W. BentzA&MIS 5251 Agenda for Session 14 Review motivation for cost allocation Review the criteria used to allocate cost in the US today Study 3 inter-activity allocation methods Illustrate the opportunity to influence costs using the step-down method. Discuss problem assignments

W. BentzA&MIS 5252 Motivation for Cost Allocation Provide unbiased information for economic decisions –Management planning & control –Operating control Example: Prairie State Paper Case Example: Nebraska Social Services Example: Canadian Air Force

W. BentzA&MIS 5253 Motivation for Cost Allocation Incent managers and employees –Financial plans & incentives –Feedback & scorekeeping –Make managers aware of the cost impact of their activities –A fundamental issue in this context is to attribute costs, revenues, cash flows, and investment to the responsible entities and individuals

W. BentzA&MIS 5254 Motivation for Cost Allocation Implement agreements –Cost sharing (joint ventures) –Cost reimbursement (programs, activities) –Cost-plus pricing (various contracts) Determine, justify and defend actions –Price discrimination lawsuits –Regulated industries –Antitrust proceedings

W. BentzA&MIS 5255 Other Objectives To satisfy financial, tax, and regulatory reporting requirements: –Quarterly reports to shareholders –Quarterly reports to creditors (if not more frequent) –Tax shifting and sharing among countries in which company operates –Regulatory reports

W. BentzA&MIS 5256 Cost Allocation In many settings, the manner in which costs are allocated can have a significant impact on the apparent success of projects, departments, programs, products, services, and managers. It is both an intra-firm issue and an inter-firm one.

W. BentzA&MIS 5257 Criteria Used to Allocate Costs Economic validity –Search for cause-effect relationships based on actual data –Find the more important cost drivers based on actual data –Has face validity

W. BentzA&MIS 5258 Another Criterion Benefits received –Use of common facilities Utilization of common facilities Products or services received –Use of resources or creation of liabilities Billings for services rendered per agreement or letter of engagement

W. BentzA&MIS 5259 More Criteria Fairness or equity –Implementation of an agreement –Appropriate in uncertain environments –Can reduce the risk premium

W. BentzA&MIS More Criteria Ability to pay –May or may not be “fair” –Joint product costing is a good example –Allocation of corporate expenses

W. BentzA&MIS Criteria to Evaluate Methods Validity of the results in an economic, accounting sense Understandability by users Perceived fairness of the results Usefulness to customers of the information Impact on the system (firm, economy, other)

W. BentzA&MIS Types of Costs Involved Variable costs (direct materials in joint processes) Capacity costs Common costs Joint purchases Shared costs (by agreement)

W. BentzA&MIS Allocation Methods Activity rates to charge users Proportional usage as in support activity cost allocation Estimates of relative exit values as in joint-product costing Opportunity cost as in linear programming Game theoretic as in Shapely method

W. BentzA&MIS Changing Directions…..

W. BentzA&MIS Attributes of Support Activity Cost Allocation Models Direct allocation to production activities –unique answer –biased if any service relationships are ignored in the process –answer always exists and can be computed using general purpose software

W. BentzA&MIS Step or sequential method Answer is unique only when the activities are acyclic and the allocation incorporates all service relationships. Answer always exists to realistic problems. Specialized software is needed to determine if activities are acyclic and to put them in the proper sequence.

W. BentzA&MIS Reciprocal Method Answer is unique. Answer is unbiased. Answer to the allocation equations always exists. Allocations can be done with standard software packages.

W. BentzA&MIS Summary of Attributes MethodDirectStep-downReciprocal Allocation is UniqueYesNoYes Allocation is BiasedMaybe No Understand -abilityHighestMiddleLowest Software Availability Not complex Most Involved High- General

W. BentzA&MIS Consider Hoosier Industries Let’s work through a problem next Please get the Hoosier industries problem from your packet now.