Adding more salespersons degrades human resource department services for all users. Marginal cost (MC): Slope of smooth opportunity cost. MC is constantly increasing along the curve. MC is hard to measure. Overhead rate (R): The average cost approximated by dividing total accounting cost by the number of salespersons. R is the slope of the dashed line in Figures 7-2, 7-3, and 7-4. Allocation is better for decision making when R>MC. (Case 1 and 2). Allocation might or might not be better when R>MC. (Case 3).

7-14 Multiproduct Firm Caveat In multiproduct firms, the average cost curve for each product might not be well-behaved. Thus, applying the preceding analysis may be problematic. However, if most externalities arise due to additional employees then the text’s analysis continues to hold as long as the total cost (including externalities) as a function of the number of employees is well- behaved.

7-15 Choice of Allocation Base The measurable activity in the allocation base often is closely related to the hard-to-measure opportunity cost. Allocation Bases:  Time spent or personnel costs  Square footage or personnel costs  Time spent or number of customers  Time spent or number of accounting transactions

7-16 Insulating vs. Noninsulating: Defined Insulating allocation scheme: The allocation base is chosen so that the costs allocated to one division do not depend on the operating performance of some other division. Example: Floor area or a fixed pre-determined rate. Noninsulating allocation scheme: The allocation base is chosen so that the costs allocated to one division does depend on the operating performance of some other division. Example: Fixed percentage to each division. Both schemes motivate mangers to reduce waste of common resources, but they differ in other incentives.

7-17 Insulating vs. Noninsulating: Incentives Insulating cost allocation:  Performance of a division does not influence rewards for others.  Each division bears its own risk of events outside its control. Noninsulating allocation:  Creates incentives for mutual monitoring and cooperation because rewards depend on each other  Reduce risk to managers of events outside their control. If random events are uncorrelated across divisions, then when one division is doing poorly, the others are probably doing well and bear more of the costs.

7-18 Appendix: Cost Allocation as Taxes The standard economic solution See Figure 7-5 Cost allocations See Figure 7-6 Substitute away from the more expensive input, salespeople, and toward the relatively cheaper input, advertising.