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The Alternative to Overhead Allocation Essay

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The Alternative to Overhead Allocation

            Goal congruence is the consistency or agreement of actions with organizational goals (AllBusiness). An important element underlying this principle is that goals set by top management are susceptible to distortion as it passes through the communication channels to the front line employees (Schaffer). Hence, the role of middle management as recipient and transmitter of the company targets is vital in achieving goal congruence. Should the branch managers of Creative Consumers Consultants, Ltd. (CCC), who are currently enjoying a high level of independence ever put their personal interests ahead of that of the company, a goal incongruence would result.

            The non-allocation of non-traceable costs to the branches provides for better goal congruence. First, it more accurately reports the profitability of the segments. Also, it reduces the potential conflict of interests of the branch managers.

Arbitrarily allocating the non-traceable costs is often justified on the ground that common costs have to be covered but this is not necessarily achieved by doing so. It may make an otherwise profitable segment appear to be unprofitable which might lead to its erroneous elimination that then results to the reduction of the overall profits to cover the common costs which is still there (Garrison, 565). For instance, the Paris office, which operated under a loss of $1 million when charged with its share of non-traceable costs yielded a profit of  $3 million (Figures 1&2). Since the consulting cost and other cost of $3.2 and $0.8 million, respectively, are common to all branches

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and are not directly attributable to the Paris branch, elimination of this segment does not ensure a better overall result for CCC. Non-allocation better reflects the profitability of the branch offices.

            Another important argument for non-allocation is that it avoids a potential conflict of interest. Since the basis of allocating the non-traceable costs is gross billings, the managers may be tempted to increase their bonuses by keeping the revenues and the traceable costs down. This would result to a higher net income for the branch, but not for CCC as a whole. The assumption for this conclusion is that the branch managers are given a bigger percentage of the branch net income than that of the total profits since they more directly influence the earnings of their respective branches than that of the company as a whole. Hence by manipulating the branches’ earnings they will still be able to obtain higher bonuses. Non-allocation reduces this problem since it presents a higher net income per branch and therefore higher bonuses for the managers (Figure 3).

            Non-allocation of non-traceable costs is advisable not only for the above mentioned reasons, but also because of the basic principle in accounting that costs should have a reasonable connection with the activity drivers. In the case of CCC, the non-traceable costs are not influenced by the gross billings.

Figure 1. Operating results of Creative Consumer Consultants, Ltd with allocation of non-traceable costs.

Total
New York
Chicago
Paris
Little Rock
Billings (Revenue)
50,000
22,000
10,000
16,000
2,000
Traceable Consulting Costs
(33,500)
(14,000)
(6,000)
(12,500)
(1,000)
Non-Traceable Consulting Costs
(10,000)
(4,400)
(2,000)
(3,200)
(400)
Gross Profit on Sales
6,500
3,600
2,000
300
600
Traceable Other Costs
(1,000)
(300)
(200)
(500)

Non-Traceable Other Costs
(2,500)
(1,100)
(500)
(800)
(100)
Net Income, total
3,000
2,200
1,300
(1,000)
500

Branch Managers’ Bonus Inputs:

Net Income, per office*

22
13
(10)
5
Net Income, total**

15
15
15
15
Total Bonus

37
28
5
20

Figure 2. Operating results of Creative Consumer Consultants, Ltd without allocation of non-traceable costs.

Total
New York
Chicago
Paris
Little Rock
Billings (Revenue)
50,000
22,000
10,000
16,000
2,000
Traceable Consulting Costs
(33,500)
(14,000)
(6,000)
(12,500)
(1,000)
Gross Profit on Sales
16,500
8,000
4,000
3,500
1,000
Traceable Other Costs
(1,000)
(300)
(200)
(500)

Net Income, per office
15,500
7,700
3,800
3,000
1,000
Non-Traceable Other Costs
(10,000)

Non-Traceable Consulting Costs
(2,500)

Net Income, total
3,000
7,700
3,800
3,000
1,000

Branch Managers’ Bonus Inputs:

Net Income, per office*

77
38
30
10
Net Income, total**

15
15
15
15
Total Bonus

92
53
45
25
*Assumption 1: The first bonus input is based on 1% of the net income of the manager’s office.

**Assumption 2: The second bonus input is based on 0.5% of company’s overall profit.

Total
New York
Chicago
Paris
Little Rock
bonus without allocation
215
92
53
45
25
bonus with allocation
90
37
28
5
20
difference
125
55
25
40
5

60%
47%
89%
20%
Note: The figures are expressed in 000’s of dollars.

Works Cited

“AllBusiness”. A D&B Company. April 17, 2009 <http://www.allbusiness.com/glossaries/goal-congruence/4942378-1.html>.

Garrison, Ray, and Eric Noreen. Managerial Accounting Ninth Edition. United States of America: Irwin McGraw-Hill, 2000.

Schaffer, Bryan. “The Nature of Goal Congruence in Organizations”. AllBusiness. April 16, 2009 <http://www.allbusiness.com/5523023-1.html>.