Cost Allocation using Kamakura Risk Manager (KRM)

Introduction
Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you wish to separately measure costs. Examples of cost objects are a product, a marketing campaign, a customer, a sales region, or a department.

Cost allocation is used for financial reporting purposes, to spread costs among departments or inventory items. Cost allocation is also used in the calculation of profitability at the department or subsidiary level, which in turn may be used as the basis for bonuses or the funding of additional activities. Cost allocations can also be used in the derivation of transfer prices between subsidiaries.  This document will focus on the use of cost allocations in the derivation of transfer prices between business units, but done at the transaction level, so that associated aggregations (product, customer, centre, and indeed any user-defined “unit”) can be analysed with ease.

Cost allocation is important because it the process through which costs incurred in bringing a certain product to market or rendering a certain service is calculated. If costs are not accurately calculated, a business might never know which products are profitable and which ones are losing money. If costs are misallocated, a business unit may be charging the wrong price to its customers and/or it might be wasting resources on products that are wrongly categorised as profitable.

Organisations allocate costs mainly for the following reasons:

• To provide information needed for decision making.
• To reduce the frivolous use of common resources.
• To encourage managers to evaluate the efficiency of internally provided services.
• To calculate the full cost of products for financial reporting purposes and for determining cost-based prices.

If any one of these objectives are not met, or if the results generated are purely for review purposes, it may be a better alternative to manage ‘at the margin’, to identify the marginal profitability of each direct unit (business unit, product, customer, transaction, user-defined attribute), and manage these on the basis that if they contribute positively to the unallocated cost pool, they are worth continuing with, and if not, to take appropriate corrective action.

Unlike manufacturing organisations which are regulated through cost allocation, financial institutions do not report on GAAP that requires “Full Costing” for external reporting purposes. As a result indirect production costs need not be allocated for services rendered or products delivered. Furthermore, full cost information is not required as there is no need for “Cost Plus” pricing, and the organisation is not mandated to provide any pricing rationale other than not being usurious whereas In the case of manufacturing entities, not only is manufacturing overhead allocated, but so are other general and administrative costs.

Generally, as resources are consumed during production, cost allocations are made to the products, departments etc., much like a fee or charge. From a decision making standpoint, the allocated cost should measure the opportunity cost of using a company resource. Unfortunately this is difficult to implement in practice as opportunity costs can change quickly.

It may be argued that fixed costs should not be allocated at all. But without charging a fee (or allocating these costs), resources are often used frivolously or for nonessential purposes. Consider fixed costs associated with computer resources. Examples include recreational web surfing, playing games, sending personal e-mail etc.  A way to eliminate frivolous use is to charge for it.

Cost allocation is also useful because is causes management to evaluate the services for which they are being charged (e.g. costs allocated to their departments or products). For example, centrally administered services such as janitorial or computer services should be allocated to various departments.  If these services were free and no allocation were made, users would not consider them. But if a charge is levied, management has a strong incentive to evaluate these services and charges and consider alternatives.

An entirely justifiable reason for not allocating costs is that no cost should be charged that the recipient has no control over. Thus, in the African Bongo Corporation example above, the company could forbear from allocating the cost of its power station, on the grounds that none of the six operating departments have any control over the power station. In such a situation, the entity simply includes the unallocated cost in the company’s entire cost of doing business. Any profit generated by the departments contributes toward paying for the unallocated cost.

The very term “allocation” implies that there is no overly precise method available for charging a cost to a cost object, so the allocating entity is using an approximate method for doing so. Thus, the user may continue to refine the basis upon which you allocate costs, using such allocation bases as square footage, headcount, cost of assets employed, or electricity usage. The goal of whichever cost allocation method you use is to either spread the cost in the fairest way possible, or to do so in a way that impacts the behaviour patterns of the cost objects. Thus, an allocation method based on headcount might drive department managers to reduce their headcount or to outsource functions to third parties.

Cost allocation typically has three steps:

• Identify the cost objectives
• Form cost pools
• Select an allocation base to relate the cost pools to the cost objectives

The first step in the cost allocation process is to determine the product, service or department that is to receive the allocation. The object of this cost allocation is called the cost objective.

The second step in the cost allocation process is to form cost pools. A cost pool is a grouping of individual costs whose total is allocated using one allocation base. For example, maintenance department costs might constitute a cost pool. Cost pools are often formed along department lines.

The third step in the allocation process is to select an allocation base that relates the cost pool to the cost objectives. If the cost objectives are products or services rendered, then direct time spent, direct amount spent or product delivery time are examples of characteristics that could be used as allocation bases. Ideally, the allocation base should relate costs to cost objectives.

When indirect costs are fixed, establishing a cause-and-effect relationship is infeasible. Therefore, purveyors use other criteria:

• Relative benefits (the allocation base should result in more costs being allocated to the cost objectives that benefit most from incurring the cost).
• Ability to bear costs (the allocation base should result in more costs being allocated to products which are more profitable).
• Equity (the allocation base should result in allocations which are fair and equitable.

• Apart from getting an allocation cost at the transaction level, the user can generate any kind of hierarchical information on the costs that are to be aggregated, and this information is kept specific to the individual centres, or can be grouped based on any user-defined criteria.
• The process of allocation can be incorporated across any type of expense, including actual amounts, budgets, and forecasts.  One can also perform ‘what if’ analyses by changing very quickly the methodologies to reprocess results.
• Whilst the methodologies used are from the profitability generation process, the results themselves are now used in the pricing of transactions, the inclusion of overheads in the FTP framework to encompass ‘all in’ pricing, and the process generates transaction-level results that are meaningful.
• This process does away with the politics associated with sequential versus simultaneous allocations, complicated allocation routines, and incomprehensible results.
• The results lend themselves to ‘what if’ pricing.
• Any mathematical, statistical, or distribution criteria can be used.
• References can be made to lags, leads, and averages.
• References can be made to any other dynamic variable.