Benefits of Cost Allocation in an Organization
Introduction: The Need for Cost Accounting and Allocation A product or a service cannot be provided without costs going into its creation. The ability to transform a raw material into the final product, whatever the final product may manifest, is unavoidably connected with a cost. Often costs are incurred in a manner that is not even directly related to the making of the final product but to activities that are necessary for the production process.
Activities such as planning and administration come under the support activities that are not directly related to the creation of a product or service but they are necessary for a organization to operate. Often a situation arises when a cost becomes attached to more than one product or department. The question as to whom to ascribe a cost to when more than one party seems responsible for the charge had been a highly problematic issue for accountants for long while. Many schools of thought have sprung up with regard to this dilemma.
Some feel that costs can be assigned based on dividing space, or percentages of use. Others were of the view that there is no need to allocate costs at all. “A third group preferred no allocation at all, because regardless of the method applied, bottom-line would not change” (Doost, 1997). The introduction of Activity Based Costing further pushed cost allocation into the background (Doost, 1997). However, Activity Based Costing had a major shortcoming in that not all cost incursion are clear-cut enough to be charged to the ultimate users.
The need to allocate costs in the face of multiple users remained. Cost allocation is also known as cost apportionment and cost distribution. Defining Cost Allocation Cost allocation is the process of accounting developed to deal with a situation in which assigning costs to a particular product or department is difficult. The process involves identifying and linking the costs incurred with the cost objectives. Cost allocation consists of three main steps: ? Defining an “object” to link costing to ?
Accruing the costs linked to the object Determining a method to link the object with the accrued cost The cost object can be thought of as an activity or a process, a product or service or even a part of the organization for which a separate measure for costs is required. Definition of the object is based largely on the needs and circumstances of the organization. After costs are incurred, they undergo an appraisal and are assigned to various pools depending upon a criterion that has been determined to link costs to the object. The costs are of two types; direct and indirect (Ijiri, 1975).
Direct costs are traceable to the cost object through a highly objective, uncomplicated relationship. Indirect costs are the real purpose of cost allocation and are cost incurred without any traceable source. They must be assigned according to some bridging activity that will form the link between costs and cost object. The Benefits of Cost Allocation Most literature follows the disadvantages of cost allocation and shows why it should not be used. However, cost allocation continues being used in numerous organizations.
Two authors, Horngren and Kaplan have been the exceptions in relating this aspect and Zimmerman builds on their work to show, that in spite of what research, what benefits are derived from cost allocation which makes it popular among the practitioners. Horngren and Kaplan refer to the benefits to managerial behavior. Zimmerman (1978) divides this into the agency problem and using allocation as a proxy. The agency problem arises whenever a relationship is formed between a principal and an agent, such as that between the owners of the company and its managers (Jenson and Meckling, 1976).
This situation assumes that the agent will do his or her best to increase the welfare of the principal; however, in reality an agent will sometimes act in ways that reduce the welfare of the principal. This is due to the lack of optimal monitoring systems. The monitoring system can restrict such acts but not completely stop them. The portion that can not be reduced is, thus, a expenditure and is known as agency costs that a principal needs to bear. A similar situation occurs between a superior and a subordinate when costs are allocated. The subordinate has his own interests at heart, including his chances of advancement.
Thus, by allocating to the subordinates the superior’s expenditures, motivation is created for subordinate to carefully monitor their superior’s spending and ensure that the superior does not spend unnecessarily or for personal gain on the company’s tab. Thus, the subordinate will monitor the spending by the superior, ensuring less shirking and adequate spending on perquisites (non monetary incentives e. g. air conditioning in the office). Thus, the superior’s welfare is dependent directly on the subordinate’s productivity, subordinate’s compensation and the agency costs related to this relationship.
This agency costs include the monitoring costs, bonding costs and residual loss. Excessive consumption of prerequisites by the superior, thus, negatively affects the subordinate’s future promotions. To avoid this, the subordinate would either go over the direct superior’s head or attempt to convince the direct superior to reduce spending. Thus, cost allocation itself allows a principal-agency relation to be created in the organization, and using allocated costs, a means of monitoring superiors is created.
This monitoring is not so effective if done by a person higher-up than the superior (because of one-to-many relation and lack of incentives), and is one reason that costs allocation are widely used in organizations. Another assumption made is the fact that lump-sum tax can also reduce an agent’s spending on perquisites. Here, costs allocations act as a lump-sum tax as they allow costs to be allocated to different departments. Thus, if a cost is allocated among five departments, then for each department this is similar to a lump-sum tax, and this is reduce the agent’s spending on perquisites in each of the departments.
However, if this tax amount is tied to profits, then theory shows that mathematically the perquisites spending may actually increase. Thus, non-controllable costs are allocated to managers to decrease their perquisite spending and should be based on lump-sum overhead allocation rather than tied to profits. The above discussion also implies that costs allocations are better used when other forms of monitoring costs are high, perhaps due to geographical locations etc. Another benefit of cost allocation is observed with regards to manufacturing overhead costs.
Zimmerman (1978) shows that a shared resource inflicts costs on others, for instance, for a shared resource a user will be constantly expanding his utilization. Besides the overuse, this agent is also inflicting a delay costs on other whose work may be affected by the delay they have to endure. After a certain point though, the costs will be more than the benefit derived from the shared resource and it would be more profitable to expand resources. Costs allocation acts a proxies to this expansion costs and allows proper allocation of costs which can be monitored. Thus, the manufacturing overhead issue is as follows.
For a manufacturing concern, its main costs are its direct material used, direct labor required and manufacturing overhead, which are not directly traceable to one product but are incurred in manufacturing. When a principal assigns an agent, he also passes on the responsibilities and decision making thus resulting in a decentralized organization. In such a setting, each person will choose that level of inputs which minimizes the overall costs. This will be at a point when minimum variable costs are used by decreasing inputs and using maximum fixed costs, which are indirect costs.
This will firstly not operate at optimum level, and secondly this will impose costs on other departments by using more of the manufacturing overhead costs. Hence, a need for centralized decision making arises. By using centralized decision making, a level of inputs is selected which minimizes input costs. . Also, manufacturing overhead is allocated based on requirements rather, than to show minimum costs. Thus, cost allocation allows optimal distribution of indirect costs, and also incorporates other immeasurable costs like delay costs, expansion costs etc.
Doost (1997) also shows how cost allocation is useful for determining actual product costs by using all relevant costs, and can be used for control purposes. He demonstrates that the budgeted amount of manufacturing overhead costs allow monitoring of overspending or under spending and is the responsibility of the specific department. Conclusion Cost accounting is a highly useful method of accounting that is very accommodating to control and coordination measures of various costs. The importance of cost allocation has not diminished over the years.
Cost allocation continues to be as important today as it was in the seventies. The basic principle behind cost allocation has remained largely the same; however, new methods of forming the link between costs and cost objects are continuously being formed. It continues to finds its application in cost control and accountability. By no means a cure-all, cost accounting does, however, provide a sound foundation for increasing responsibility, control and accountability by changing the very behavior of managers and creating an environment where cost reduction can be linked to advancement.