cost allocation lump sum

COST ALLOCATIONS- EASY METHOD IS NOT ALWAYS RIGHT

April 19, 2012
by browne_admin

After being a witness to a company’s boardroom profitability review, I began to wonder whether the current economic condition has given rise to a renewed focus area of cost management. Cost allocation is a managerial accounting process of assigning of common costs to cost objects. One key observation during our client’s SBU profitability review meeting was that each of the SBUs had a diverse product/service lines with widespread disparity in their profitability. The company was following a common cost allocation approach a deep-rooted belief that all costs must in some manner be fully allocated to the revenue generating units of an organization. This approach assumes that costs are proportional to the output which may be far from truth. For example, Cost of unbilled Resources who are not assigned to projects was being allocated on a lump-sum basis to all the SBUs. As a result of this, SBUs with lower headcount were undercosted and SBUs with higher headcount were overcosted. This was one of the reasons which had led to the widespread disparity in profitability across the SBUs that led to their goals go out of reach. Bad information was leading to bad decisions. Lump-sum allocation method is easier to implement, it ignores changes in activity levels. Lump-sum allocation method provides a very little tie-up between costs and volume of products / services actually consumed.

On the other hand, finer allocations based on actual activities involved in a process/SBU may reveal the right costs. Activity based costing (ABC) is a method that leads to lesser undercosting or overcosting of products / services. Activities in ABC could range anything from processing purchase orders, producing software using certain employee headcount, setting up machinery /equipment, inspecting finished goods, packing customer orders, etc. Although ABC implementation is costlier, the benefits derived far outweigh the costs. I would like to conclude that ABC employs the activity concept thereby providing satisfactory data to end-users such as how product/service is produced, how much efforts is needed to perform an activity and finally how much money is spent on performing this activity. Using the ABC model, it has been proven that concealed losses and pricing decisions can be analyzed.

-Pratibha Sharma

Cost Allocation

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on June 08, 2023

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Table of contents.

Cost allocation is a process in which businesses and individuals identify the costs incurred by activity and distribute them to appropriate accounts .

This allows for better decision-making when determining how much should be spent on different business areas.

Types of Costs

There are types of costs to consider during the process of cost allocation. They include:

Fixed costs . These are expenses that remain the same no matter how many units of production have been made or sold. For example, a business spends $100,000 on rent every month. Even if the company can only produce and sell 50 units of a product in one month (when they normally make and sell 100), this cost remains at $100,000 for that given time period.
Variable costs . These expenses depend on the amount of production or sales made within a given period, such as raw materials used for making products. For example, it costs a furniture shop $50 to make a chair—$20 for raw materials such as wood, cane, metal, leather, and fabrics, and $30 for the direct labor involved in making one chair.

Below shows how the variable costs change as the number of chairs made varies.

As the production output of chairs increases, the bakery’s variable costs also increase. When the furniture shop does not make any chair, its variable costs drop to zero.

Indirect costs . These are expenses that cannot be directly linked to the making or selling of goods or services, such as administrative salaries, office expenses, security expenses, and utilities.
Direct Costs. These are costs that can be directly linked to the making or selling of goods or services. For example, if a company pays for equipment rental to produce their product, this cost is considered direct because it links back to how many units have been produced.

Why Is Cost Allocation Important?

Cost allocation is an important part of any business. The following points reflect why you should always be sure to allocate all your expenses:

It helps in accurate decision-making. When costs are known, it is easier to determine which strategies will most benefit the business or individual.
Allocating cost enables comparison between different products and services.

For example, comparing the cost of producing one product versus another can help decide which should be produced more often based on its profitability compared with other goods or services offered by a company.

It helps in understanding which departments are more profitable than others. Identifying the cost of different areas of business allows for better decision-making at the departmental level, and overall.
It can help identify problem areas within a company to allow for improvements or changes that might be beneficial for future production or sales.

Taking these factors into account when allocating cost allows businesses and individuals to understand better how much money they need coming in (revenue) compared with how much they must spend (costs).

This makes setting prices easier since there is an understanding of what each unit sold brings in revenue-wise.

Common Mistakes People Make When Allocating Costs

Not accounting for overhead . Overhead is a general term that refers to indirect expenses, which are not directly attributed to the cost of goods sold (COGS) or fixed costs.
Not taking into account which projects are currently generating revenue and which ones aren’t.
Not allocating indirect expenses equally among departments and projects within a company.
Not considering how fluctuating revenue affects indirect expenses. If you’re seeing a lot of variability in revenue over time, you need to account for that when allocating costs.
Using the incorrect allocation method. There are many different methods for allocating costs and using more than one can help you get a better idea of where your business is spending its money.

Process of Cost Allocation

The following is an overview of how to allocate costs and some tips on what you should take into consideration when doing so.

Step One: Identify Your Costs

The first step is to identify all of your costs. This includes both direct and indirect expenses, as well as fixed or variable costs.

Step Two: Allocate Indirect Costs Between Departments or Products

Indirect costs should be allocated between departments, projects, and products based on a fair allocation plan that reflects their use in those areas.

For example, suppose your company produces two products, products A and B.

In that case, you will need to construct a cost-allocation plan that reflects the allocation of overhead expenses between these areas.

Step Three: Allocate Fixed Costs Among Departments or Projects

Fixed costs are allocated among departments or projects based on how they benefit each area.

For example, if Product A produces a specific product that is used for Product B, it would be appropriate to allocate the fixed costs associated with producing Product A between these two products.

Step Four: Allocate Variable Costs Among Departments or Projects

Variable costs are allocated among departments or projects based on how much of each cost driver they use.

For example, if your company produces two products, A and B (and each product has its own direct labor cost), you would first need to determine how many units of Product A are produced for every unit of Product B sold.

You can then use this information to allocate the variable costs associated with producing each product based on their respective rates.

Step Five: Use Cost-Volume-Profit Analysis to Determine the Best Allocation Method

If your company uses multiple products, services, or departments that incur indirect costs, cost allocation is important in determining which method will work best for reporting profits accurately.

For example, suppose you’re using a full absorption costing (FAC) system and another department within your company is using a direct labor cost system.

In that case, you may need to use more than one allocation method.

Step Six: Use Cost Allocation for Decision Making & Reporting

Cost allocation is important for both decision-making and reporting purposes.

Using cost allocation, you can determine which areas of your company are over or under-spending and how changes to specific processes will affect the overall profitability of a product or department.

Common Cost Allocation Methods

Cost allocation faqs, what is cost allocation.

Cost allocation is the process of assigning expenses to one or more cost objects. A cost object can be a product, project, department, business unit, or another grouping within an organization with costs associated with it.

How is cost allocation done?

There are many ways to allocate expenses, including the high/low method and step-up/down. There’s also a simple way called the direct materials cost method that uses an allocation base of the same value as the variable rate. Using FAC or Variable costing can provide more accurate reporting on your company’s financials.

What are the benefits of cost allocation?

Cost allocation allows you to determine where costs can be reduced and provides accurate reporting on company financials based on its relative performance. Allocating indirect expenses is also important for decision-making purposes. With this information, you can determine which areas of your business need improvement and how changes in production will affect overall profitability. Cost allocation can also show you which departments or products are spending too much money on indirect expenses, and which ones aren’t using enough of them. This enables you to make more informed staffing decisions in the future based on how your company’s needs change over time. Finally, cost allocation allows companies to compare their performance against similar businesses.

What are common mistakes people make when allocating costs?

