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14-26  (Cont’d)

4.Strengths  of Rhodes' proposal relative to existing single-cost pool method:

a.  Better able to capture cause-and-effect relationships.  Interest on debt is more likely caused by the financing of assets than by revenues.  Personnel and payroll costs are more likely caused by the number of employ­ees than by revenues.

b.Relatively simple.  No extra information need be collected beyond that already available.  (Some students will list the extra costs of Rhodes' proposal as a weakness.  However, for a company with $30 billion in revenues, those extra costs are minimal.)

Weaknesses of Rhodes' proposal relative to existing single-cost pool method:

a.May promote dysfunctional decision making.  May encour­age division managers to lease or rent assets rather than to purchase assets, even where it is economical for Richfield Oil to purchase them.  This off-balance sheet financing will re­duce the "identifiable assets" of the division and thus will reduce the interest on debt costs allocated to the division.  (Richfield Oil could counteract this problem by incorporating leased and rented assets in the "identifiable assets" base.)

Note:  Some students criticized Rhodes' proposal, even though agreeing that it is preferable to the existing single-cost pool method.  These criticisms include:

a.Proposal does not adequately capture cause-and-effect relationships for the legal and research and development cost pools.  For these cost pools, specific identification of individual projects with an individual division can better capture cause-and-effect relation­ships.

b. Proposal may give rise to disputes over the definition and valuation of "identifiable assets."

c.Use of actual rather than budgeted amounts in the allocation bases cre­ates interdependencies between divisions.  Moreover, use of ac­tual amounts means that division managers do not know cost alloca­tion consequences of their decisions until the end of each reporting period.

d.Separate allocation of fixed and variable costs would result in more refined cost allocations.

e.Questionable that 100% of central corporate costs should be allo­cated.  Many students argue that public affairs should not be allocated to any division, based on the notion that division managers may not control many of the individual expenditures in this cost pool.

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