Applications and Implementation

OPTIMAL ALLOCATIONS OF
JOINT (COMMON) COSTS:
A PARAMETRIC PROGRAMMING APPROACH

Robert E. Jensen, Florida State University

ABSTRACT
A parametric programming model for allocating joint costs is described and il-
lustrated. Given M mutually exclusive missions and P alternative systems for ac-
complishing such missions, the model first determines the optimal choice of systems for all
missions simultaneously. It then allocates both joint and separable costs such that no mis-
sion receives a greater cost allocation than any other mission alternative that might be
suboptimal for the mission but nonoptimal when all missions are simultaneously con-
sidered. Although the model initiully assumes a mission priority ranking, this assumption
is relaxed later on as alternative rankings are evaluated and cost allocation ranges under all
priority rankings are evaluated.

INTRODUCTION

One of the long-standing gaps between economic theory and practice con-
cerns the allocation of joint (or common) costs. Economists typically assert that
allocations of joint costs are arbitrary and futile. Conversely, accountants in both
public and private sectors continue to allocate joint costs for a variety of pur-
ported reasons, in particular to measure entity income and/or to emphasize the
recovery of joint costs in transfer pricing decisions. Thomas [15] argues that,
although such allocations are arbitrary, there are useful arbitrary allocations.
Allocation problems arise in social accounting as well (see [7, pp. 59-88]).
The purpose of this paper is to present a means of optimal allocation of such
costs by means of parametric linear programming.
General definitions and assumptions of the model are as follows:
1. There exists a set of M mutually exclusive missions (tasks) that must be ac-
complished. A set of P alternative systems is available for accomplishing the
missions.
2. Each alternative system j (j = 1, ..., P) accomplishes one or more of the mis-
sions (tasks) and is independent of any and all other system choices.
3. All M missions (tasks) are to be accomplished at the lowest system-wide ag-
gregate cost. Any system contained in the optimal set of systems will be
termed an optimal system. Alternative systems not in the set are termed non-
optimal systems.
4. If an optimal system accomplishes more than one mission, joint costs are to
be allocated among those affected missions such that no mission receives an

436
19781 JOINT COSTS 437

allocation yielding a total mission cost (separable cost plus its allocated joint
cost) in excess of the total cost of achieving the mission under a non-optimal
system.
5. The separable cost plus the allocated portion of the joint cost of a system is
the transfer price of that system to a given mission.
The model may be applied in two situations with respect to joint cost alloca-
tion priorities:
Situation I. All missions are ranked according to joint cost allocation prior-
ity, e.g., on the basis of ability to pay, importance of the mission relative to other
missions, etc.
Situation II. All missions have equal priority in terms of joint cost alloca-
tion.
In Situation I, unique mission costs are computed by the model. In Situation
11, a range of cost allocation alternatives may be determined for one or more of
the missions rather than a single unique cost assignment.

ILLUSTRATIVE SETTINGS

It is beyond the scope of this paper to delve extensively into why system costs
are allocated to missions. Ample evidence exists that costs are allocated in prac-
tice, and that cost allocation formulas have been studied extensively, e.g., Crow
[2], Louderback [ l l ] , and Moriarity [12] [13]. Three settings relevant to the
parametric cost allocation model developed in this paper are provided for il-
lustrative purposes:
Military Missions. This paper was inspired by a military cost allocation prob-
lem in which Crow [2] describes a military cost allocation problem in the context
of allocating common costs of multi-mission military systems. The Defense
Department often faces situations in which multiple missions or objectives are
determined. A set of alternative systems for achieving these missions is
designated, a subset of systems is decided upon for achieving the missions, and
system costs are allocated among the various missions. Cost allocation schemes
are often politically controversial, particularly if cost allocations of chosen
systems exceed costs of achieving missions under alternative systems.
Transfer Pricing of Centralized Services. By way of illustration, suppose a
computer center provides centralized computing services for various divisions in a
firm. Each potential computing job order might be viewed as a “mission” for
which some “mission manager” is responsible. Perhaps the comptroller is
responsible for monthly payroll accounting or the marketing manager is responsi-
ble for market survey studies, etc.
A typical transfer pricing dilemma arises when the computer center wants to
set a transfer price that recovers all separable and joint computing costs of the
center. Mission managers object if this transfer price exceeds costs of alternative
systems (e.g., hand processing without a computer or sending jobs to outside
438 DECISION SCIENCES [Vol. 9