One of the most common mistakes is to allocate indirect expenses based on current production volume. Other issues include not performing cost allocation at all or using arbitrary rates rather than industry standards. When deciding how to allocate these types of expenses, companies should consider their company’s size and what it will cost to produce a certain amount of output.

How is cost allocation performed?

Cost allocation can be done manually or through software. It’s important to keep detailed records of all your company’s expenses so you have accurate financial reports for decision-making purposes. If you don’t have cost records, the process of allocation can be time-consuming and difficult to determine. You may not know which department or product each expense is associated with, so your reports will lack accuracy.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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Lump Sum Contracts: Advantages, Disadvantages & When to Use

All construction contracts address critical aspects of a project, including its scope of work, price and payment terms, schedule and an explanation of each party’s rights and responsibilities. However, lump sum contracts have specific criteria that can be both a benefit and a hindrance to a construction project.

What Is a Lump Sum Contract?

Under a lump sum contract, also known as a stipulated sum contract, the project owner provides explicit specifications for the work, and the contractor provides a fixed price for the project. These contracts require the owner to complete the project’s plans, designs, specifications and schedule before the contractor can establish a price. The contractor then estimates the costs of materials, tools, labor and indirect costs such as overhead and profit margin and provides a quote.

If the project’s final costs are lower than the contactor’s estimate, then their profit increases. If the estimate is too low, the contractor’s bottom line suffers. However, the project owner’s finances are unaffected in either scenario.

So, what does lump sum mean in a contract? Despite the “lump-sum” moniker, this term refers to how the project is priced rather than the payment terms. With these contracts, payment usually occurs on an installment basis. This can be as project benchmarks are met or in regular increments (e.g., monthly).

To modify a lump-sum contract, project owners must submit a change order document that the contractor must approve along with any price changes. That makes lump-sum contracts somewhat inflexible, but they provide a reliable price for owners and reliable revenue for contractors, making them one of the most popular types of construction agreements.

Contractors and project owners often wonder, “what is the difference between fixed price and lump sum contracts?” Simply put, these terms are interchangeable and are two names for the same concept. However, there are some crucial distinctions between lump sum contracts and other construction agreements.

Lump Sum vs. Cost-plus Contracts

Cost-plus contracts are similar to lump sum contracts in that the owner agrees to pay the contractor’s costs, including labor, subcontractors, equipment and materials and an amount for the contractor’s profit and overhead. But instead of a lump sum to cover all the expenses, those costs are reimbursed individually.

These agreements do not require the project owner to have finalized plans for the project. That means that the scope and cost are subject to change. Unlike lump-sum agreements, owners take on more risk and will benefit or be disadvantaged if the final costs are lower or higher than estimated as they are directly reimbursing the contractor’s expenses.

There are three types of cost-plus contracts:

A cost-plus-fixed-fee contract where the contractor is paid a base amount independent of the final project cost.
A cost-plus fixed fee with a guaranteed maximum price contract where the contractor’s compensation is based on a fixed amount that does not exceed a specific threshold.
A cost-plus fixed percentage contract where the contractor’s compensation is based on a percentage of the cost.

These contracts are most common when designs, plans or other specifications are still in flux, but the owner still wants to begin construction, such as when the project is on a tight schedule.

The main advantage of cost-plus contracts for both owners and contractors is that the work likely gets done to specifications because the contractor won’t incur any extra costs for increased materials or labor costs. However, contractors and project owners must track costs and supervise the project carefully to ensure fair payment, requiring more burdensome paperwork and oversight.

Lump Sum vs. Time and Materials Contracts

Time and materials (T&M) contracts stipulate that the owner provides reimbursement for materials and a daily or weekly payment for labor costs. Like cost-plus contracts, time and materials contracts work well with project specifications and scopes that are still ambiguous as the project starts.

T&M contracts provide contractors with a daily or weekly rate, providing a steady income. Project owners benefit from the adaptability of these agreements, ensuring that the work occurs to specification.

Time and materials contracts require additional paperwork compared to lump sum contracts because labor costs must be recorded accurately.

Lump Sum vs. Unit Price Contracts

For unit price contracts, the price is based on the estimated per-unit cost of the materials and is divided into stages, usually by construction trade (e.g., carpentry, electric, plumbing and more). For this reason, unit price contracts are standard in subcontracting agreements. Many painting contracts, for example, follow a unit-price structure as painting is generally charged on a square-foot basis.

As with cost-plus and T&M contracts, unit price contracts benefit project owners when they have a general idea of the project that needs to be done, but the concrete planning isn’t completed. For example, you may establish a per-square-foot price for flooring and installation, even though you don’t know exactly how many square feet of flooring you’ll need covered. Because you know approximately how much materials and labor would cost, you can establish a unit price for this and other aspects of a construction project. Contractors can get a handle on good approximations of costs and revenue from each stage. Both owners and contractors can adapt the project as necessary without having to submit change orders and renegotiate prices, as they would have to do with a lump sum contract. A notable shortcoming is that there is a significant risk of cost overrun since these contracts usually lack a unit threshold.

Lump Sum vs. Guaranteed Maximum Price Contracts

A guaranteed maximum price contract (GMP), also known as a not-to-exceed price contract, requires owners to compensate contractors for their direct costs as well as a fixed fee for overhead and profit — but only to a certain threshold. The contractor is responsible for additional costs once reaching this amount. The maximum price can be increased via a change order if the project’s scope changes, but not for errors or cost overruns.

Remember, with lump sum contracts, whether or not the project actually cost the estimated amount, the contractor gets the same amount. That is not the case with maximum price contracts and the owner, not the contractor, will keep cost savings if things come in under budget. In some cases, the owner can share a portion of any savings with the contractor to encourage timely work and keep costs low.

These contracts are suitable for owners who have a tight budget as there is an absolute upper limit. For contractors, however, GMP contracts increase their financial risk if costs exceed the limit.

When Would You Use a Lump Sum Contract?

Lump sum contracts are standard in construction projects, but they aren’t suitable for every situation. These contracts work best for projects with finalized plans, clearly defined scopes and schedules and proper documentation of all assessments and other pre-construction activities. These aspects are crucial to allow the contractor to estimate project costs and provide the lump-sum amount accurately.

These agreements are best suited for simple projects with subcontractors, specific parameters and a low risk of unforeseen problems.

When all of these elements align, lump sum contracts provide an uncomplicated agreement that both project owners and contractors can easily understand and agree on. But what are the advantages and disadvantages of a lump sum contract? Advantages for owners include simplified accounting and little financial risk, and disadvantages include rigidity in project scope and a need to have every detail planned before beginning the project. Advantages for contractors include clear directions, less paperwork and a potential for profit if the project comes in well under budget, and disadvantages include risk if the project is more costly than expected.

Advantages of Lump Sum Contracts

The simplicity of lump sum contracts provides benefits for both owners and contractors.

Advantages for project owners

The predictability of lump sum contracts is the primary benefit to project owners. The owner can expect the project to be completed within budget and often more quickly so that the contractor can maximize resources and save on labor costs. Lump sum contracts also render little financial risk for owners as the contractor is responsible for any cost overruns. These factors make it easier for project owners to obtain financing since lenders prefer to fund defined projects with clearly delineated costs.

Owner supervision of lump-sum contracts is minimal as the owner does not need to track costs. Also, the payment structure of lump sum contracts usually comprises regular payments at specific iterations or as a percentage of the work that has been completed, simplifying accounts payable processes.

Advantages for contractors

Despite the increased financial risk of lump sum contracts compared to some other types of agreements, contractors still receive many benefits.

