Common costs, also known as indirect costs, are expenses incurred by a business that cannot be directly attributed to a specific product or process. These costs are unavoidable and must be borne by the business regardless of its operations. Allocating common costs is essential for accurately determining the profitability and performance of products or departments. However, this allocation process can be complex and challenging. This article explores the concept of common costs, the methods used for their allocation, and the drawbacks associated with these methods.
Key Facts
- Common costs are expenses that are incurred by a business but cannot be directly linked to a specific product or process.
- Common costs are unavoidable and must be borne by the business regardless of its operations.
- Allocating common costs is important for accurately determining the profitability and performance of products or departments.
- There are three commonly used methods for allocating common costs: stand-alone method, incremental method, and the Shapley value method.
- Stand-alone method: This method distributes costs based on the percentage each department would have paid separately.
- Incremental method: This method is used when one cost is inevitable and the other is additional. The additional cost is subtracted from the total amount to determine the allocation.
- Shapley value method: This method involves calculating the average of two or more costs to determine the allocation.
- The choice of allocation method depends on the specific circumstances and objectives of the business.
- Allocating common costs can have drawbacks, such as arbitrary and inconsistent results, distortion of profitability and performance, and creating disincentives for managers and employees.
Methods for Allocating Common Costs
There are three commonly used methods for allocating common costs:
Stand-Alone Method
This method distributes costs based on the percentage each department would have paid separately. For example, if Department A pays $900 for rent and Department B pays $1,500, the total rent cost is $2,400. If the company receives a discount and now pays $2,000 for rent, the stand-alone method allocates $750 to Department A (37.5% of $2,000) and $1,250 to Department B (62.5% of $2,000).
Incremental Method
This method is used when one cost is inevitable, and the other is additional. The additional cost is subtracted from the total amount to determine the allocation. For instance, if Department B’s workspace rental is inevitable, and Department A’s workspace rental is additional, the incremental method allocates $1,500 to Department B and $500 to Department A.
Shapley Value Method
This method involves calculating the average of two or more costs to determine the allocation. For example, if the cost of renting a workspace for Department A is $500 and the cost for Department B is $1,500, the Shapley value method allocates $700 to Department A and $1,300 to Department B.
Drawbacks of Allocating Common Costs
Allocating common costs can have several drawbacks:
Arbitrary and Inconsistent Results
The choice of allocation method can lead to arbitrary and inconsistent results, as different methods may produce different allocations. This can make it difficult to compare the profitability and performance of products or departments accurately.
Distortion of Profitability and Performance
Allocating common costs can distort the profitability and performance of products or departments. This is because the allocation method may not accurately reflect the cause-and-effect relationships between costs and products or departments.
Disincentives for Managers and Employees
Allocating common costs can create disincentives for managers and employees. If managers are allocated a large portion of common costs that are beyond their control, they may feel demotivated or resentful. Similarly, if employees are allocated a small portion of common costs that are easy to control, they may have no incentive to reduce them.
Conclusion
Common costs are a necessary part of business operations, but their allocation can be complex and challenging. The choice of allocation method can significantly impact the profitability and performance of products or departments. Therefore, businesses must carefully consider the advantages and disadvantages of each allocation method before making a decision. Additionally, businesses should strive to minimize the drawbacks associated with allocating common costs by using multiple allocation bases, considering activity-based costing, and implementing the dual-rate method. By doing so, businesses can ensure that common costs are allocated fairly and accurately, leading to better decision-making and improved financial performance.
References
- Indeed Editorial Team. (2021, November 18). What Is Common Cost? Definition and Examples. Indeed Career Guide. https://www.indeed.com/career-advice/career-development/what-is-common-costs
- SendPulse. (2023, March 22). Common Costs: Formula | SendPulse. SendPulse. https://sendpulse.com/support/glossary/common-costs
- Donald S., Andrea Tiller, Syahrul Nazri Mohd Sai’on, Iraida Margarita Rodriguez Purtell. (2023, July 23). How do you deal with the issue of common fixed costs in cost allocation? LinkedIn. https://www.linkedin.com/advice/0/how-do-you-deal-issue-common-fixed-costs-cost-allocation
FAQs
1. What are common costs?
Common costs, also known as indirect costs, are expenses incurred by a business that cannot be directly attributed to a specific product or process. These costs are unavoidable and must be borne by the business regardless of its operations.
2. Why is allocating common costs important?
Allocating common costs is important for accurately determining the profitability and performance of products or departments. By allocating common costs, businesses can calculate the contribution margin and net income of each product or department, compare them with each other or with the overall performance of the company, and make informed decisions about pricing, production, and marketing.
3. What are the different methods for allocating common costs?
There are three commonly used methods for allocating common costs:
- Stand-alone method: This method distributes costs based on the percentage each department would have paid separately.
- Incremental method: This method is used when one cost is inevitable, and the other is additional. The additional cost is subtracted from the total amount to determine the allocation.
- Shapley value method: This method involves calculating the average of two or more costs to determine the allocation.
4. What are the challenges of allocating common costs?
Allocating common costs can be challenging due to several factors, including:
- Arbitrary and inconsistent results: Different allocation methods can produce different results, making it difficult to compare the profitability and performance of products or departments accurately.
- Distortion of profitability and performance: Allocating common costs can distort the profitability and performance of products or departments if the allocation method does not accurately reflect the cause-and-effect relationships between costs and products or departments.
- Disincentives for managers and employees: Allocating common costs can create disincentives for managers and employees if they are allocated a large portion of costs that are beyond their control or a small portion of costs that are easy to control.
5. How can businesses minimize the drawbacks of allocating common costs?
Businesses can minimize the drawbacks of allocating common costs by:
- Using multiple allocation bases
- Considering activity-based costing
- Implementing the dual-rate method
6. What is the stand-alone method for allocating common costs?
The stand-alone method allocates common costs based on the percentage that each department would have paid separately if they were responsible for their own costs. This method is simple to apply, but it can lead to arbitrary and inconsistent results if the departments have different cost structures.
7. What is the incremental method for allocating common costs?
The incremental method allocates common costs by identifying the cost that is avoidable and subtracting it from the total cost. The remaining cost is then allocated to the departments that benefit from it. This method is more complex than the stand-alone method, but it can provide more accurate results.
8. What is the Shapley value method for allocating common costs?
The Shapley value method allocates common costs by calculating the average of all possible allocations of the costs to the departments. This method is complex and computationally intensive, but it can provide fair and equitable results.