Why might it be a mistake to allocate fixed costs to different products or segments?

Allocating Fixed Costs

A firm has a product line . 

The total cost of production is

If we equate MR and MC for each product, revenue and variable costs are as given in columns 4 and 5 of the following table.

(See below for solution.)

          Table 1: Allocating Fixed Costs

One way an accountant might allocate fixed costs is to use the variable cost share.  Since the total variable cost is 120 and the variable cost for product 1 is 48, the cost share is 48/120 = 0.4.

Based on this rule, product 1 should be eliminated from the product line.  Table 1 becomes

Table : </span></p> <p class="MsoNormal"><span style="font-size:14.0pt">Since the profit is zero the form shuts down.</span></p> <p class="MsoNormal"><span style="font-size:14.0pt">&nbsp;</span></p> <p class="MsoNormal"><span style="font-size:14.0pt">An alternative Accounting Rule is to allocate costs according to the revenue share.</span></p> <p class="MsoNormal"><span style="font-size:14.0pt">&nbsp;</span></p> <p class="MsoNormal"><span style="font-size:14.0pt">&nbsp;</span></p> <table border="1" cellspacing="0" cellpadding="0" style="border-collapse:collapse;border:none"> <tr> <td width="71" valign="top" style="width:53.6pt;border:solid windowtext .5pt;padding:0pt 5.4pt 0pt 5.4pt"> <p class="MsoNormal"><span style="font-size:14.0pt">product</span></p> </td> <td width="33" valign="top" style="width:24.8pt;border:solid windowtext .5pt;border-left:none;padding:0pt 5.4pt 0pt 5.4pt"> <p class="MsoNormal"><span style="font-size:14.0pt"><script> MPSetEqnAttrs('eq0011','',3,[[9,11,4,-1,-1],[13,15,5,-1,-1],[14,19,7,-1,-1],[14,17,7,-1,-1],[19,22,8,-1,-1],[25,28,11,-2,-2],[40,47,17,-3,-3]]); MPEquation();

Revenue

Variable
Cost

Revenue
share

Allocated

Fixed cost

Accounting

Profit

1

6

14

84

48

0.28

47.60

-11.60

2

12

18

216

72

0.72

122.40

21.60

Total

300

120

1.0

170

10

          Table 2: Allocating Fixed Costs under alternative accounting rule

Thus under this rule product 1 is again unprofitable and is eliminated.

What should the firm do?

How should it do its accounting?

___________________________________________________

Solving for profit maximizing quantities (ignoring the fixed cost.)

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 &amp;nbsp; &lt;/span&gt;&lt;/p&gt; &lt;p class="MsoNormal" style="text-indent:36.0pt"&gt;&lt;span style="font-size:14.0pt"&gt;&amp;nbsp;&lt;/span&gt;&lt;/p&gt; &lt;p class="MsoNormal"&gt;&lt;span style="font-size:14.0pt"&gt;Then to maximize the profit from product 2,&amp;nbsp; &lt;script&gt; MPSetEqnAttrs('eq0018','',3,[[47,18,4,-1,-1],[65,24,5,-1,-1],[79,30,7,-1,-1],[72,27,7,-1,-1],[96,35,8,-1,-1],[120,44,11,-2,-2],[201,74,17,-3,-3]]); MPEquation();.</span></p> <p class="MsoNormal"><span style="font-size:14.0pt">&nbsp;</span></p> </div> </body> </html>

What are the problems of allocating fixed costs?

What are the disadvantages of fixed costs?

Why is it inappropriate to allocate common fixed expenses to segments or divisions?

What are the disadvantages of allocation?