Aswath Damodaran 206
Allocated Costs
! Firms allocate costs to individual projects from a centralized pool (such as
general and administrative expenses) based upon some characteristic of the
project (sales is a common choice)
! For large firms, these allocated costs can result in the rejection of projects
! To the degree that these costs are not incremental (and would exist anyway),
this makes the firm worse off.
- Thus, it is only the incremental component of allocated costs that should show up
in project analysis.
! How, looking at these pooled expenses, do we know how much of the costs
are fixed and how much are variable?
Allocation is the accountant’s mechanism for fairness.
If the allocation is of an expense that would be incurred anyway, whether the
project is taken or not, it is not incremental.
It is difficult to figure out what allocated expenses are fixed and what are
incremental. One approach that works reasonably well for firms with a history is
to look at the expense (say, G&A) over time and compare it with some base
variable (revenues or number of units). If the expense is fixed, it should not vary
with the base variable. If it is variable, it will, and the nature of the variation will
help define how much is fixed and how much is variable.
G & A Expense = a + b (Revenues) across time
The coefficient on revenues will be the amount G& A will increase by for a
dollar change in revenues. This can then be used in conjunction with the
revenues on the new project, to specify the G&A that the new project should
carry.
