The Role of Cost Allocation in Mitigating Resource Over-Consumption and Performance Impact of Distorted Cost Allocation

Abstract

This study first investigates whether cost allocation is essential, in the sense that it creates incentives for managers to control costs. I document that the absence of allocation negatively affects firms cost management, which could be interpreted as the result of over-usage of common resources. Next, among firms that allocate costs, I assume that some firms distort cost, so that the allocated cost is deviated from the optimal level, which a division expects that they are accountable for. I investigate the impact of cost distortion on segment- and firm-level performance by using a comprehensive sample compiled from a Compustat-Segment database from 2000 to 2015. I find (partial) evidence that over-allocation (under-allocation) discourages divisional managers to improve their subsequent performance and that cost distortion, in general, negatively affects the segment-level and overall firm-level performance. My findings suggest that in order to motivate managers and facilitate their decisions, overhead costs should be allocated at an anticipated level, which reflects the actual divisional consumption of common resources.