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.
