Academic journal article Journal of Financial Management & Analysis

Focus on Cost Allocation for Performance Evaluation : Methodological Approach

Academic journal article Journal of Financial Management & Analysis

Focus on Cost Allocation for Performance Evaluation : Methodological Approach

Article excerpt


The use of cost allocation in performance evaluation is a controversial subject. One view suggests that as overhead costs are a joint, responsibility, all segments of the organisation should be aware of them. Furthermore, cost allocation can be used to motivate individual managers to exercise a degree of control over their consumption of central services'. The alternative view is that the allocation of central overhead costs moves costs away from where they are incurred, and ought to be controlled, to other parts of the organisation where it is more difficult to exercise control. The allocation of central overhead costs among divisions of the firm may not be relevant if top management in divisionalised companies do not use such accounting information for performance evaluation purposes. However, this issue is debatable because managers may act on information that is good for the company.

The main purpose of this study is to analyse he different explanations given for central cost allocation for the purposes of performance evaluation with a view to offer an explanation for divisionalised companies' practice regarding this issue. For the purposes of the study, the following definitions are used:

* Central overhead costs are the costs of a service incurred at headquarters level for the benefit of two or more components of a company. Such costs need to be allocated among the segments of the firm (e.g. centralized computer facility resear'ch and development, maintenance costs and general administration costs). Central overhead costs may be known within the organisation as common costs, corporate indirect costs, central administrative costs, management charges, central head office costs and so on2 4 3.

* Cost allocation is the process of assigning accumulated indirect costs among two or more cost objects. The cost of the resource is allocated to a cost object when a direct measure does not exist for the quantity of the resource consumed by the cost object.

* A cost object is anything for which a separate measurement of cost is desired4. A cost object could be a unit of product, a service, a production line, a project, a contract, a customer, a machine, a department, a division, an activity, or a program.

Cost Allocation and Performance Evaluation

Cost allocations are made for different purposes (e.g., performance evaluation, decision making and financial reporting). This study is solely concerned with the allocation of central overhead costs for the purposes of performance evaluation. Allocations for other purposes can be examined individually in other research projects. Further, the study is concerned-with cost allocation in large divisionalised companies. The reasons is that in small or simple businesses it may be possible to attribute cots directly to individual users. But as business becomes more complex, it is increasingly difficult to attribute costs in this way. So, it is not surprising to discover that historically, interest in cost allocation accompanied the development of large-scale business enterprise.3106

The advocates of responsibility accounting and the controllability principle claim that subordinate managers' performance should be based on factors over which they exercise control. The rationale is that this will provide the most satisfactory base for controlling and motivating subordinate managers710". Such a view indicates that cost allocations should not be made for the purposes of performance evaluation. However, this issue is debatable because we agree on a cost allocation base that the subordinate controls and then he will be charged based on a targeted rate for the usage of central overhead costs. So, allocations may be acceptable from the point of view of the subordinate manager although he does not control the original cost of the services provided to him.

Moreover, some authors in the management accounting literature suggest that central costs should be allocated to segments of the firm. …

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