Product Cost Bias and Selection of an Allocation Base.

This paper constructs a model to explain the determinants of the extent of product cost bias which results when a firm employs a conventional two-stage overhead cost allocation system. The extent of product cost bias has previously been hypothesized to be a function of (1) production technology heterogeneity, (2) unit input costs, and (3) product mix. Our model provides an explicit framework within which to analyze such factors and their interactions. In particular, we derive an expression for the firm's economic loss from product cost distortion as a function of each product's squared bias and the extent of product market competition. In turn, the squared bias is shown to be a function of the heterogeneity of the production technology, unit input costs, and the product mix. In addition, the paper uses the model described above to develop and evaluate algorithms which managers can use as practical guides in choosing the best allocation base at each overhead cost pool. Such algorithms are potentially valuable to firms in two ways. First, in designing the firm's cost system, particularly the overhead cost pool structure, the algorithms can help managers to quantify the magnitude of cost distortion induced by alternative allocation bases, thus allowing improved tradeoffs to be made. Second, once an overhead cost pool design has been chosen, the proposed algorithms can also be used in selecting the best allocation base at each cost pool. [ABSTRACT FROM AUTHOR]