Under a lump sum agreement, project owners must provide contractors with finalized plans and thorough documentation, resulting in specific, linear project tasks. Lump sum contracts also require less paperwork, management and accounting , decreasing administrative costs.

Another advantage of lump sum contracts is that they do not require contractors to disclose how they calculated their materials or labor costs, allowing them to provide estimates with sufficient cushion to avoid going over budget. If the project is under budget, the contractor keeps the profit.

Disadvantages of Lump Sum Contracts

Lump sum contracts can have downsides for owners and contractors, as well.

Disadvantages for project owners

Owners must submit and adhere to completed designs and finalized plans, making the project inflexible. If a change is needed, lump sum contracts stipulate the use of a formal change order process and a considerable amount of paperwork.

There is also the risk of being charged a higher amount to cover the contractor costs for unforeseen situations. Similarly, contractors could use inferior materials or otherwise cut costs to increase their profit from the fixed price. That’s why it’s prudent for owners to specify materials in the pre-construction documentation they provide to the contractor.

Disadvantages for contractors

Contractors incur the cost of going over budget, which can eat into profits. Contractors also share the disadvantage of time-consuming change order paperwork if modifications need to occur.

Variations in Lump Sum Contracts

Variations are prevalent triggers of disputes in construction projects. With lump sum contracts, any change in the plan, scope or costs is considered a variation. The most common causes of variations include:

Design errors, omissions and discrepancies
Incorrect interpretation of plans or designs
Specification changes
Increases or decreases in necessary material quantities

There are two types of variations. Beneficial variations reduce or eliminate costs, shorten the schedule or otherwise improve the project, which can be a boon to owners and contractors. Detrimental variations negatively affect costs, time and other aspects of the project, such as discovering an unexpected water main which results in an overhaul of the original construction plans.

In either case, some variations require a formal change order request from either the owner or the contractor. Change orders must include four key points:

A comprehensive description of the requested modification
A credible justification of the change
An estimation of the costs of the proposed change
An explanation of the impact that the proposed change could have on the project completion date

Modifications cannot occur unless all parties agree to the new terms. That often requires negotiations that can go on for some time, halting work.

Lump sum contracts are designed to reduce variations significantly, but they can still occur if there are overlooked details or unforeseen circumstances. Ensuring that all materials are available, the design and plan are accurate and that everyone fully understands the project can further protect project owners and contractors from time- and money-consuming variations.

Common Issues With Lump Sum Contracts

While lump sum contracts are straightforward and reduce many common construction contract headaches, they are not without issues that can have varying impacts on project owners and contractors.

Delays are often consequences of unforeseen circumstances out of either party’s control, such as weather or supply chain disruptions. Other times, a lack of clarity, failure to provide timely instructions, inadequate labor or a lack of equipment or materials is to blame.

Lump sum contracts should include provisions that stipulate the circumstances under which each party would be responsible for delays and the associated costs. That can reduce the risk of contract breaches as well as the need for time-consuming and costly litigation.

Cost fluctuations

The price of labor and materials can be fluid and subject to change throughout the project. Lump sum contracts generally do not account for these fluctuations, so contractors have to absorb the cost if prices rise. However, they can also realize savings if rates go down. These risks are arguably more pronounced in extended projects.

Contractors must factor in possible upward fluctuations and price the project accordingly when providing the estimate.

Provisional sums

Although lump sum contracts are pretty iron-clad as far as scope and cost, provisional or stipulated sums refer to the price of optional project work. The provisional sum is included as a separate estimate within the contract and only changes if the owner decides it’s a good idea to move forward with the elective work.

The work associated with stipulated sums can cause issues with the project schedule, primarily if implemented later in the project. It can also lead to modifications that require formal change orders. That’s why it’s essential that the terms of a lump sum detail how to handle provisional sums and the limits of any related changes.

Lump Sum Contract Construction Example

It’s essential to develop a lump sum contract correctly and fulfill it to the letter. But what is a lump sum contract in construction? It’s one kind of construction contract where a single price is used for an entire project. The estimated cost is developed after the contractor understands all the details of the construction project, including specifications, materials and timelines. Proper creation and execution of a lump sum contract for a construction project look something like this:

A project owner needs to build a storage shed to increase inventory space, so he approaches a contractor for the job. The owner has already completed the building design and construction plan, performed the necessary surveys and received the required permits. In the construction plan, the project owner also notes that he would like to use a particular cement brand.

The contractor evaluates the documentation and calculates how much the labor and materials will cost. She takes the pricier cement that the owner requested into account and includes a buffer amount to allow for unanticipated expenses. She then adds another amount to cover overhead and profit to the final project estimate. The project owner agrees to the price, and the lump sum contract:

Adequately lays out the scope of the project
Contains robust project modification controls
States a price that includes all costs related to the project
Details who is responsible for various additional costs
Delineates provisional sums and the associated work
Includes the estimated completion date

Both parties agree to the contract’s terms. The work, which should take six months, begins. The owner pays one-sixth of the fee every month.

Halfway through the project, the project owner decides to install tile flooring over the concrete. That is outside of the original agreement’s scope, so the owner submits a formal change order that the contractor reviews and then provides a new estimate for the project. The project owner agrees, and work continues. Installing the tile pushes the estimated completion date out by two weeks and increases labor costs for the contractor, but the additional amount that was agreed to via change order protects the contractor’s profits.

When the project is complete, the contractor managed to come in under budget, providing her with additional profits.

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Accounting Software for Lump Sum Construction Contracts

Managing risks, variations and other lump sum contract issues is seamless with the right accounting software. Accounting software can improve all aspects of accrual basis job cost accounting , including billing, bookkeeping and financial reporting. It can automate cost calculations, perform payroll tasks and keep track of payables and receivables. Single-entry functionality can also eliminate some manual data entry.

Accounting software for construction projects often includes job cost modules to track project-related purchases, labor costs and overhead. This kind of accounting software can also track details down to project tasks and be applied to contracts, allowing contractors to track the original lump sum contract amounts and any change order amounts. It’s also possible to put controls into place that establish a threshold for costs to ensure that the project stays within budget.

While they are one of the least complicated types of construction contracts and have a myriad of benefits for both owners and contractors, lump sum contracts still require careful consideration and execution. Utilizing capable technology is imperative so lump sum contracts perform as intended. Financial management software can help contractors expedite contract processes across the board, from developing an estimate to implementing modifications to processing final payments.

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Home > Fixed Assets > Lump Sum Purchase Calculator

Lump Sum Purchase Calculator

A business will often purchase a group of assets, known as a basket purchase , for a lump sum total cost. This lump sum purchase calculator uses the relative fair market value method to allocate this total cost to each of the individual assets.

Using the Lump Sum Purchase Calculator

This lump sum purchase calculator can be used to allocate the total purchase cost of a group of up to 12 assets in proportion to the fair market value of each asset at the time of purchase.

Instructions

Costs to Allocate

Firstly enter the lump sum purchase amount.

Finally for each asset enter an asset description and its estimated fair market value at the date of purchase.

It is important to realize that a maximum of up to 12 assets can be entered. If there are less than 12 assets in the lump sum purchase then leave the description blank and enter zero for the fair market value amount.

Lump Sum Purchase Calculator Download

The lump sum purchase worksheet is available for download in Excel format by following the link below.

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About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

Cost Allocation: The Key to Understanding Financial Efficiency

✅ All InspiredEconomist articles and guides have been fact-checked and reviewed for accuracy. Please refer to our editorial policy for additional information.

