|
|
|
|
 |
 |
February 2006 Ask A Professor
|
|
|
Stefan Reichelstein, the William R. Timken Professor of Accounting, responds:
One of the truisms in accounting is that cost allocations are always wrong. In many organizations, cost allocations are contentious not only because they have a substantial impact on the reported profitability of different products and business units, but also because there is no well-articulated economic rationale for the particular cost allocation rules in place. In one company I recently worked with, divisional managers made the following comment with regard to the company’s internal cost and profit figures: “We try to do the right thing despite the numbers.” In essence, cost allocations and profit measurement were viewed as a pastime of the accountants rather than a useful guide for management.
The linchpin of any cost allocation system is the choice of allocation bases, sometimes also referred to as the drivers. For instance, until recently it was common practice in U.S. manufacturing firms to allocate all manufacturing overhead costs on the basis of the direct labor hours required by different products. Accordingly, product A would be charged twice as much in overhead costs as product B, if A was twice as labor intensive as B. It seems obvious that such simplistic allocation rules will generally not reflect the economics of producing and selling a range of products that differ dramatically in their complexity and resource requirements.
The entire movement around activity-based costing (ABC) and activity-based management (ABM) is predicated on the notion that a good management accounting system can identify drivers and activities so as to capture the causal link between the activities that generate overhead costs and the products requiring those activities. Even though ABC and ABM have been around for many years now, many companies continue to refine their methods for allocating overhead costs to products in order to better understand their cost structure. Doing so becomes a matter of survival in industries with slim profit margins.
Cost allocations are not only essential to inform management as to which products make or lose money, they are also essential in guiding the flow of resources within firms. Complex organizations require a variety of support functions that deliver goods and services to other departments. Information technology services are a good case in point for both manufacturing and service-oriented companies. An economically meaningful system of cost allocations provides the downstream users of these support functions with proper information about the value of resources they are consuming. At the same time, the allocation of service department costs should allow management to evaluate the competitiveness of particular in-house support functions; that is, would it be cheaper to obtain comparable services from an outside vendor?
Cost allocations frequently seem arbitrary in connection with fixed costs that are charged over time—for example, depreciation and amortization charges. Critics of such fixed cost allocations point out that these costs are sunk and therefore economically irrelevant. However, there are good reasons for the practice of charging sunk costs. From a responsibility-accounting perspective, it is essential that managers anticipate that they will be charged in the future for assets acquired today when the cost of acquiring these assets is not yet sunk but still avoidable. A well-conceived system of intertemporal cost allocations is essential in matching a share of the asset acquisition cost with a corresponding share of the cash returns obtained in subsequent periods. Nonetheless, critics have a point in warning against the dangers of simplistic full-cost calculations, which lump together sunk costs with costs that are relevant going forward. Good practice requires a two-tier system of fixed and variable charges that accommodate the dual needs of holding managers accountable for past decisions and providing relevant information for future decisions.
In sum, cost allocations may appear arbitrary, because a variety of methods are being used and some companies have not spent sufficient effort in justifying the use of particular methods. This observation should not obscure the considerable benefits of proper cost-allocation schemes. Charging costs across products, business units, and time periods in an economically meaningful fashion is a simple necessity for measuring the periodic value to contributions made by individual products and business segments.
Personal Finance: Investing for Retirement
Ask
A Professor
|
|
|
|
