How a company allocates its overhead and internal support costs—of information systems, production control, and other internal services—to its various production departments or projects can impact the profitability of those departments or projects

While the allocation may not affect the firm’s profit as a whole, the allocation can make the profitability of some departments and projects (and their managers) look better or worse than they should. In other cases, the allocations can affect the decisions of managers and, as the following article shows, competition.

Cost Allocation and the United States Postal Service^*

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In recent years, cost allocation at the United States Postal Service (USPS) has been a hotly contested business and political issue. The dispute centers on how USPS splits its fixed “institutional” costs, such as driver salaries, trucking fees, and other overhead expenses, between its two businesses: the “market dominant” letter business (a government-protected monopoly) and the “competitive” package business (which competes against United Parcel Service [UPS] and FedEx, among others).

In 2017, the “market dominant” business accounted for 97% of USPS volume and 70% of revenue, while the “competitive” business comprised only 3% of volume, but 30% of revenue. USPS is required to cover the costs of its competitive business but how much of fixed costs should be allocated to this business? U.S. law requires USPS to cover at least 5.5% of its fixed costs with revenue from the “competitive” package business (although, based on volume, only 3% of fixed costs would be allocated). UPS and FedEx argue that the “competitive” business should pay a larger share of the fixed costs—approximately 30%, which is in line with USPS package-delivery revenue. They believe that by allocating lower costs to the competitive business, USPS charges lower package shipping rates and unfairly subsidizes the “competitive” business with the monopoly “market dominant” business.

Companies like Amazon want to keep the share at 5.5%, or even eliminate it entirely, because they rely heavily on USPS to ship their orders and would like to keep delivery prices low. These heavy-shippers argue that cost allocation should be based on volume, not revenue. Some observers believe that increasing the cost allocation and raising shipping prices on Amazon, which accounts for 25% of USPS “competitive” revenue, would encourage Amazon to create its own infrastructure around the so-called “last mile”—that is, putting things directly into the hands of customers—that USPS has had in place for the past century. That would potentially result in a significant drop in the contribution of the “competitive” business to overall USPS revenue.

The same allocation dilemmas apply when costs of corporate support departments are allocated across multiple divisions or operating departments at manufacturing companies such as Nestle, service companies such as Comcast, merchandising companies such as Trader Joe’s, and academic institutions such as Auburn University. This chapter focuses on the challenges managers face when allocating costs and revenues and the consequences of those allocations.