CHAPTER SEVEN Cost Allocation: Theory

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-2 Outline of Chapter 7 Cost Allocation: Theory  Pervasiveness of Cost Allocations  Reasons To Allocate Costs  Incentive/Organizational Reasons for Cost Allocations  Appendix: Cost Allocations as Taxes

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-3 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-4 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-5 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-6 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-7 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-8 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.  Third-party 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-9 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Microeconomic Analysis of Cost Allocation (Figures 7-1 and 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 = P A A + P s S With cost allocation, overhead rate R is added to salesperson costs: Costs = P A A + (P s +R)S Since R makes sales persons more expensive, the optimum level of salespersons decreases from S Y to S Z. Some advertising is substituted for salespersons, and the optimum level of advertising increases from A Y to A Z.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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 accountingtransactions

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.