Efficient Cost Allocation

Abstract

Firms routinely allocate the costs of common corporate resources down to divisions. This paper explores cost allocation rules that induce efficient capital investments by these divisions. It examines efficient allocation rules that satisfy properties of actual rules used in practice, namely budget balance, fairness, and simplicity. The main idea is that any efficient allocation rule must reflect the firm's underlying costs. I explore the efficiency of linear allocation rules, and examine when nonlinear, simple allocation rules induce efficient investment. Finally, I propose a new allocation rule that achieves efficiency and approximates budget balance, and is feasible even when the firm does not know its cost function exactly but must estimate it from internal cost data.

Keywords: Cost allocation, Free-rider problem, mechanism design

JEL Classification: M40, M46, G31