INSTRUCTIONS: Make a thoughtful argument about the topic.

The role of cost allocation

The Zimmerman approach

The Kaplan and Cooper approach is based on the received wisdom that non-volume related costs should not be allocated to the product unit level.

There is, however, a school of thought in favour of such allocations, suggesting that cost allocations have an important role to play in motivating and controlling managers.

Zimmerman,[3] for example, suggested that there are certain service/support costs which are fixed with respect to short-run changes in production volume, but which are related, in the longer term, to the level of primary inputs (e.g. labour). Such costs would typically be classified under the general overhead category. An example would be a works canteen.

Every additional worker employed places additional demands on the canteen. Although actual cost of the canteen may be fixed in the short-term, opportunity costs arise in the form of delays and/or degradation of service to other users. As time goes by, management will tend to adjust the actual level of service provided, in order to reduce delays/degradation of service, and hence costs rise.

Zimmerman argues that these opportunity costs and consequent long-term incremental actual costs should be taken into account by individual managers when deploying labour resources. Such costs are hard to observe/measure, but allocating current average cost can serve to proxy them.

Thus, for example, a production manager deciding on the optimal mix of factor inputs will be induced to take into account the additional costs of using labour--in terms of the demands it places on the works canteen--if labour hours are made to carry the burden of recovering this overhead cost.

The resultant factor input mix, it is argued, will be closer to the optimal one than would be the case if such costs were ignored.

The isoquant shows all the possible combinations which could be used to produce a particular output. All points assume technical efficiency (i.e. no waste); the optimal combination (i.e. that producing the lowest unit product cost) will depend on the slope of the isocost line which represents the relative prices of input factors. Isocost line 1 represents relative prices if the demands placed by labour on service departments such as the canteen are ignored and only the actual cost of labour itself is taken into account. The 'true' cost of using labour resource is understated and in consequence more labour hours are used than would otherwise be the case. The manager is, in effect, basing his decision on false price information.

If the true cost of using labour is proxied by means of charging labour hours with service department overhead, the relative price of labour increases, as shown by isocost line 2, and less of it should be used. The resultant input mix (point 2) is closer to the real optimum, because the hidden costs of using labour are recognised. By charging labour hours with fixed overhead burden, overhead is factored into the unit product cost. If a unit requires one labour hour, a corresponding amount of overhead will be included in the unit cost. According to the logic of Zimmerman's argument, this is justified since, in the longer term, actual costs of the service resource will tend to rise in relation to the number of labour hours worked and the allocated fixed cost is a proxy for these additional costs, i.e. one labour hour gives rise to x canteen cost.

The question naturally arises as to which costs should be classified as long-run volume-related costs and thus allocated to the product unit level-after all, virtually all costs change if volume is increased enough! What about, for example, rent? Zimmerman's argument appears to relate to those areas where there is additional consumption of resources as a result of an increase in a primary input such as labour. As a consequence of this consumption of resources, delays/degradation of service to other users occurs. These opportunity costs give rise to additional actual costs in the longer term as management adjusts the level of service provision. This is unlikely to apply to rent, unless a huge increase in labour force was being contemplated-necessitating a new factory!

Therefore an assumption about the likely volume level over the planning horizon is required in deciding whether to allocate or not to allocate. If, over the anticipated volume range, significant delays/ degradation of service--as a result of increasing primary inputs--are considered a realistic possibility, then there is a good case for cost allocation. Where, over the anticipated volume range, it is considered unlikely that delays/degradation of service to other users will result--as a consequence of increasing primary inputs--there is not a good case for cost allocation.

Applying this criterion, it may be appropriate to allocate works canteen, payroll and personnel costs, for example; it will probably not be appropriate to allocate rent and so on.

The Japanese approach

A slightly different rationale for cost allocation is that apparently adopted by a number of Japanese manufacturing firms? These firms load labour hours with overhead burden--not because they believe this will result in an optimal mix of inputs, but to encourage the substitution of capital for labour as part of their advanced manufacturing technology (AMT) strategy. All production overhead--including non-volume related costs (i.e. batch level, product-sustaining level costs etc) are allocated using labour hours. Consequently, the resultant 'unit costs' are of little use for either longterm or short-term decisions--since they are neither the short-term nor long-term incremental costs of

producing a unit! Japanese managers do not believe that the resultant product costs are a reasonable proxy for long run incremental costs; rather, they believe that the behavioral benefits accruing from cost allocation outweigh the disadvantages, namely inaccurate product costs and possible erroneous decisions! Japanese companies tend to use estimated product costs produced outside the management accounting system and based on managers' past experience or intuition.[5] It appears that the primary purpose of management accounting in Japan is to influence behaviour rather than to provide accurate product costs. It is not clear that the West is ready to sacrifice its penchant for accurate product cost information, which has been the cornerstone of western management accounting since its beginning.