Cost allocation: Hugh Evans and Deborah Wall offer their guide to developing an accurate, yet simple and pragmatic, approach to cost allocation that's most appropriate for your organisation.

AuthorEvans, Hugh
PositionTechnical matters

Cost allocation arrangements tend to influence an organisation's behaviour significantly if, as the saying goes, "what gets measured gets done"--providing that it's recognised and rewarded. If a company's chosen approach to allocation elicits the wrong behaviour, this can be commercially sub-optimal at best and dysfunctional at worst. For example, if a firm allocates costs to products--laptop PCs, say--this often focuses managers' attention on the quantity of laptops in possession instead of the true cost performance metrics. Conversely, a well planned and constructed allocation method can help to drive effective business strategy.

Leading global organisations have realised the importance of cost allocation and have developed suitable approaches that allow them to manage allocations and recoveries in a way that's aligned to their strategies. They are also increasingly recognising that using the right method is only part of the journey. The ultimate goal should be improved cost-efficiency across the organisation, with better, faster and more informed decision-making.

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Cost allocation also often has direct external commercial effects. First, it will have an impact on charges made to joint-venture partners that might want the allocation method audited and certified, especially if costs are not linked clearly to the services provided. Second, the choice of allocation method will have an impact on transfer pricing compliance and the group tax charge; and, when the allocation mechanics are driven entirely by the business, the tax impact might not be considered.

Charges between a group's subsidiaries for the provision of goods and services must be calculated at an "arm's-length" price--as if those subsidiaries were independent third parties. So, whenever a firm is thinking about changing its allocation method, it is crucial to ensure that the tax aspects are considered in order to set a price that is arm's-length and thereby avoid being penalised. The impact on the tax charge and cash tax should also be considered to ensure that there is no unexpected result. For these reasons, any allocation method must ensure that the mechanics are justifiable and transparent; that all parties see the allocation as fair and justifiable; that it can be defended as being arm's-length; and that the impact on the group tax charge and partner recovery is understood clearly.

Lastly, an attribute that should be uppermost in a company's thinking...

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