Cost Allocation Definition

Cost allocation is a financial accounting process that involves assigning various costs incurred by a business to the specific activities or elements used or benefitted from incurring these costs. Its purpose is to accurately represent the financial contribution of different parts of a business, providing insights into areas of efficiency or inefficiency, ultimately contributing to pricing and strategic decisions.

Methods of Cost Allocation

There are several methods of cost allocation that organizations can employ, each with their own merits and applications based on the specific circumstances, requirements, and objectives of the business.

Direct Allocation

Direct allocation, sometimes referred to as the direct method, is the most straightforward approach to cost allocation. Simply put, this method entails assigning costs directly to the appropriate cost objects, such as departments, products, or services, without taking into account whether those costs were incurred by multiple cost objects.

This method is predominantly used in situations where it is relatively easy to identify the specific cause-and-effect relationship between incurred costs and cost objects. Thus, it is particularly suitable for settings where resources are worn-out by specific departments, products, or services.

Step-Down Allocation

In contrast to direct allocation, the step-down method, also known as the sequential method or the stair-step method, allows for a more comprehensive spread of costs. This method begins with allocating the costs of the service department that provides the most services to other service departments. The total cost of each service department, including the allocated costs, is allocated step-by-step until all service departments have been allocated.

The step-down method is useful in situations where there are multiple service departments and some serve others more than they are served. It allows for a more distinct tracing of costs, improving the accuracy of indirect cost allocation. However, it can be somewhat arbitrary in terms of deciding which department's costs should be allocated first.

Reciprocal Allocation

The reciprocal allocation method, also known as the simultaneous or algebraic method, is the most accurate and complex of the allocation methods. It accurately accounts for the mutual services provided among service departments.

The use of reciprocal allocation is recommended in situations where an organization has service departments that provide significant amounts of mutual services to each other. Although it requires a certain level of mathematical sophistication, this level of detail and precision can yield more accurate cost assignments and can facilitate better decision-making.

Remember, the key is for an organization to select the method that best fits its unique settings, demands, and operational stipulations. Each method has its own strengths and weaknesses, and hence a well-informed decision is critical to optimally assign costs and enhance economic efficiency.

Criticality of Cost Allocation

Understanding the criticality of cost allocation goes beyond just marking it as a method of sharing costs. It plays a substantial role in the effective operation of a business in various ways:

Accurate Product Cost

One of the main benefits of cost allocation is achieving accurate product cost. With costs properly allocated, the actual costs incurred in producing a given product or service are easily identifiable. This not only facilitates pricing decisions, but also measures the profitability of each product or service. An inaccurate cost allocation can lead to distorted product costs. This could mean over-pricing, which can discourage customers, or under-pricing, which could lead to business losses.

Operational Efficiency

Cost allocation assists in measuring operational efficiency. For example, if a particular department is consistently exceeding its allocated budget, it might be a sign that the operations in that department are not as efficient as they should be. Management can then delve into the department's operations to identify and rectify the inefficiencies. By allocating and reviewing costs, businesses can highlight areas of wastage, inefficiency, and potential improvement.

Meaningful Financial Reports

Lastly, cost allocation supports the generation of meaningful financial reports. Such reports provide deep insights to stakeholders – be it managers, investors, or creditors. They relay important information about business performance, profit generation, asset utilisation and cost management. Without proper cost allocation, these reports could be misleading, making it difficult for stakeholders to make informed decisions.

In conclusion, cost allocation is not merely an accounting formality, but a tool that can significantly impact a company's ability to accurately price products, operate efficiently, and provide meaningful financial information. Its criticality in business operations cannot be overstated.

Cost Pools and Cost Drivers in Cost Allocation

In cost allocation, consistency and accuracy are paramount. And two concepts play a significant role in ensuring this: Cost Pools and Cost Drivers .

Role of Cost Pools in Cost Allocation

Cost pools are essentially aggregations of individual costs that relate to a specific task or factor. They play an essential role in simplifying the cost allocation process. Rather than assigning may individual costs to specific products, services, or departments, firms organize these costs into cost pools that can be allocated based on a common denominator – the cost driver.

Role of Cost Drivers in Cost Allocation

Cost drivers are the actual basis upon which these costs are allocated. They are units of activity or volume that cause a business to incur costs. Typical cost drivers include direct labor hours, machine hours, or units produced. Cost drivers serve as a measure of resource consumption and establish an ongoing basis of measurement for the cost pool.

Connection Between Cost Pools and Cost Drivers

The allocation of cost pools across different departments or products is driven by these cost drivers. In essence, cost drivers provide the linkage between the collected costs (cost pools) and the segments to which those costs are assigned. They provide a consistent basis for distributing costs in the cost pool to the relevant cost objects.

Selecting Appropriate Cost Drivers

Choosing the right cost driver is crucial for accurate cost allocation. Firms should select cost drivers that have a strong correlation with the root cause of costs. This is often derived through a cause-and-effect relationship. For instance, if a factory's costs are primarily driven by machine operations, then 'machine hours' might be an appropriate cost driver.

Likewise, if a service-based organization incurs more costs due to labor, 'labor hours' could serve as the key cost driver. Firms need to ensure that chosen cost drivers reflect a degree of variance. If certain costs have little variability, regardless of changes in the driver, that driver may not be appropriate.

In summary, cost pools and cost drivers are critical elements of the cost allocation process. They enable firms to aggregate related costs and to distribute them in a consistent, fair manner based on a measurable factor. The careful selection of cost drivers ensures that costs are allocated in a way that accurately reflects the realities of an organization's operations.

Cost Allocation in Decision Making

Cost allocation in decision making is integral to multiple areas of a business. A few of these areas, such as pricing, budgeting, and investment decisions, leverage cost allocation heavily.

Role of Cost Allocation in Pricing

In most businesses, pricing decisions directly involve cost allocation. To competitively price a product or a service, firms must divide the total costs into units of a product or service. This process allows them to determine the minimum price to cover the costs and achieve the desired profit margin.

For instance, a manufacturing company using varied types of raw materials, labor, and machinery might initially find it difficult to ascertain the price of one finished unit. Cost allocation, however, provides a mechanism to allot each cost element to each unit. Thus, unit costs drive the ultimate pricing decisions and influence the firm's competitiveness in the market place.

Impact of Cost Allocation on Budgeting

Cost allocation affects budgeting, virtually shaping every financial decision a company makes. Businesses, with clarity on cost division across departments, processes, or products, can plan budgets more effectively. They can identify which areas are cost-intensive and adjust the budget proportionately. Without the right cost allocation, a budget may not accurately reflect the financial resources needed or generated by different business segments.

For example, an IT company might allocate shared costs like server expenses, software license fees, and maintenance costs based on the users or usage in different departments. This allocation helps formulate realistic budgets, ensuring cost efficiency and operational effectiveness.

Cost Allocation and Investment Decisions

Investment decisions constitute another crucial area where cost allocation aids informed decision-making. When evaluating the profitability of an investment opportunity, whether it’s a new project, acquisition, or expansion, companies must understand the associated costs thoroughly.

By correctly allocating costs, companies can more accurately calculate potential returns, leading to more informed investment decisions. Misplacing or underestimating costs might mistakenly make an unprofitable investment appear profitable, resulting in detrimental financial outcomes.

In summary, the process of cost allocation serves to bridge the gap between operational activities and financial management. This linkage is vital in making strategic business decisions, from setting product prices to planning budgets to making investment decisions. Therefore, understanding cost allocation is fundamental to business' financial success.

