The usefulness of cost allocations : an experimental investigation

ABSTRACT This paper reports the effects of service department cost allocation schemes on demands for service by divisional managers. Cost allocations have been suggested to be useful in specific managerial settings (Thomas 1980). Zimmerman (1979) suggested that if allocation methods that include the costs of externalities (e.g., delays, degraded service) were developed, they should encourage decisions that are more behaviorally congruent than decisions made with methods that do not incorporate externality costs. The general experimental setting in this research consists of a decentralized firm with two manufacturing divisions and a centrally-run service department. The role of each division manager is to demand maintenance, knowing the specific benefits the maintenance will have on divisional profits, but only the allocation method used to charge for the cost of the service provided. Parameters of the experiment are set so as to discourage excessive demands by the managers. Five allocation methods are used in this study along with a control group that makes the same decision (how much maintenance to demand) with no costs allocated to the division. To test various hypotheses, amounts of maintenance demanded are compared between methods and are compared to optimal levels for the firm and for the divisions. MOTIVATION AND LITERATURE REVIEW The usefulness of accounting cost allocations has been debated for many years. Arthur Thomas argued that financial cost allocations, which are typically allocations over time, are irrelevant (Thomas 1969, 1974). However, he discusses in other works (Thomas 1971, 1980) that cost allocations for managerial purposes, such as the allocation of joint and common costs and transfer pricing, might be useful in attaining goal congruence between managers' behavior and the objectives of the firm. He categorizes an allocation method as behaviorally congruent if it encourages managers to act in ways that are consistent with what central management wants (Thomas 1980: 11-12). Research has shifted to the positive question of why cost allocations are used. Zimmerman (1979) is one of the earliest to identify situations where cost allocations could yield net positive benefits to the firm. The cases he uses to illustrate the usefulness of cost allocations are those where externalities arise from the use of a common resource or service. In particular he notes how not allocating any of the fixed cost of a WATS line can result in overuse of the service and can impose delay costs on those waiting to use the service. In another situation he considers a decentralized firm providing a common resource or service to its independent divisions. When there is a limited amount of the common service or resource available, as one division increases its usage of the resource, less is available to the other divisions. A reduction in available resources can impose costs on these other divisions by causing delays, by reducing the quality of the output in the divisions, or by causing the divisions to seek out other, more expensive alternatives. While these costs are hard to observe and difficult to quantify, they represent opportunity costs or externalities to the other divisions. The implication of these examples is that the actual cost to the firm of providing common resources or services to the divisions is more than just the reported costs. There can exist opportunity costs, resulting from externalities imposed on one division by another when a limited resource is shared, that could significantly add to the cost of operating a service department. As explained by Zimmerman (1979: 515), "[T]he value of the firm is larger . if each production manager takes account of the costs which he imposes on the other managers by consuming more of the fixed resource when choosing his mix of inputs. That is, instead of just looking at the reported costs of the factors, each manager should also consider all the costs he generates via delays, degradation and eventual expansion costs in the service departments. …