Learning Objective 4 Understand criteria to guide cost-allocation decisions
such as identifying factors that cause resources to be consumed
Exhibit 15-8 presents four criteria managers use to guide cost-allocation decisions. These decisions affect both the number of indirect-cost pools and the cost-allocation base for each indirect-cost pool. As we have indicated in previous chapters, we emphasize the superiority of the cause-and-effect and the benefits-received criteria, especially when the purpose of cost allocation is to provide information for economic decisions or to motivate managers and employees. Cause and effect is the primary criterion used in activity-based costing (ABC) systems. ABC systems use the cost hierarchy to identify the cost driver that best represents the cause-and-effect relationship between an activity and the costs in the related cost pool. The cost drivers are then chosen as cost-allocation bases. Cause and effect is often difficult to determine in the case of division-sustaining and corporate-sustaining costs. In these situations, managers and management accountants interested in allocating costs use other methods, such as benefits received, fairness (or equity), or ability to bear, summarized in Exhibit 15-8.*
Exhibit 15-8
Criteria for Cost-Allocation Decisions
Details of the four criteria for decision making are as follows:
Cause and Effect. Using this criterion, managers identify the variables that cause resources to be consumed. For example, managers may use number of sales orders as the variable when allocating the costs of order taking to products and customers. Cost allocations based on the cause-and-effect criterion are likely to be the most credible to operating personnel.
Benefits Received. Using this criterion, managers identify the beneficiaries of the outputs of the cost object. The costs of the cost object are allocated among the beneficiaries in proportion to the benefits each receives. Consider the decision of how to allocate corporatewide advertising costs to divisions when these costs promote the general image of the corporation rather than specific products of the divisions. The costs of this program may be allocated to divisions on the basis of division revenues; the higher the revenues, the higher the division’s allocated cost of the advertising program The rationale behind this allocation is that divisions with higher revenues presumably benefited more from the advertising than divisions with lower revenues and, therefore, ought to be allocated more of the advertising costs
Fairness or Equity. This criterion is often cited in government contracts when cost allocations are the basis for establishing a price satisfactory to the government and its suppliers. Cost allocation here is viewed as a “reasonable” or “fair” means of establishing a selling price in the minds of the contracting parties. For most allocation decisions, fairness is a matter of judgment rather than an operational criterion.
Ability to Bear. This criterion advocates allocating costs in proportion to the cost object’s ability to bear costs allocated to it. An example is the allocation of corporate administration costs on the basis of division operating income. The presumption is that the more-profitable divisions have a greater ability to absorb corporate administration costs.
The best way to allocate costs if cause and effect cannot be established is to use the benefits-received criterion by identifying the beneficiaries of the output of the cost object. Consider, for example, the cost of managing the wholesale channel for Provalue, such as the salary of the manager of the wholesale channel. There is no cause-and-effect relationship between these costs and sales made by wholesalers. But it is plausible to assume that customers with higher revenues benefited more from the wholesale-channel support than customers with lower revenues. The benefits-received criterion justifies allocating the costs of managing the wholesale channel of $800,000 to customers based on customer revenues.
Fairness and ability to bear are less frequently used and more problematic criteria than cause and effect or benefits received. It’s difficult for two parties to agree on criteria for fairness. What one party views as fair another party may view as unfair.* For example, a university may view allocating a share of general administrative costs to government contracts for scientific and medical research as fair because general administrative costs are incurred to support all activities of the university. The government may view the allocation of such costs as unfair because the general administrative costs would have been incurred by the university regardless of whether the government contract existed. Perhaps the fairest way to resolve this issue is to understand, as well as possible, the cause-and-effect relationship between the government contract activity and general administrative costs. This is difficult. In other words, fairness is more a matter of judgment than an easily implementable choice criterion.
To get a sense of the issues that arise when using the ability-to-bear criterion, consider Customer G where customer-level costs exceed revenues before allocating any division-sustaining or corporate-sustaining costs. This customer has no ability to bear any division- or corporate-sustaining costs, so under the ability-to-bear criterion none of these costs will be allocated to Customer G. The logic for not allocating these costs to Customer G is that Provalue Division managers will reduce Customer G’s demands on division- and corporate-sustaining costs (such as administration costs) to restore Customer G’s profitability. However, if division- and corporate-sustaining costs are not reduced but simply allocated to other customers, these customers would subsidize Customer G. The ability-to-bear criterion would then result in artificially lower customer profitability for profitable customers and the potential for incorrect actions, such as increasing prices to restore profitability, which might invite competition.
Most importantly, companies must weigh the costs and benefits when designing and implementing their cost allocations. Companies incur costs not only in collecting data but also in taking the time to educate managers about cost allocations. In general, the more complex the cost allocations, the higher these education costs.
The costs of designing and implementing complex cost allocations are highly visible. Unfortunately, the benefits from using well-designed cost allocations, such as enabling managers to make better-informed sourcing, pricing, and cost-control decisions, are difficult to measure. Nevertheless, when making cost allocations, managers should always consider the costs as well as the benefits. As the costs of collecting and processing information decrease, more detailed cost allocations will be better able to pass the cost–benefit test.
