Accounting Business Reporting for Decision Making

CHAPTER 11 Costing and pricing in an entity 467

• to encourage the use of central resources by business units — if managers are charged for the costs of

a service (e.g. legal services and training services) whether they use it or not, they will be encouraged

to use it.

• to encourage mutual monitoring to control costs. If a manager is to be charged for a shared service,

the allocated costs will be benchmarked against external providers to ensure that the allocation is

within commercial limits.

Cost drivers

In order to allocate the indirect costs to individual cost objects, an appropriate driver (or allocation base)

needs to be identified to establish the link between the indirect cost and the many cost objects that make

use of the resource. A cost driver provides a measure of activity that explains the cost object’s use of

the indirect cost. In contrast, an allocation base is simply a variable used to allocate costs from a cost

pool to a cost object — there may not be a causal relationship. The accuracy of the cost allocation is

increased if there is a cause and effect relationship between the cost driver (allocation base) and the

indirect cost. That is, a change in the use of the cost driver should cause a corresponding change in the

amount of cost incurred. Criteria that can be used in the selection of an appropriate cost driver include:

• cause and effect — choosing the variables that cause resources to be consumed (e.g. allocating

machine costs based on the cost object’s use of machine time)

• benefits received — identifying the beneficiaries of the outputs of the cost object (e.g. allocating

advertising costs based on the cost object’s increase in income)

• fairness or equity — selecting the costs that appear reasonable and fair


• ability to bear — allocating costs in proportion to the cost object’s ability to bear them (e.g. allocating

indirect costs based on a cost object’s level of profit or level of income)

• behavioural — selecting a cost driver to modify behaviour (e.g. using direct labour hours to encourage

a reduction in the use of labour hours).

An analysis of the above criteria shows that, if accuracy of the full cost is the objective, the cause

and effect cost driver will be the most appropriate. All other criteria are subjective and may lead to

behavioural problems. Imagine that you are the manager of the department with the highest revenue;

how would you react if you were burdened with the majority of the indirect costs incurred to support all

departments simply because your unit earned the most revenue? The benefits received by particular cost

objects might be difficult to pinpoint; for example, how could an entity identify which particular depart-

ment benefited from an entity-wide advertising campaign? The ability to bear criterion will burden better

performing departments, while the behavioural criterion will be more focused on modifying behaviour

than developing the most accurate full cost. For example, in a Victorian municipality the council charged

more rates to the owners of vacant land than to home owners; the rates were set higher to encourage

construction. However, this approach to setting council rates caused much debate and dissent within the

community. The ratepayers of Palmerston City Council found themselves in a similar situation regarding

changes to the allocation of the council budget. See the reality check ‘Palmerston City Council rate

changes could cost residents “hundreds of dollars”, protesters say’.

REALITY CHECK

Palmerston City Council rate changes could cost residents ‘hundreds

of dollars’, protesters say

Palmerston City Council’s plan to change the way it calculates rates for some residential properties has

seen close to 200 residents take to the streets in protest.

Currently the council charges a flat rate but under the new proposal rates would be calculated based

on property values set the by Northern Territory’s Valuer General.