Cost Allocation as a Coordination Mechanism

Abstract

This paper shows that cost allocation can endogenously arise as a coordination mechanism in a decentralized firm. This result is derived in a setting with multiple (internally supplied) resources shared by multiple users, which constitutes a departure from previous literature. While standard cost allocation procedures use one allocation base, the optimal cost allocation mechanism derived here can select many allocation bases, therefore, providing support for the use of Activity Based Costing. Like the cost allocation itself, the selection of allocation bases also arises endogenously.

Keywords: Cost allocation, pricing, decentralization, activity based costing