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Unformatted text preview: Electronic copy of this paper is available at: http://ssrn.com/abstract=965925 Efficient Cost Allocation Korok Ray * February 22, 2007 Abstract Firms routinely allocate the costs of common corporate resources down to divisions. This paper explores cost allocation rules that induce efficient capital investments by these divisions. It examines efficient allocation rules that satisfy properties of actual rules used in practice, namely budget balance, fairness, and simplicity. The main idea is that any efficient allocation rule must reflect the firm’s underlying costs. I explore the efficiency of linear allocation rules, and examine when nonlinear, simple allocation rules induce efficient investment. Finally, I propose a new allocation rule that achieves efficiency and approxi- mates budget balance, and is feasible even when the firm does not know its cost function exactly but must estimate it from internal cost data. * University of Chicago Graduate School of Business. I would like to thank Canice Prendergast, Madhav Rajan, Stefan Reichelstein, and participants of the Chicago Accounting brown bag for helpful comments and suggestions. Alex Frankel and Maris Goldmanis provided outstanding research assistance. University of Chicago GSB provided financial support. 1 Electronic copy of this paper is available at: http://ssrn.com/abstract=965925 1 Introduction The multiple divisions within a firm often share a variety of common resources, such as informa- tion technology, legal services, human resource management, executive time, etc. Managerial accounting textbooks (Horngren et al. (2005)) and surveys of company practice (Fremgen and Liao (1981), Atkinson (1987), Ramadan (1989), Dean et al. (1991)) document the widespread practice of common cost allocation to induce appropriate consumption of corporate resources. For example, if divisions were not allocated any corporate costs, they may have adverse incen- tives to overconsume such common resources. The objective of this paper is to examine cost allocation rules that solve this free-rider problem, i.e. induce efficient investment by divisions acting simultaneously and independently. The analysis here operates in environments that more closely resemble real-world settings, with the aim of recommending cost allocations that will be practically useful to managers. First, I depart from formal mechanism design theory (such as Green and Laffont (1979)) by working within a world of incomplete contracts. In particular, I assume that the private infor- mation of the divisional managers is too complex to be embedded within the firm’s contracts. Therefore, the firm cannot perfectly obtain the manager’s entire private information through a complex reporting game and contracts that depend on announcements of private information....
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