Arbitrary Allocation
Arbitrary allocation is a term in cost management referring to a method where the allocation base used to distribute costs among different departments, products, or activities does not necessarily reflect the true cause-and-effect relationship of incurred expenses. This type of allocation is generally recognized for its potential to skew the real cost associated with various functions within an organization.
Example
Take the scenario of allocating the cost of a lecture: whether addressing 10 students or 200, the lecture demands the same resource expenditure — one lecturer working for one hour. Using the number of students as a basis for cost distribution (allocation base) leads to an arbitrary allocation. The cost per student appears drastically lower in a larger class, but this doesn’t accurately reflect the actual cost of delivering the lecture.
The Move Toward Rational Allocations
The advent of activity-based costing (ABC) has highlighted the inefficiencies of arbitrary allocations. ABC advocates for cause-and-effect allocations, where costs are distributed based on actual consumption or influence on costs, striving for accuracy that supports better decision-making and resource utilization.
Why Avoid Arbitrary Allocation?
Arbitrary allocations can lead to misleading cost information, which may result in poor strategic decisions, inefficiencies in resource utilization, and unjustified pricing strategies. Understanding and identifying these allocations help managers avoid these pitfalls, ensuring financial clarity and operational efficiency.
Related Terms
- Cost Allocation: Refers to the process of identifying, aggregating, and assigning costs to cost objects, such as departments or products.
- Allocation Base: A measure or metric used to distribute total costs among different cost objects, ideally reflecting the cause-and-effect relationship.
- Activity-Based Costing (ABC): A methodology that assigns manufacturing and non-manufacturing costs to products or services based on the activities those products or services require.
- Cause-and-Effect Allocations: Allocation strategies that rely on direct correlations between the resource being consumed and the resulting costs.
Suggested Books for Further Studies
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren - Delve into cost management practices including detailed information on different types of costing methodologies.
- “Activity-Based Costing: Making It Work for Small and Mid-Sized Companies” by Douglas T. Hicks - Explore ABC’s applicability beyond large corporations, understanding its relevance to smaller business contexts.
Arbitrary allocation holds a comedic value in the often dry world of accounting — imagine using the number of coffee cups used as a basis for allocating the electricity bill! Despite the humor, the very real consequence is the distortion of cost information, which is no laughing matter when managing a business’s wallet.
