Chapter Seven

Cost Allocation: Theory

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Outline of Chapter 7
Cost Allocation: Theory

 Pervasiveness of Cost Allocations

 Reasons To Allocate Costs
 Incentive/Organizational Reasons for Cost
Allocations

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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.

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 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.

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 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.

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 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
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 External Cost-based Contracts

 Usage: Some institutions without strong profit motives 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.

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 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.
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 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

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 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
resources with higher cost allocation rates.
 Example shows imposing an overhead rate R on
salespersons decreases the optimum level of
salespersons. This is economically equivalent to a
payroll tax on salesperson compensation.

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 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?

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 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.
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 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.

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 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).

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 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.

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 Choice of Allocation Base
 The measurable activity in the allocation base should be closely related
to the hard-to-measure opportunity cost.
 Good base: Allocating utility costs with meters for each department.
 Worse base: Allocating utility costs based on floor space.

 Examples of allocation bases (Table 7-5):

 Overhead Cost Allocation Bases
 Executive salaries Time spent or personnel costs
 Central office rent Square footage or personnel costs
 Advertising and marketing Time spent or number of customers
 Data processing and Time spent or number of accounting
transactions

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 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: Share of sales or costs of each division.

 Both schemes motivate mangers to reduce waste of

common resources, but they differ in other incentives.

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 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.

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 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.

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