Analyzing Alternative Allocation Schemes for Distribution Costs

Telstar Electronics manufactures and imports a wide variety of consumer and industrial electronics, including stereos, televisions, camcorders, telephones, and VCRs. Each line of business (LOB) handles a single product group (e.g., televisions) and is organized as a profit center. The delivery of the product to the wholesaler or retailer is handled by Telstar's distribution division, a cost center. Previously, Telstar was organized functionally, with manufacturing, marketing, and distribution as separate cost centers. Two years ago, it reorganized to the present arrangement.

Distribution assembles products from the various LOBs into larger shipments to the same geographic area to capture economies of scale. The division is also responsible for inbound shipments and storage of imported products. It has its own fleet of trucks, which handles about two-thirds of the shipments, and uses common carriers for the remainder. Currently, the costs of the distribution division are not allocated to the LOBs, but LOBs do pay the cost for any special rush shipment using an overnight or fast delivery service, such as Federal Express or UPS. For example, if a customer must have overnight delivery, the LOB ships directly without using Telstar's distribution center and the LOB is charged for the special delivery.

The corporate controller is mulling over the issue of allocating the costs of distribution. Several allocation schemes are possible:

1. Allocate all distribution division costs based on gross sales of the LOBs.

2. Allocate all distribution division costs based on LOB profits.

3. Allocate the direct costs of each shipment (driver, fuel, truck depreciation, tolls) using the gross weight of each LOB's product in the shipment. Then allocate the other costs of the distribution division (schedulers, management, telephones, etc.) using the total direct shipping costs assigned to each LOB.

One argument against allocating is that it will distort relative profitability. The controller says, "Because allocations are arbitrary, the resulting LOB profitabilities become arbitrary." Another argument is that it is not fair to charge managers for costs they cannot control. LOBs cannot control shipping costs. For example, there are savings when two small separate shipments are combined into a single large shipment. LOBs will tend to avoid opening up new sales territories when other Telstar products are not being shipped to that area.

Required

Should Telstar begin allocating distribution costs to the LOBs? If so, which allocation scheme should it use?