Challenges and Criticisms of Cost Allocation

Despite their usefulness, implementing cost allocation methods can often be fraught with several challenges. Some of these obstacles are intrinsic to the process of allocation, such as the complexity of accurately tracing costs to specific cost objects and the subjectivity inherent in some allocation bases.

Arbitrary Allocation

One frequent criticism is the arbitrariness of some allocative decisions. For instance, in the allocation of indirect costs, the choice of allocation base (e.g., labor hours, machine hours, etc.) can be somewhat subjective. Some critics argue that this introduces a degree of arbitrariness that may distort the true cost picture.

While there is no perfect solution to this problem, efforts can be made to ensure that the chosen allocation bases are logical and justifiable given the nature of the costs being allocated. Some organizations may also choose to use multiple allocation bases for different types of costs to minimize this arbitrariness.

Overemphasis on Full Costing

Another criticism of cost allocation is its overemphasis on full costing. Full costing attempts to assign all costs, both direct and indirect, to cost objects. However, this approach can lead to the inclusion of irrelevant costs in decision-making processes, which might not add any value. For example, the inclusion of fixed costs, which are incurred regardless of the level of output, may not be helpful in short-term pricing decisions.

In response to this, some firms might opt to use variable costing as a supplement, which includes only those costs that change with production volume. This can provide a more relevant basis for operational and tactical decision-making.

The Use of Assumptions

Different cost allocation methods rely on different assumptions. These assumptions may not always hold true and can lead to inaccurate cost data. For example, the assumption of cost homogeneity in a cost pool may lead to inappropriate allocations if the costs in the pool are driven by different activities.

To mitigate this, it's essential to carefully examine and validate the assumptions underlying a chosen allocation method. Continuous review and refinement of cost pools and allocation bases can also help in keeping allocations realistic and meaningful.

Inaccurate Estimations

Cost allocations also rely heavily on estimations. Inaccurate estimations can lead to over or under-allocation of costs.

To address this challenge, organizations can develop robust estimation methods and validate their cost estimates periodically. This will not only reduce inaccuracies but also enhance the credibility of the cost data generated.

In conclusion, while cost allocation is not without its challenges and criticisms, these can be managed and mitigated through thoughtful and informed management practices. Regular reviews and audits, coupled with the use of technological tools for data collection and analysis, can further enhance the accuracy and relevance of cost allocation in an organization.

Principles of Cost Allocation within a Business Entity

Cost allocation within a business entity should uphold certain principles for the process to be fair, efficient, and effective. The guiding principles of cost allocation are causality, benefits received, fairness, and ability to bear.

Causality refers to the direct correlation between costs incurred and the activities leading to them. When a certain activity or set of activities within an organization results to specific costs, the principle of causality suggests that these costs should be allocated to that activity or activities. This kind of cost allocation allows businesses to link each cost with the function that drives it, making it easier to manage costs and improve profitability.

Benefits Received

The principle of 'benefits received' posits that costs should be shared among departments or units depending on the extent to which they benefit from the cost pool. If a department derives more value from a resource or service, then it should bear a higher proportion of the cost. Consequently, such a sideways view of cost allocation can incentivize departments to be more efficient in how they use shared resources or services.

Fairness is a crucial principle in cost allocation. The goal is to distribute costs in a manner that all departments or units perceive as just. This rarely means each department pays an equal share of the costs; rather, the distribution takes into account factors like usage, value derived, and department size. Unfair allocation could demoralize departments or units, leading to internal conflicts and reduced productivity.

Ability to Bear

The 'ability to bear' principle suggests that costs should be allocated considering the unit's capacity to absorb the cost. Here, larger or more profitable departments may shoulder a larger share of the costs. However, it is important that the application of this principle does not stifle the growth potential of smaller or less profitable units.

These principles aim to allocate costs in a way that reflects the operational realities of an organization while promoting fairness and operational efficiency. By adherently diligently to these principles, an organization can ensure a seamless and fair cost allocation process.

Cost Allocation and Its Implications on CSR and Sustainability

Correlation between Cost Allocation and CSR Efforts

Cost allocation plays a significant role in a company's Corporate Social Responsibility (CSR) efforts. Resources, both tangible and intangible, are frequently limited within organizations. The allocation of these resources can either inhibit or promote CSR activities. If CSR is not viewed as a business priority, resources may not be allocated sufficiently to develop and implement effective initiatives. Conversely, if an organization is committed to its CSR responsibilities, it will allocate costs accordingly to ensure its efforts are adequately funded and supported.

Inappropriately allocating costs could lead some stakeholders to wrongly believe that an organization is not committed to its CSR responsibilities. Therefore, cost allocation not only influences the actual implementation of CSR measures but also political and public perceptions of an organization’s ethical and social responsibilities.

Impact of Cost Allocation on Sustainability Measures

Sustainability measures are another key area impacted by cost allocation. When it comes to sustainability reporting, cost allocation is essential. The amount of funds set aside for these initiatives can boost a company's green programs or alternatively limit their scope. This can vary from energy-efficient modifications to the infrastructure, reduction in waste production to policy changes that minimize an organization’s environmental footprint.

The strategic decision-making process is a critical area where the effects of cost allocation are evident. If sustainability is significant for an organization, the costs associated with these measures will likely be prioritized in strategic decisions. Leaders must consider both short-term financial implications and long-term societal and environmental impacts. Particularly, these decisions bear a direct influence on the company's reputation and sustainability.

Moreover, cost allocation decisions have a bearing on the company's external communication as well. Specifically, when it comes to issuing sustainability reports, the allocation of costs provides an explicit representation of the company's commitment to sustainable practices.

Making strategic decisions with sustainability implications in mind could increase costs in the short-term but prove beneficial and cost-saving in the long run. Therefore, it is essential that decision-makers view cost allocation as not just a financial concern but a critical aspect of their CSR and sustainability efforts.

Cost Allocation as a Reflection of Organizational Priorities

Through the lens of CSR and sustainability, the implications of cost allocation are evident in the allocation decisions made by an organization. How a company chooses to allocate its costs is a reflection of its values and priorities. If sustainability and ethics are prioritized, cost allocation will support corresponding initiatives. If not, cost allocation can inadvertently communicate non-commitment to external stakeholders, potentially adversely affecting the organization's reputation and market position.

Cost Allocation across Different Industries

Although cost allocation is a universal concept in all kinds of businesses, the way it is implemented can differ significantly between industries.

The Manufacturing Industry

For the manufacturing sector, cost allocation is primarily linked with material costs, labor costs, and overhead expenses, which are apportioned to individual products. By allocating costs following these categories, companies are better positioned to price their products accurately. For instance, in direct material cost allocation, a manufacturing company can include the expenditures related to raw materials required to produce a particular product.

However, this straightforward approach can face complications when dealing with shared or indirect costs. For example, in a factory that builds both toasters and microwaves, how would one allocate the cost of shared raw materials, like steel or energy used in the factory? It becomes even more complex with overhead costs like salaries of administrative staff and, maintenance and depreciation of machinery, where a direct relationship between the cost and product isn’t apparent.

The Service Industry

On the other hand, within the service industry, cost allocation is traditionally more abstract. Labor cost is typically the most significant category, but costs associated with physical resources, like office spaces or computer equipment, also become relevant. Unlike manufacturing, services can't inventory their output in advance of demand. Service industries often allocate costs according to service hours provided or the number of clients served, but this also raises unique challenges.

For instance, a law firm may find it challenging to allocate the cost for a lawyer who handles various cases simultaneously. Similarly, a hospital might struggle with cost allocation for shared resources, such as an MRI machine used by multiple departments. These challenges necessitate creative and fair methods to spread costs and ensure profitability.

