Allocation Cost

An organization’s service and administrative costs can be substantial, and some or all of these costs usually are allocated to cost objects.  Thus, the allocations of service and administrative costs can have a significant impact on product cost and pricing, asset valuation, and segment profitability.

Required

1.  What are service and administrative costs?

2.  When service and administrative costs are allocated, they are grouped into homogenous pools and then allocated to cost objects according to some allocation base.

      a.     Compare and contrast the benefit and cost criteria for selecting an allocation base.

     b.     Explain what the ability-to-bear costs criterion means in selecting an allocation base.

Solution:

1. Service and administrative costs are costs that are incurred by headquarters' staffs or other central units. In order to maintain the company as a functioning entity, administrative costs are incurred for the benefit of all units of the company. Service units generally exist to provide services to other units and, thus, are not as broad in nature as administrative costs.

2. Homogeneous cost pools are collections of costs that are similar in nature and have a presumed causal connection. Examples of homogeneous pools include personnel-related costs, payroll-related costs, space-related costs, and energy-related costs. A cost object can be any physical unit or organizational sub-set for which costs are measured or estimated. Examples of cost objects include products, contracts, projects, sales territories, or other organizational subdivisions.

a. The "benefit" or “equity” criterion, often applied to corporate administrative costs, allocates costs according to some measure of the benefit received. The benefit criterion holds that cost objects that benefit from particular costs should share responsibility for these costs. The "cause" criterion focuses on the cost objects that precipitated the costs involved. The cause criterion is often applied to service costs and allocates these costs to those units or cost objects that gave rise to these costs.

b. The "ability to bear " criterion, which is similar in objective to the benefit criterion, is based on the ability of the cost objects to cover or absorb costs and allocates costs based on the profits of the cost objects. This allocation base does not consider the benefits derived from nor the cause of the costs to be allocated but only the relative profitability of the cost objects. Therefore, the most profitable unit is charged with the greatest proportion of cost. Because of the disincentive to be profitable and the dysfunctional effect on management behavior, the "ability to bear costs" criterion has limited use.