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Different cost allocations

5 important questions on Different cost allocations

What is a death spiral?

Elimination of products/services due to spreading costs based on volume instead of their root causes of costs.

Using full cost transfer pricing & allowing the users to buy from the market may cause death spiral

Reduction in product/service demand --> spreading costs to the smaller number --> average cost per unit rises --> demand drops

How to avoid death spiral?

When excess capacity exists:
- charge users only for variable costs
- alternatively, reduce the total amount of fixed costs allocated
- excess demands then need to be met by outsourcing

Use practical capacity instead of actual utilization to calculate the overhead per unit
- are all services irregular? Can we standardize some?
- average number of processing hours over period

Why allocate service department costs to operating costs?

Encourages reduction of use of costly services & reveals economic demand for services

Can be used to approximate hard to observe externalities. E.g. Hiring persons puts extra burdon on IT or HR. Rational users will pay a transfer price only when the benefits are greater than costs

Compare internal service departments to external vendors. Gross inefficiency is revealed when internal transfer prices exceed external prices

How does firm value change by allocating HR costs?

If average cost is increasing --> allocate indirect costs

If average cost is decreasing --> cost allocation may do more harm than good

How to allocate service department costs to operating units?

DIRECT
Goes straight to department. Is quick simple and commonly used. Downside: true relationship? Ignores the fact that service departments serve each other.

STEP-DOWN
Partial recognition of the services transferred between support services. E.g. IT supports accounting. Step from support --> accounting

RECIPROCAL
Recognizes mutual support services. Up and down from IT to accounting. Yet is not intuitive and complex, often small differences