How do you deal with indirect costs without cost drivers?

In the previous sections, I have stressed that the allocation base of a cost pool should be the cost driver of all the indirect costs gathered in that cost pool. There should be both causation and correlation between the allocation base and the indirect costs it allocates. I also stressed that a failure to comply with this principle results in costing distortions: some products are over-costed (they are allocated more than they consume) and other products are under-costed (they are allocated less than they consume).

When stating these principles, I purposefully ignored what caused the controversy between absorption costing and variable costing: differences in cost behavior and more specifically the difference between variable costs and fixed costs (typically capacity costs). The latter do not change with the volume of activity. Therefore they have no cost driver and they cannot be correlated with anything: no variation, no correlation because correlation is common variation.

Capacity costs are the costs of acquiring in advance (i.e. before the work is done) resources necessary to make or deliver goods or services. They ensure that the company is able to achieve a desired level of production or to provide the desired level of service while maintaining product or service attributes, such as quality. These costs are incurred because the capacity is made available, not because the capacity is used.

So what can we do with capacity costs which have no underlying cost drivers? We have three options: interpret the rule loosely; maintain the rule at a cost; or ignore the rule completely to pursue another goal.

Interpreting the rule loosely: single rate cost allocation system

Causality is an ambiguous idea. Here, it is helpful to understand its two facets which are implicit in the distinction between “why?” and “what for?”:

  • Why does a bakery incur energy costs? Because it uses lights and machines which both consume energy;
  • What does a bakery incur energy costs for? To lighten the factory and produce bread and pastries.

The notion of Cost driver refers to the “why” of a cost, the event that triggered the consumption of resource; it relies on “push” reasoning where the cause (cost driver) always precedes the consequence (resource consumption). The notion of purpose refers to the “what for” of a cost, the reason justifying the resource consumption; it relies on a “pull” reasoning where the cause of a cost is not what precedes, but what follows, i.e. the desired consequences of consuming the resource.

Interpreting the rule loosely consists in pooling together indirect costs which serve the same purpose (what for?) but do not necessarily have the same cost driver (why?) and thus may have different behaviors (i.e. they are not correlated). For instance, the depreciation or insurance of machines are fixed costs incurred every period, whatever the level of activity. Now these costs are incurred for the purpose of making machine hours available for production. Therefore it makes sense to pool them with energy and other machine maintenance costs, which all serve the same purpose, and then to allocate them all together based on machine hours. This reasoning results in a single rate cost allocation system where indirect costs are pooled based on their purpose and no further distinction is made based on cost behavior.

A single-rate cost allocation system uses a unique allocation base and allocation rate for each cost pool.

Sticking to the rule: dual rate cost allocation system

Sticking to the rule consists in using distinct cost pools for costs which have not only different purposes, but also different behaviors. Technically, it subdivides cost pools based on purpose in two sub-cost pools: one gathering indirect costs serving the same purpose and proportional to the volume of activity (variable indirect manufacturing costs); and one gathering indirect costs serving the same purpose but not proportional to the volume of activity (fixed or capacity indirect manufacturing costs). This results in a dual rate cost allocation system.

The dual-rate cost allocation system splits any cost pool into two sub-pools, typically one for variable costs and one for fixed costs, each sub pool having at least a different allocation rate, sometimes even a different allocation base.

The underlying reasoning is that while the first kind of costs is driven by actual activity, the second kind is driven by planned activity. Indeed, planned activity resulted in the acquisition of the resources necessary to achieve it; therefore, planned activity drives capacity costs. This is a powerful distinction to manage costs, especially combined with normal or standard costing which we will discuss in another section. However, it effectively doubles the number of cost pools and therefore increases the cost of costing.

Ignoring the rule: arbitrary vs. discretionary allocation bases

The last approach consists in ignoring the rule, and there is a good way and a bad way to do it (or I should probably write “a bad way and a worse way”). The bad way is to select an allocation base which has no cause and effect relationship with the indirect costs it allocates and serves no alternative purpose: this is an arbitrary allocation base. The good way is to select an allocation base which has no cause and effect relationship with the indirect costs it allocates but serves an alternative purpose: this is a discretionary allocation base.

When you allocate costs using an allocation base, you make the use of this allocation base more expensive. For instance, if you pay your employees 60 euros per hour and allocate 20,000 euros of factory building rent over 1,000 hours worked in a month, every labor hour will effectively cost 60 + 20,000 / 1,000 = 80 euros to the cost objects (and thus to managers) using them.

This additional “taxation” of labor hours provides an incentive to reduce as much as possible their use. If this is by accident, i.e. the manager did not want to discourage the use of labor, the allocation base is arbitrary. However, if this is on purpose, the allocation base is discretionary: it is at the discretion of the manager who uses this as a tool to orient the decisions made by other managers (so for management control).

Another goal which can be pursued with discretionary allocation bases (besides taxation) is to elicit dialogue between managers about how to manage some shared costs. Indeed, if they bear these costs together, they will care about these costs together. In any case, when selecting an allocation base not causally related to the costs it allocates, it is crucial to determine whether it will induce desirable consequences (e.g. taxing the use of chemicals which hurt the planet vs. taxing labor).

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