The Retail Industry

In the retail industry, purchasing and storing inventory comprise a significant portion of costs. Transportation costs, warehouse expenses and inventory buying costs are examples of costs that are allocated across various products. However, deciding on an allocation basis can be complex. While using sales volume might seem the easiest route, it might distort cost allocation for slow-moving or seasonal products.

As seen above, the cost allocation methods differ across industries due to their operational divergences, and each faces its unique set of challenges. Therefore, it's crucial for a business to understand the approach that works best for its industry and specific situation.

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Allocating Lump-Sum Purchases

When a company acquires multiple assets in a lump sum, it must allocate the lump-sum acquisition price to the individual assets. This is done using the fair market value method.

Under the fair market value method, the company must estimate the fair market value of each asset acquired. The fair market value is the amount that the asset would be exchanged for between willing buyers and sellers in an arm’s length transaction.

Once the fair market value of each asset has been estimated, the lump-sum acquisition price is allocated to the individual assets based on their relative fair market values.

A company acquires a building and some land for a lump sum of $1 million. The building is estimated to have a fair market value of $800,000 and the land is estimated to have a fair market value of $200,000. The company would allocate $800,000 to the building and $200,000 to the land.

The allocation of the lump-sum acquisition price has a significant impact on the company’s financial statements. The assets that are allocated a larger portion of the lump-sum acquisition price will have a higher basis and will be depreciated over a shorter period of time.

The allocation of the lump-sum acquisition price is also important for tax purposes. The company will be able to deduct the cost of the assets that are allocated a larger portion of the lump-sum acquisition price over a shorter period of time.

Caroline Grimm

Caroline Grimm is an accounting educator and a small business enthusiast. She holds Masters and Bachelor degrees in Business Administration. She is the author of 13 books and the creator of Accounting How To YouTube channel and blog. For more information visit: https://accountinghowto.com/about/

Dollar-Cost Averaging vs. Lump-Sum Investing

Watch video: Dollar-Cost Averaging vs. Lump-Sum Investing

Upbeat music plays throughout.

Narrator: Say you've got a chunk of money you want to invest. Is it better to put it to work in the market all at once or to buy gradually over time? I'm Cameron May, and this is Comment below.

Brandon Low commented, "Great content." Hey, thanks Brandon. "I hope you can do a video comparing dollar-cost averaging and lump-sum investing. Which are better performers in the long run?"

Well, Brandon, the debate between dollar-cost averaging and lump-sum investing is a long one. Let's look at each side.

Dollar-cost averaging is continuously investing the same amount of money in a security over time, regardless of fluctuating prices, rather than the entire amount all at once.

For example, if you wanted to invest $1,000 in shares of stock that's currently trading at $50 per share, you could break it up in to five increments of $200 to purchase shares at regular intervals.

Let's say you were able to purchase shares at $50, $48, $47, $51, and $52 over a period of time. Your average price per share would be $49.60.

There are a couple of benefits to this. First, you have a psychological benefit of not risking the entire amount immediately and having the anxiety associated with the stock falling.

Second, if the stock falls after your first purchase, you're only losing on a small amount, and the pain is less.

Third, as you saw with the example, buying over time could bring down your average cost per share if the stock drops.

However, there are risks. If the stock price rises over time, you're buying at a higher price, which will increase your average price per share. Not to mention missing out on possible gains if you'd invested the full amount at the beginning. Of course, if the stock price falls over time, you'll keep buying at lower prices, but there's no guarantee the stock will go back up.

Also, investors who practice frequent dollar-cost averaging may generate additional trading costs, commissions, and other transaction costs that outweigh any cost benefit.

Another approach is lump-sum investing, which is the immediate investment into a security using all available funds. So, going back to the earlier example, it'd mean investing the full $1,000 at once for $50 per share.

If the stock rises, you're all in, and you get all the benefits. If the stock falls, you're all in, and you get all the losses.

Now back to the question earlier: Which are better performers in the long run?

Is it lump-sum investing or dollar-cost averaging?

Let's look at an example.

Imagine there were two long-term investors who received $2,000 at the beginning of each year from 2001 to 2020 and invested in a hypothetical portfolio that tracked the S&P 500 ® index.

One is a lump-sum investor who put the $2,000 in the market right away on the first trading day of each year.

And one used a dollar-cost averaging strategy and divided the money into 12 equal portions to invest at the beginning of each month.

After 20 years of investing, which investor stood on top?

Animation: Chart compares the lump-sum investor who made $135,471 versus the dollar-cost averaging investor who made $134,856 from 2001 to 2020.

On-screen text: Disclosure: Source: Schwab Center for Financial Research. Past performance is no guarantee of future results. 1

Narrator: In this example, the lump-sum investor who invested the money immediately was the winner, but not by much—only $615. The dollar-cost averaging investor was right behind.

In fact, Schwab analyzed 76 rolling 20-year periods dating back to 1926—for example, 1926 to 1945, 1927 to 1946, and so on. In 66 of the 76 periods, the results were the same.

The takeaway here is don't procrastinate. Realistically, the best action long-term investors can take, based on our analysis, is to determine how much exposure to the stock market is appropriate for their goals and risk tolerance and then consider investing as soon as possible, regardless of the current level of the stock market.

However, there still can be a place for dollar-cost averaging. It could help investors who like the discipline of investing small amounts at regular intervals, especially if they think they might regret a large investment if it sees a short-term drop.

Dollar-cost averaging allows you to manage some risk on entry, but lump-sum investing, plus portfolio management strategies like rebalancing, may provide the best of both worlds: putting money to work more quickly along with risk management throughout the lifetime of your investments. Regardless of which approach you choose, be aware of your risk tolerance and be intentional about your strategy for managing risk.

On-screen text: [Schwab logo] Own your tomorrow ®

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Investing Basics: The Power of Compounding

Lump-sum investing versus cost averaging: Which is better?

Imagine receiving a windfall due to an inheritance, bonus payment, or sale of a small business. How would you invest the cash? Would you immediately invest all of it as a lump sum? Or would you make a series of investments over time—a strategy known as cost averaging—to avoid the risk of investing the entire amount right before a market downturn?

A recent Vanguard research paper, Cost averaging: Invest now or temporarily hold your cash? explores these and other questions, including an analysis of the performance of cost averaging (CA) and lump-sum investing (LS) across markets, historical periods, and simulated return scenarios.

"We find that LS tends to outperform CA, highlighting how a cash allocation reflects the opportunity cost of lost risk premium," said Megan Finlay, an investment strategist in Vanguard's Enterprise Advice group, who coauthored the paper with Josef Zorn, a U.K.-based wealth planning research strategist in the group. "But for some risk-averse investors, a CA approach may be more suitable, because it reduces the risk of drawdown or even abandoning their investment plan altogether because they fear large losses."

History shows that LS outperforms CA on average

Using MSCI World Index returns for 1976–2022, Finlay and Zorn calculated that LS outperformed CA 68% of the time across global markets measured after one year. However, CA was still better than remaining completely in cash; it outperformed cash 69% of the time.

LS mostly outperforms CA, but CA still largely beats cash

Notes: This figure is for illustrative purposes only and does not represent any particular investment. Outperformance is based on comparing wealth after a one-year investment horizon with a lump-sum strategy versus a three-month cost averaging split (splitting a lump sum into three equal parts and investing each one a month apart). The investment is assumed to be 100% equity, with no interest earned on any uninvested portion, and performance is measured on a rolling basis after one year. The cash-only strategy is approximated by the 3-month U.S. Treasury bill rate. Calculations are made using MSCI World Index returns for 1976–2022.

