Consequences of an inappropriate allocation base

Cost figures play a key role in many important decisions. If these figures result from allocation

bases that fail to capture cause-and-efect relationships, managers may make decisions that con-

flict with maximising long-run company net income. Consider the use of direct manufacturing

labour costs as an allocation base in machine-paced manufacturing settings. In this environment,

indirect-cost rates of 500% of direct manufacturing labour costs (or more) may be encountered.

Thus, every €1 of indirect manufacturing labour costs has a €6 impact (€1 in direct costs + 500%

per €1 in indirect costs) on reported product costs. Possible negative consequences include the

following points:

1 Product managers may make excessive use of external suppliers for parts that have a high

direct manufacturing labour content.

2 Manufacturing managers may pay excessive attention to controlling direct manufacturing

labour-hours relative to the attention paid to controlling the more costly categories of

materials and machining. By eliminating €1 of direct manufacturing labour costs when the

indirect-cost rate is 500% of these costs, €6 of reported product cost can be eliminated. When

the indirect-cost rate is 500% of these costs, managers can control much of the accounting

amounts allocated to products by controlling direct labour use. However, this action does not

control the larger materials and machining costs actually incurred.

3 Managers may attempt to classify shop-floor personnel as indirect labour rather than as direct

labour. As a result, part of these labour costs will be allocated (inappropriately) to other products.

4 Products may be under- or overcosted. The danger then arises that a company will push to gain

market share on products that it believes are profitable when in fact they are unprofitable. Similarly,

the company may neglect products that are profitable because it believes they are unprofitable.