Accounting Business Reporting for Decision Making

572 Accounting: Business Reporting for Decision Making

Pricing guide

The second objective of preparing divisional performance reports is to provide a guide for the pricing of

products and services. The report in table 14.2 shows common costs of $200 000. A share of this cost is

normally allocated to each division, even though the divisional managers do not have any control over

such costs. This is done mainly for pricing determination. When setting the prices of their products, the

divisional managers must remember that the prices have to cover the entity’s total costs and operations.

These would include the entity’s common costs. The other benefit of allocating the common costs is to

increase awareness of the total entity costs and operations. Figure 14.5 lists the reasons why companies

allocate common costs.

FIGURE 14.5 Pros and cons of the allocation of corporate and other common costs to divisions

Source: Surveys conducted by Fremgen, J & Liao, S 1981, The allocation of corporate indirect costs, National Association

of Accountants, New York; Ramadan, S 1989, ‘The rationale for cost allocation: a study of UK divisionalised companies’,

Accounting and Business Research, Winter; and Dean, G, Joyce, M & Blayney, P 1991, Strategic management accounting

survey, The University of Sydney, Sydney.

Pros

1. To remind profit centre managers that indirect costs exist and that profit centre earnings must be
   adequate to cover some share of those costs.


2. To encourage the use of central services that would otherwise be underutilised.


3. To stimulate profit centre managers to put pressure on central managers to control service costs.


4. To acknowledge that divisions would incur such costs if they were independent units or if services were
   not provided centrally.
   Cons


5. Agreement on the allocation method is hard to obtain.


6. Allocation method is time consuming.


7. Allocations are seen as arbitrary.


8. Friction can arise between managers regarding allocations.


9. Usage of corporate and common services is hard to monitor.


10. Allocations can sometimes result in divisional losses being reported.

The difficulty in allocating common costs is in determining the basis for allocation. The direct costs of

each division can easily be traced to each division, but how can the common costs be allocated fairly to

each division? Should they be allocated based on factory floor space, revenues or investment? Common

costs must be allocated arbitrarily because there is no true cause/effect basis upon which to allocate

them. This was discussed in chapter 11. Illustrative example 14.3 provides an example where common

costs are allocated according to floor space.

ILLUSTRATIVE EXAMPLE 14.3

Divisional performance with common costs allocated

Using   the  information    from    illustrative    example 14.2,   assume  that     the     majority   of   common costs   arise   

from the building in which the factory is housed (that is, rates, insurance and so on). Therefore, it has

been    decided to   allocate   common  costs   according   to   floor  space.  Based   on   this    allocation,    the  cor-

porate division would be allocated 900/2000 × $200 000 = $90 000 in common costs. The department

stores division and the specialty stores division would be allocated $30 000 and $80 000 respec-

tively. After the allocation, the profit (loss) for each division is as follows: corporate division $310 000;

department stores division ($100 000); and the specialty stores division ($10 000). This is depicted in

table 14.3.