Source: Vanguard.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

The paper also examines the performance of LS and CA using a one-year investment horizon of a $100,000 initial investment across three portfolios: 100% equity, 60% stocks/40% bonds, and 40% stocks/60% bonds. In most historical market environments, investors would have been better off investing the lump sum.

"A key takeaway from the analysis is that the longer the CA horizon, the greater the opportunity costs incurred and the greater LS's performance advantage over CA," Finlay said.

Is CA preferable for risk-averse investors?

The paper also compares the two strategies using 10,000 simulated-return scenarios that tested various types of portfolios and CA period lengths. Consistent with findings from the historical analysis, LS in most cases yielded greater wealth after one year, but also greater losses in some of the worst market environments.

Because not all investors aim purely to maximize their wealth, and because some might find value in taking a slower path to portfolio growth if it helps to avoid big losses, Finlay and Zorn tried to quantify a loss-averse investor's preference for a lower-risk CA strategy. They constructed a utility model that considered hypothetical investors with varying levels of risk aversion and loss aversion and determined which strategy—CA or LS—each investor might prefer. They found that investors with significant loss aversion may be better suited for a CA strategy.

But Finlay cautions that even if you're an investor with high loss aversion, it's best to minimize opportunity costs by keeping a relatively short CA period, such as three months.

"A CA strategy is superior to remaining entirely in cash and, if implemented properly, may be more suitable for risk-averse investors," she said. "But given the cost of holding cash for extended periods, most investors—particularly those who don't have significant aversion to loss—should invest a lump sum immediately."

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We're here to help you navigate your options, together.

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Start with this step-by-step guide to opening a personal investment account, such as a general investing brokerage account or an IRA.

All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Investments in bonds are subject to interest rate, credit, and inflation risk.

Dollar-cost averaging, asset allocation, and lump sum investing

NIDA Business School in Bangkok
Hong Kong Polytechnic University

Research output : Contribution to journal › Article › peer-review

Both practitioners and academics have long disputed whether investors should choose dollarcost averaging (DCA) or lump sum investing (LS) as their investment strategy. While the issue still has not been completely settled, this study shows that an endeavor to make a performance comparison between DCA and LS might not be completely relevant. In this article, we demonstrate theoretically, numerically and empirically, that DCA is approximately equivalent to an asset allocation strategy in which about 50%-65% of wealth is invested in risky assets and the rest in riskless assets, while LS is the same as a 100% risky asset allocation. With different proportions of risky assets, DCA and LS are suitable for different types of investors with different levels of risk tolerance; thus, DCA and LS should not be compared. We emphasize that DCA should be recommended only to moderately riskaverse investors and should be compared with a 50%-65% risky asset allocation instead of to LS. Compared with a 50%-65% risky asset allocation, we also show that DCA is ineffi cient, as it lies below a capital allocation line. Thus, investment advisors should recommend DCA to their clients with caution because a 50%-65% risky asset allocation is superior to DCA.

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10.3905/jwm.2016.18.4.075

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Costs Social Sciences 100%
Investors Social Sciences 100%
Portfolio Selection Economics, Econometrics and Finance 100%
Investment Social Sciences 66%
Superior Social Sciences 33%
Risk Social Sciences 33%
Academic Social Sciences 33%
Tolerance Social Sciences 33%

T1 - Dollar-cost averaging, asset allocation, and lump sum investing

AU - Panyagometh, Kamphol

AU - Zhu, Kevin X.

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Y1 - 2016/3/1

N2 - Both practitioners and academics have long disputed whether investors should choose dollarcost averaging (DCA) or lump sum investing (LS) as their investment strategy. While the issue still has not been completely settled, this study shows that an endeavor to make a performance comparison between DCA and LS might not be completely relevant. In this article, we demonstrate theoretically, numerically and empirically, that DCA is approximately equivalent to an asset allocation strategy in which about 50%-65% of wealth is invested in risky assets and the rest in riskless assets, while LS is the same as a 100% risky asset allocation. With different proportions of risky assets, DCA and LS are suitable for different types of investors with different levels of risk tolerance; thus, DCA and LS should not be compared. We emphasize that DCA should be recommended only to moderately riskaverse investors and should be compared with a 50%-65% risky asset allocation instead of to LS. Compared with a 50%-65% risky asset allocation, we also show that DCA is ineffi cient, as it lies below a capital allocation line. Thus, investment advisors should recommend DCA to their clients with caution because a 50%-65% risky asset allocation is superior to DCA.

AB - Both practitioners and academics have long disputed whether investors should choose dollarcost averaging (DCA) or lump sum investing (LS) as their investment strategy. While the issue still has not been completely settled, this study shows that an endeavor to make a performance comparison between DCA and LS might not be completely relevant. In this article, we demonstrate theoretically, numerically and empirically, that DCA is approximately equivalent to an asset allocation strategy in which about 50%-65% of wealth is invested in risky assets and the rest in riskless assets, while LS is the same as a 100% risky asset allocation. With different proportions of risky assets, DCA and LS are suitable for different types of investors with different levels of risk tolerance; thus, DCA and LS should not be compared. We emphasize that DCA should be recommended only to moderately riskaverse investors and should be compared with a 50%-65% risky asset allocation instead of to LS. Compared with a 50%-65% risky asset allocation, we also show that DCA is ineffi cient, as it lies below a capital allocation line. Thus, investment advisors should recommend DCA to their clients with caution because a 50%-65% risky asset allocation is superior to DCA.

UR - http://www.scopus.com/inward/record.url?scp=84978431958&partnerID=8YFLogxK

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JO - Journal of Wealth Management

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A light rail tram is tested on the streets of Southport on the Gold Coast

‘The cheap option’?: why the Gold Coast may be on track to build the most expensive light rail in the world

Limiting reliance on the private sector, hiring foreign experts, and improving contracting transparency could be ways to keep costs down, experts say

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L ight rail is as much a fixture of the Gold Coast as bikinis or boogie boards; the attractive yellow vehicles trundling up and down the coast suit the place so well it feels as if they’ve been there much longer than their decade in service.

As in Queensland’s second city, light rail has sprung up in Canberra, the Sydney CBD, Parramatta and Adelaide. Similar “trackless trams” are soon opening in Perth and Brisbane. One of the only places there aren’t plans is Melbourne, home to the world’s largest tram network. Around the country, there has been a proclaimed renaissance in light rail .

On opening in 2014, the Gold Coast light rail was an immediate success . Public transport patronage jumped by 32% in the first three years, even before stage two opened in 2017. At the 2018 Commonwealth Games , the G:link zipped 100,000 passengers a day around the glitter strip in its distinctive yellow carriages.

“Since the year 2000 almost 200 cities [around the world] have introduced new tramways and I can confidently say Gold Coast light rail has been one of the most successful,” said the GoldLinQ chair, John Witheriff, in 2021 , after 10 years of operation. GoldLinQ is the private consortium contracted to finance, design, build, operate and maintain the network for 18 years.

Transport planners are attracted to light rail because, without the need for tunnelling, it’s cheaper and more deliverable. All you need is a wide road.

Urban planners like it because it can unlock higher-density, high-amenity developments – without the traffic jams.

And politicians like it because it can be done on a lower budget. Until it can’t.

Last month the Queensland transport minister, Bart Mellish, released a preliminary business case that estimated stage four of the 40km G:link network could cost up to seven times more than stage one, for the same length of track.

