As the former CEO of Best Buy, Brad Anderson decided to implement a rather unorthodox approach to retail: to separate his 1.5 million daily customers into “angels” and “devils.”
The angels, customers who increase profits by purchasing high- definition televisions, portable electronics, and newly released DVDs without waiting for markdowns or rebates, are favored over the devils, who buy products, apply for rebates, return the purchases, and then buy them back at returned-merchandise discounts. These devils focus their spending on “loss leaders,” discounted merchandise designed to encourage store traffic, but then flip the goods at a profit on sites like eBay.com.
Best Buy found that its most desirable customers fell into five distinct groups: upper-income men, suburban mothers, small- business owners, young family men, and technology enthusiasts. Male technology enthusiasts, nicknamed Buzzes, are early adopters, interested in buying and showing off the latest gadgets. Each store analyzes the demographics of its local market, and then focuses on two of these groups. For example, at stores popular with Buzzes, Best Buy sets up videogame areas with leather chairs and game players hooked to mammoth, plasma-screen televisions.
Best Buy also began working on ways to deter customers who drove profits down. It couldn’t bar them from its stores. Starting in 2004, however, it began taking steps to put a stop to their most damaging practices by enforcing a restocking fee of 15% of the purchase price on returned merchandise. To discourage customers who return items with the intention of repurchasing them at an “open-box” discount, Best Buy started reselling the returned items over the Internet, so the goods didn’t reappear in the store where they were originally purchased.
This strategy stimulated growth for several years at Best Buy and helped the company survive the economic downturn while Circuit City, its leading competitor, went bankrupt. But Best Buy’s angels and devils strategy now must confront a new competitor, Walmart. With Walmart’s focus on consumers seeking no-frills bargains, Best Buy intends to match its new competitor’s prices while leveraging its tech-savvy sales force to help consumers navigate increasingly complicated technology.
To determine which product, customer, program, or department is profitable, organizations must decide how to allocate costs. Best Buy analyzed its operations and chose to allocate costs towards serving its most profitable customers. In this chapter and the next, we provide insight into cost allocation. The emphasis in this chapter is on macro issues in cost allocation: allocation of costs into divisions, plants, and customers.
Recall that indirect costs of a particular cost object are costs that are related to that cost object but cannot be traced to it in an economically feasible (cost-effective) way. These costs often comprise a large percentage of the overall costs assigned to such cost objects as products, customers, and distribution channels. Why do managers allocate indirect costs to these cost objects? Exhibit 14-1 illustrates four purposes of cost allocation.
For some decisions related to the economic-decision purpose (for example, long-run prod- uct pricing), the costs in all six functions are relevant. For other decisions, particularly short-run economic decisions (for example, make or buy decisions), costs from only one or two functions, such as design and manufacturing, might be relevant.
For the motivation purpose, costs from more than one but not all business functions are often included to emphasize to decision makers how costs in different functions are related to one another. For example, to estimate product costs, product designers at companies such as Hitachi and Toshiba include costs of production, distribution, and customer service. The goal is to focus designers’ attention on how different product-design alternatives affect total costs. For the cost-reimbursement purpose, a particular contract will often stipulate what costs will be reimbursed. For instance, cost-reimbursement rules for U.S. government con-tracts explicitly exclude marketing costs.
For the purpose of income and asset measurement for reporting to external parties under GAAP, only manufacturing costs, and in some cases product-design costs, are inventoriable and allocated to products. In the United States, R&D costs in most industries, marketing, dis- tribution, and customer-service costs are period costs that are expensed as they are incurred. Under International Financial Reporting Standards (IFRS), research costs must be expensed as incurred but development costs must be capitalized if a product/process has reached technical feasibility and the firm has the intention and ability to use or sell the future asset.
After identifying the purposes of cost allocation, managers and management accountants must decide how to allocate costs.
Exhibit 14-2 presents four criteria used to guide cost-allocation decisions. These deci- sions affect both the number of indirect-cost pools and the cost-allocation base for each indirect-cost pool. We emphasize the superiority of the cause-and-effect and the benefits- received criteria, especially when the purpose of cost allocation is to provide information for economic decisions or to motivate managers and employees.2 Cause and effect is the primary criterion used in activity-based costing (ABC) applications. ABC systems use the concept of a cost hierarchy to identify the cost drivers that best demonstrate the cause- and-effect relationship between each activity and the costs in the related cost pool. The cost drivers are then chosen as cost-allocation bases.
Fairness and ability-to-bear are less-frequently-used and more problematic criteria than cause-and-effect or benefits-received. Fairness is a difficult criterion on which to obtain agreement. What one party views as fair, another party may view as unfair.3 For example, a university may view allocating a share of general administrative costs to gov- ernment contracts as fair because general administrative costs are incurred to support all activities of the university. The government may view the allocation of such costs as unfair because the general administrative costs would have been incurred by the university regardless of whether the government contract existed. Perhaps the fairest way to resolve this issue is to understand, as well as possible, the cause-and-effect relationship between the government contract activity and general administrative costs. In other words, fair- ness is more a matter of judgment than an easily implementable choice criterion.
To get a sense of the issues that arise when using the ability-to-bear criterion, con- sider a product that consumes a large amount of indirect costs and currently sells for a price below its direct costs. This product has no ability to bear any of the indirect costs it uses. However, if the indirect costs it consumes are allocated to other products, these other products are subsidizing the product that is losing money. An integrated airline, for example, might allocate fewer costs to its activities in a highly contested market such as freight transportation, thereby subsidizing it via passenger transport. Some airports cross-subsidize costs associated with serving airline passengers through sales of duty-free goods. Such practices provide a distorted view of relative product and service profitabil- ity, and have the potential to invite both regulatory scrutiny as well as competitors attempting to undercut artificially higher-priced services.
Most importantly, companies must weigh the costs and benefits when designing and implementing their cost allocations. Companies incur costs not only in collecting data but also in taking the time to educate managers about cost allocations. In general, the more complex the cost allocations, the higher these education costs.
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