Allan Stratton is a cost management consultant with over 35 years of experience who shares the benefit of his experience providing tools and resources via the internet. In one of his articles he debunks three myths on cost allocation.
All sorts of businesses and government organizations use cost allocation. It is a way of dividing and assigning the money that an entity spends.
Sometimes this means spreading costs incurred by one department amongst others who also benefitted from the expense, sometimes it means distributing a cost across all products. Over time, several dangerous myths about cost allocation have developed.
First, that allocating costs improves decisionmaking;
this is the intent but the outcome depends on the way it is done. Attention must be paid to cause and effect and/or the actual operating relationships, otherwise those using the data to make decisions may be misled.
Second, that all costs must be allocated. There is no reason to allocate a cost that will not influence a decision.
Third, that idle capacity cost must be allocated to actual products and services. A dangerous downward spiral could be started if idle capacity cost is allocated to products because this would result in higher product costs. If higher product costs are reported then the company may raise their prices in order to continue making the same profit margin.
Questions:
1 Explain how applying each of the above three myths can lead to bad decisions.
2 What changes should be made to cost allocations to avoid the bad decisions?