The business plan estimated the 13km stretch of track will cost between $3.13bn and $7.6bn. If it does hit the top cost estimate, the project may be the most expensive light rail project of its type, per kilometre, on the planet.

As one transport expert said: “Queenslanders should ask why we’re expecting to pay Ferrari prices for a Subaru.”

‘Light rail used to be regarded as cheap’

Alon Levy, co-lead of the transportation and land use program at New York University’s Marron Institute, has spent years studying why some countries are able to build transport infrastructure cheaply and others aren’t.

Though the preliminary business case of the expansion of Gold Coast light rail includes few details, Levy estimates that the project may ultimately cost as much as 10 times more than comparable European infrastructure.

The middle cost estimate for the next stage of the light rail, of $343m a kilometre or $4.5bn in total, would be expensive in Europe even for a fully underground subway with all the trimmings, according to Levy’s estimates.

Construction of Queensland’s first light rain system on the Gold Coast in 2013.

At this middle cost, the final stage of the Gold Coast light rail would also be the most expensive comparable Australian project ever designed, 20% more costly than the Sydney CBD and south-east light rail schemes, the current record-holder . It would be up to 11 times as expensive as Canberra’s first light rail line stage (completed 2019), which is 1km shorter.

Transport economist Neil Douglas pointed to Auckland’s proposed underground light rail system as an example of the sort of project that runs off the rails. It was costed at NZ$1bn for each of its 24 kilometres, before it was cancelled, he says.

Douglas has evaluated and peer reviewed transport projects across Australia and agrees the Gold Coast project’s estimated costs are high. He says “construction costs are now ludicrous”.

“It defies the point of it, because light rail used to be regarded as the cheap option for rail,” he says.

Levy says there is an endemic problem in what he calls “the peripheral Anglosphere”.

“We’re seeing the same things in Australia, Canada, and to the extent that there’s enough data there, New Zealand is just a steady increase in costs,” they say.

“Often, it’s just a matter of shared institutional factors.”

Those include, Levy says, a lack of contracting transparency, over-engineering, politicisation, poor allocation of cost risk – and above all, contracting out to the private sector.

Private sector efficiency and a ‘delusion’

Scott Elaurant, a transport planner and 35-year veteran of the industry, says the most efficient place he ever worked is the Queensland department of roads in the 1980s.

The state government had a steady supply of work planned years or decades in advance, with economies of scale, zero profit margin, and extremely low borrowing and insurance costs to manage risk. It contracted out discrete technical tasks to private firms, but routine tasks like project management were done in-house.

But in the 80s, governments started hiring private firms to do project management. The thinking was that the government was slow and old-fashioned and if the entrepreneurial private sector was given the job it could do things better, cheaper, faster. The idea was much less popular in mainland Europe.

Elaurant says the idea was simply wrong.

“This desire to have just simple competition on lowest fixed lump sum price was based on the delusion that the private sector is better at managing risk than government,” Elaurant says. “I’ve worked on both sides; I have no ideological preference. But I have seen no evidence of that in my entire career.”

Construction of stage two of the Gold Coast light rail in 2018.

Contracting can also mean hollowing out. Many transport engineers, planners and economists spoken to for this story said the public sector bureaucracy no longer has the skills to complete infrastructure projects in-house.

That means governments have little choice but to hire a private expert firm to act as “lead contractor” – responsible for the entire job, not just a small part of it. The lead contractor then sub-contracts to the same specialist firms the department once did.

Dependence on private sector contractors can create its own problems . The federal Labor government has ordered the commonwealth bureaucracy to set targets for banishing their use in core business , bringing skills and knowledge back in house.

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Melbourne Law School senior fellow Kiri Parr says small government can also prove to be less-informed government as well.

If the government is managing a project at arm’s length, it is likely to have less information about the infrastructure than the lead contractor, she says. The contractor is in a position to exploit that to its advantage.

Parr says the “very few, very large contractors who can deliver these very large projects”, are largely concerned about commercial risk: “Can I make money on the project?”

“One way or another, the government agency pays the bills.”

Gold Coast-based Griffith University transport researcher Prof Matt Burke says the cost of fixing up utilities – like water piping or power lines – was adding so much complexity and cost to Australian transport projects that many sector academics believe it’s time to consider not upgrading the utilities, even if it means passengers will be delayed by flooding in the future. Canberra’s light rail line – which bucked the trend and delivered under-budget – is known to have been stingy about funding utilities upgrades.

Burke also wants a more healthy contracting environment, with more players.

Projects are now so complex and expensive, he says, only a handful of companies can afford to bear the weight of risk in order to bid for them, driving prices up more. In Queensland, there are just two companies the government can pick from, CPB and Thiess John Holland.

“It’s not the same as a truly competitive market with five infrastructure bidders competing in one space,” he says.

“We don’t have a market like that. Market concentration is a real problem.”

What can we do better?

Levy argues the upper cost estimate in the Gold Coast preliminary business case – intended to prevent cost overruns – virtually guarantees it.

Contractors will aim their bids at the publicised figure.

“7.6 guarantees 7.6.”

Levy says if Australia wants to get better at building public transport, it needs governments to hire many people with the technical skills to build it. In France, for example, the Parisian public transport agencies employ thousands of engineers, project managers, economist and other experts – and contract them out to smaller regional centres for their own projects at low cost.

“If Queensland is too small for this, it’s OK to set up a system in which New South Wales does it and other states pay at-cost to New South Wales,” Levy says.

The Gold Coast light rail Broadbeach South terminus and bus interchange in 2022.

Several transport experts said Australia should hire foreign experts to work as project managers, who are likely to be trained in more efficient processes.

A spokesperson for the Queensland Department of Transport and Main Roads said the central $4.5bn figure “represents a preliminary cost estimate only and the final cost would be subject to completion of the detailed business case”, while the range of cost estimates published – from $3.13bn to $7.6bn – allows for “unknown risks, which will be further clarified and updated in the detailed business case”.

The detailed business case is due for completion in late 2025.

The spokesperson said the major differences of stage three compared with previous, cheaper sections of the light rail include “the length, two major creek crossings and bridge works, alignment within an international airport, and the width of the Gold Coast Highway corridor.

“Finally, costs increase over time. This can be seen in the comparison between stage one and three. The stage two alignment did not travel through as much urban corridor compared to stage one and three so its cost is not comparable.”

Elaurant says that the answer is not to give up on public transport. Without good cost control, he argues, Queenslanders will lose faith in rail transport.

That means projects like high speed rail, or improved suburban rail, may lie forever out of reach.

“We can build a light rail system with the capacity of a six-lane freeway for about two-thirds the price of the six-lane freeway. And yet we still get a lot of six-lane freeways. So obviously people are making decisions on things other than price,” Elaurant says.

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COST ALLOCATIONS- EASY METHOD IS NOT ALWAYS RIGHT

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Cost Allocation

Written by True Tamplin, BSc, CEPF®

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Types of Costs

Why Is Cost Allocation Important?

Common Mistakes People Make When Allocating Costs

Process of Cost Allocation

Step One: Identify Your Costs

Step Two: Allocate Indirect Costs Between Departments or Products

Step Three: Allocate Fixed Costs Among Departments or Projects

Step Four: Allocate Variable Costs Among Departments or Projects

Step Five: Use Cost-Volume-Profit Analysis to Determine the Best Allocation Method

Step Six: Use Cost Allocation for Decision Making & Reporting

Common Cost Allocation Methods

How is cost allocation done?

What are the benefits of cost allocation?

What are common mistakes people make when allocating costs?

How is cost allocation performed?

True Tamplin, BSc, CEPF®

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