A number of important objectives are associated with the allocation of support department costs to producing departments and ultimately to specific products. The following major objectives have been identified by the IMA:1
1. To obtain a mutually agreeable price
2. To compute product-line profitability
3. To predict the economic effects of planning and control
4. To value inventory
5. To motivate managers
Competitive pricing requires an understanding of costs. Only by knowing the costs of each service or product can the firm create meaningful bids. If costs are not accurately allocated, some costs could be overstated, resulting in bids that are too high and a loss of potential business. Alternatively, if the costs are understated, bids could be too low, producing losses on these products. Good estimates of individual product costs also allow a manager to assess the profitability of individual products and services. Multiproduct companies need to be sure that all products are profitable and that the overall profitability of the firm is not disguising the poor performance of individual products. This meets the profitability objectiveidentified by the IMA.
By assessing the profitability of various support services, a manager may evaluate the mix of support services offered by the firm. From this evaluation, executives may decide to drop some support services, reallocate resources from one to another, reprice certain support services, or exercise greater cost control in some areas. These steps would meet the IMA’s planning and control objective. The validity of any evaluation, however, depends to a great extent on the accuracy of the cost assignments made to individual products. For a service organization such as a hospital, the IMA objective of inventory valuation is not relevant. For manufacturing organizations, however, this objective must be given special attention. Rules of financial reporting (GAAP) require that all direct and indirect manufacturing costs be assigned to the products produced. Since support department costs are indirect manufacturing costs, they must be assigned to products. This is accomplished through support department cost allocation. Inventories and cost of goods sold, then, include direct materials, direct labor, and all manufacturing overhead, including the cost of support departments.
Allocations also can be used to motivate managers. If the costs of support departments are not allocated to producing departments, managers may tend to overconsume these services. Consumption of a support service may continue until the marginal benefit of the service equals zero. In reality, the marginal cost of a service is, of course, greater than zero. By allocating the costs and holding managers of producing departments responsible for the economic performance of their units, the organization ensures that managers will use a support service until the marginal benefit of the service equals its marginal cost. Thus, allocation of support department costs helps each producing department select the correct level of support service consumption.
There are other behavioral benefits. Allocation of support department costs to producing departments encourages managers of those departments to monitor the performance of support departments. Since the costs of the support departments affect the economic performance of their own departments, those managers have an incentive to control these costs through means other than simple usage of the support service. For instance, the managers can compare the internal costs of the support service with the costs of acquiring it externally. If a support department is not as cost effective as an outside source, perhaps the company should not continue to supply the service internally. Many university libraries, for example, are moving toward the use of outside contractors for photocopying services. They have found that these contractors are more cost efficient and provide a higher level of service to library users than did the previous method of using professional librarians to make change, keep the copy machines supplied with paper, fix paper jams, etc. This possibility of comparison should result in a more efficient internal support department. Monitoring by managers of producing departments will also encourage managers of support departments to be more sensitive to the needs of the producing departments.
Clearly, then, there are good reasons for allocating support department costs. The validity of these reasons depends, however, on the accuracy and fairness of the cost assignments made. Although it may not be possible to identify a single method of allocation that simultaneously satisfies all of these objectives, several guidelines have been developed to assist in determining the best allocation method. These guidelines are cause and effect, benefits received, fairness, and ability to bear. Another guideline to be used in conjunction with any of the others is cost-benefit. That is, the method used must provide sufficient benefits to justify any effort involved. Cause and effect requires the determination of causal factors to guide allocation. For example, a corporate legal department may track the number of hours spent on legal work for its various divisions (e.g., handling patent applications, lawsuits, etc.). The number of hours worked by lawyers and paralegals has a clear cause-and-effect relationship with the overall cost of the legal department and may be used to allocate the cost of the corporate legal department to the various company divisions.
The benefits-received guideline associates the cost with perceived benefits. Research and development (R&D) costs, for example, may be allocated on the basis of the sales of each division. Although some R&D efforts may be unsuccessful and while the successful efforts may happen to benefit one division in one year, all divisions have a stake in corporate R&D and will at some point have increased sales because of it. Fairness or equity is a guideline often mentioned in government contracting. In the case of cost allocation methods, fairness usually means that the government contract should be costed in a method similar to nongovernmental contracts. For example, an airplane engine manufacturer may allocate a portion of corporate legal department costs to the government contract if these costs are usually allocated to private contracts. Ability to bear is the least desirable guideline. It tends to “penalize” the most profitable division by allocating to it the largest proportion of a support department cost regardless of whether the profitable division receives any services from the allocated department. As a result, no motivational benefits of allocation are realized. In determining how to allocate support department costs, the guideline of costbenefit must be considered. In other words, the costs of implementing a particular allocatio scheme must be compared to the benefits expected to be derived. As a result, companies try to use easily measured and understood bases for allocation.Also read allocating one departments coststo another department.
