Performance Effects of Insulating and Non-Insulating Cost Allocations

• In Event: Decision-Making in the Presence of Ambiguity and Uncontrollable Events

Abstract

Despite improvements in the ability to track or trace costs to individual business units, firms still often allocate significant amounts of common costs between units for several purposes, including decision-making and control. Thus, the selection of appropriate allocation bases and methods represent important control choices for firms. One decision firms must make in this regard is whether allocations will be insulating or non-insulating. Non-insulating cost allocations distribute costs ex post based on same-period relative performance, creating a contemporaneous interdependency between managers. Conversely, insulating cost allocations distribute costs ex ante and are independent of relative performance during the period. Theory suggests this fundamental difference is likely to affect managers’ perceptions and behavior in important ways. In an experiment, we predict and find that performance is lower when managers are allocated common costs via a non-insulating cost allocation as compared to when costs are allocated via an insulating allocation. We also predict and find that, under an insulating cost allocation, performance is lower when a negative uncontrollable event occurs that reduces the return to managers’ effort. However, the shock-absorbing, interdependent nature of the non-insulating allocation leads to performance increases in the presence of such an event. Our study helps inform managers of some of the costs and benefits of different cost allocations.

Authors

• Jason Brown, Indiana University - Bloomington

• Geoff B Sprinkle, Indiana University - Bloomington

• Dan Way, Clemson University