On the allocation of overhead costs

Abstract

This paper analyses optimal overhead allocation in a simple one-period setting with several divisions (production, sales or service departments). At the begin-ning of the period, headquarters has to decide on the procurement of a common input. The divisions possess private information on their respective marginal profit expectations of the common input. The objective of headquarters is to determine the most efficient overhead allocation mechanism. Different mechan-isms are compared. The conclusion is that the non-allocation of the common costs leads to a presentation of excessive profit expectations by the divisional managers and will thus induce an overinvestment in the common input. The Groves scheme prevents such a misallocation of resources only if collusion is precluded. In contrast, full-cost allocation leads to the first-best solution if allocation is based on a measure that ideally approximates the divisions' pro-portion of marginal profitability of the input. Thus, in the case of homogeneous divisions which benefit equally from the common input an equal allocation is optimal. In the case that divisions with higher profits benefit more from a common input, the allocation of overhead costs according to the divisional profits observable at the end of the period (‘ability-to-bear’ principle) can be optimal.