Cost allocation is used in all sorts of business and government enterprises to distribute the money the entity spends to those that “deserve it”. For some, this means that cost incurred by one department should be spread between other departments that benefited from the expense. For others, this means that cost must be distributed to all products. Every dollar spent needs to find its appropriate home for who or what is responsible for the money. But over the years, we’ve developed some dangerous myths on cost allocation.
Myth 1 – Allocating cost improves decision making. Certainly, the intent of cost allocation is to improve decision making. However, this depends on how the allocation is done. If cost is simply spread over departments or products without regard to cause and effect and/or the actual operating relationships, those making the decisions will be misled. In one company I worked for, we produced and sold millions of small, inexpensive parts as well as thousands of complete, expensive assemblies. Had we allocated cost based of volume as some advocate, the small parts would have been very unprofitable. Yet they contributed a healthy part of our bottom line. A decision based on inaccurate information would have been a disaster.
Myth 2 – All cost must be allocated. No. If a cost will not influence a decision, then why allocate it. For example take the company executives such as the CEO and CFO. At least for a multiproduct company, whether or not the company offers one particular product or not will not affect these costs – They will neither increase nor decrease. So why allocate these costs at all. A better approach would be to hold these separate as business sustaining costs. Then the portfolio of products and services needs to cover these costs and to provide the expected profit.
Myth 3 – Idle capacity cost must be allocated to actual products and services. This practice may start the dangerous death spiral. This is when idle capacity cost is allocated to products. Then observing the higher product costs, the company raises prices to make their same percentage of profit. When asked to pay higher prices with no added value, customers take their orders to competitors. As order volume drops, there is more idle capacity causing even higher products costs. Then with higher costs, the company again raises prices. And so on until they company is bankrupt. Much better to identify idle capacity, hold this cost separate and deal with it. Idle capacity is not the responsibility of the product produced. Rather, management must take full responsibility to find new opportunities to sell or to dispose of this capacity.
These myths are dangerous to company health and profits. Let’s debunk these myths now so that all decisions can be better informed.