The End of Cost Allocations as We Know Them

Cost allocation issues have befuddled management around the world for over a century. And, because of “informational asymmetries” and agency conflicts between operating management and headquarters, there is no clear theoretical solution to the problem. Nevertheless, there are good reasons for allocating costs. If properly structured, transfer‐pricing schemes can serve the same purpose as a market price. By communicating useful information about the relative scarcity of resources within an organization, they can serve to balance supply and demand for the product or service being priced. Unfortunately, most transfer‐pricing approaches, like Activity Based Costing, attempt to solve the problem by refining standard cost measures. In contrast to ABC, this article begins by recognizing that efforts to develop more precise cost allocations are bound to be frustrated by the information and incentive problems noted above. And in place of more precisely formulated measures of cost, the author proposes a process of negotiation between two parties to an exchange—a process that is reinforced by a performance measurement system that gives both parties incentives to reveal their “reservation” prices for the good or service in question. For transfers involving multiple users of a given service or products, the author recommends a transfer auction process that is also designed to make would‐be users reveal their assessments of value.