1. To obtain a mutually agreeable price
2. To compute product-line profitability
3. To predict the economic effects of planning and control
4. To value inventory
5. To motivate managers
Competitive pricing requires an understanding of costs. Only by knowing the costs of each service or product can the firm create meaningful bids. If costs are not accurately allocated, some costs could be overstated, resulting in bids that are too high and a loss of potential business. Alternatively, if the costs are understated, bids could be too low, producing losses on these products. Good estimates of individual product costs also allow a manager to assess the profitability of individual products and services. Multiproduct companies need to be sure that all products are profitable and that the overall profitability of the firm is not disguising the poor performance of individual products. This meets the profitability objectiveidentified by the IMA.
By assessing the profitability of various support services, a manager may evaluate the mix of support services offered by the firm. From this evaluation, executives may decide to drop some support services, reallocate resources from one to another, reprice certain support services, or exercise greater cost control in some areas. These steps would meet the IMA’s planning and control objective. The validity of any evaluation, however, depends to a great extent on the accuracy of the cost assignments made to individual products. For a service organization such as a hospital, the IMA objective of inventory valuation is not relevant. For manufacturing organizations, however, this objective must be given special attention. Rules of financial reporting (GAAP) require that all direct and indirect manufacturing costs be assigned to the products produced. Since support department costs are indirect manufacturing costs, they must be assigned to products. This is accomplished through support department cost allocation. Inventories and cost of goods sold, then, include direct materials, direct labor, and all manufacturing overhead, including the cost of support departments.
Allocations also can be used to motivate managers. If the costs of support departments are not allocated to producing departments, managers may tend to overconsume these services. Consumption of a support service may continue until the marginal benefit of the service equals zero. In reality, the marginal cost of a service is, of course, greater than zero. By allocating the costs and holding managers of producing departments responsible for the economic performance of their units, the organization ensures that managers will use a support service until the marginal benefit of the service equals its marginal cost. Thus, allocation of support department costs helps each producing department select the correct level of support service consumption.
There are other behavioral benefits. Allocation of support department costs to producing departments encourages managers of those departments to monitor the performance of support departments. Since the costs of the support departments affect the economic performance of their own departments, those managers have an incentive to control these costs through means other than simple usage of the support service. For instance, the managers can compare the internal costs of the support service with the costs of acquiring it externally. If a support department is not as cost effective as an outside source, perhaps the company should not continue to supply the service internally. Many university libraries, for example, are moving toward the use of outside contractors for photocopying services. They have found that these contractors are more cost efficient and provide a higher level of service to library users than did the previous method of using professional librarians to make change, keep the copy machines supplied with paper, fix paper jams, etc. This possibility of comparison should result in a more efficient internal support department. Monitoring by managers of producing departments will also encourage managers of support departments to be more sensitive to the needs of the producing departments.
Clearly, then, there are good reasons for allocating support department costs. The validity of these reasons depends, however, on the accuracy and fairness of the cost assignments made. Although it may not be possible to identify a single method of allocation that simultaneously satisfies all of these objectives, several guidelines have been developed to assist in determining the best allocation method. These guidelines are cause and effect, benefits received, fairness, and ability to bear. Another guideline to be used in conjunction with any of the others is cost-benefit. That is, the method used must provide sufficient benefits to justify any effort involved. Cause and effect requires the determination of causal factors to guide allocation. For example, a corporate legal department may track the number of hours spent on legal work for its various divisions (e.g., handling patent applications, lawsuits, etc.). The number of hours worked by lawyers and paralegals has a clear cause-and-effect relationship with the overall cost of the legal department and may be used to allocate the cost of the corporate legal department to the various company divisions.
The benefits-received guideline associates the cost with perceived benefits. Research and development (R&D) costs, for example, may be allocated on the basis of the sales of each division. Although some R&D efforts may be unsuccessful and while the successful efforts may happen to benefit one division in one year, all divisions have a stake in corporate R&D and will at some point have increased sales because of it. Fairness or equity is a guideline often mentioned in government contracting. In the case of cost allocation methods, fairness usually means that the government contract should be costed in a method similar to nongovernmental contracts. For example, an airplane engine manufacturer may allocate a portion of corporate legal department costs to the government contract if these costs are usually allocated to private contracts. Ability to bear is the least desirable guideline. It tends to “penalize” the most profitable division by allocating to it the largest proportion of a support department cost regardless of whether the profitable division receives any services from the allocated department. As a result, no motivational benefits of allocation are realized. In determining how to allocate support department costs, the guideline of costbenefit must be considered. In other words, the costs of implementing a particular allocatio scheme must be compared to the benefits expected to be derived. As a result, companies try to use easily measured and understood bases for allocation.Also read allocating one departments coststo another department.
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