computing centers), for accomplishing their computing jobs. Hence, if these

managers are responsible for minimizing costs or maximizing profits of their
tasks, the transfer prices of central services should not exceed prices of alternative
sources of these services.
Transfer Pricing in a Socialist Economy. Oskar Lange [lo, pp. 82-83] ex-
plains production decisions in a socialist economy as follows:
The Central Planning Board performs the functions of the market. I t establishes
the rules for combining factors of production and choosing the scale of output
of a plant, for determining the output of an industry, for the allocation of
resources, and for the parametric use of prices in accounting. Finally, it fixes the
prices so as to balance the quantity supplied and demanded of each commodity.
It follows that a substitution of planning for the function of the market is quite
possible and workable.
Consumer demand and possibly other considerations give rise to economic
output goals (missions). In making this the factor input decision for achieving
each mission, the Central Planning Board (CPB) must compare alternate factor
input systems. Linear programming and dual (shadow) price analysis are well-
known means for approaching the problem, e.g., see Gordon [4] [ 5 ] , Most [14],
and Abdel-Khalik [l]. A complicating element is that alternate systems may ac-
complish two or more missions jointly, in much the same manner as a computer
center is a factor input to multiple divisions. The CPB’s problem is one of choos-
ing optimal systems for the economy as a whole and then setting transfer prices
such that plant managers cannot achieve production quotas more cheaply by
resorting t o other (non-optimal) factor input systems jointly affecting multiple
missions. Transfer prices appropriately determined help to avoid preferences of
managers for a non-optimal means of achieving il mission (e.g., production
quota). These transfer prices are the sum of separable cost plus allocated joint
cost determined by the parametric programming model described below.
Although the model may be used t o set transfer prices, other factors such as ex-
ternalities and return on capital may enter into transfer pricing decisions in a
socialist economy. Sensitivity analysis, however, may be used to examine the ef-
fects of varying system costs. Although this paper will focus on joint (common)
cost allocation, it is directly applicable t o transfer pricing settings where joint
costs exist.

THE MODEL

The model in this paper will also serve as a generalization of a joint cost
allocation scheme proposed by Moriarity [12]. In particular the model will satisfy
the objectives mentioned by Moriarity [12, pp. 794-7951:
1. The cost objective is never charged more than the next best alternative
method of providing the product service.
2. The allocation process involves comparison of the cost of providing joint
products or services with the next best alternative.
19781 JOINT COSTS 439

3. Every cost object shares in the savings resulting from the decision to incur
the joint cost.
4. Some cost is allocated to every cost object, using the joint product or ser-
vice (unless the object’s best alternative entails no joint cost).
5. The procedure provides an incentive to managers to continue to search for
less costly alternative means of obtaining the joint product or service.
The model discussed here is more general than that proposed by Moriarity in that
it is a mathematical programming formulation for selecting the “best” accept-
able joint cost allocations. Also, the model considers other joint cost alternatives,
whereas Moriarity’s approach is limited to comparing a given joint cost system
with costs of services purchased separately.
The model considered here is quite different from the overhead allocation
schemes proposed by Kaplan and Thompson [8] and extended by Kaplan and
Welam [9]. Those schemes assumed a fixed overhead cost to be allocated on the
basis of dual model shadow prices. Demand curves and product prices were also
assumed to be known. In this scheme, joint costs may be either variable or fixed,
and the model may be applied in situations where demand curves and external
pricings of products are not meaningful. (For instance, in government defense
contracting, “sales” of national defense services are not operational concepts.)
The formulation is also a more general parametric programming scheme than the
dual evaluator scheme proposed by the above authors.

FINDING OPTIMAL SYSTEMS VIA PRIMAL LINEAR PROGRAMMING

A three-mission example analyzed by Crow [2] is given in Table 1. The first
task of central headquarters (after missions and systems are established) is to find
the optimal set of systems to accomplish all missions under consideration. A net-
work formulation is shown in Figure 1.

TABLE 1
A Three-Mission and Five-System Example Costs*

System Alternatives
costs A B C D E

Joint Costs 50 60
Separable Costs:
Mission 1 65 20
Mission 2 45 30 30
Mission 3 10
60 - -
---
Totals 65 45 60 100 100
~~
- - - --
*Source: Robert Thomas Crow [3].
440 DECISION SCIENCES [Vol. 9

FIGURE 1
Network Formulation With Missions Listed in Inverse Order of Priority*

Missions -3 2 -I
(Lowest (Medium (Highest
Priority) Priority) Priority)

L
stop (S) I

System Utilized
Alternative Routes Mission 3 Mission 2 Mission 1 Total Costs*

Origin - C-E-A-S C E A (60)+ (60 + 30) + (65) = 215

Origin - C-E-A-S C E D (60)+ (60 + 30) + (50 + 20) = 220
Origin - C-D-D-S C D D (60)+(50+30)+(20) = 160 (Optimal)
Origin - C-D-A-S C D A (60)+ (50 + 30) + (65) = 205
Origin - C-B-D-S C B D (60)+ (45) + (50 + 3a) = 18s
Origin - C-B-A-S C B A (60)+ (45) + (65) = 170
Origin - E-D-D-S E D D (60+10)+(50+30)+(20) = 170
Origin - E-D-A-S E D A (60+ 10)+(50+20)+(65) =205
Origin - E-B-D-S E B D (60+10)+(45)+(50+20) = I 8 5
Origin - E-B-A-S E B A (60+10)+(45)+(65) =I80
Origin - E-E-D-S E E D (60+ 10)+(30)+(50+20) = 170
Origin - E-E-A-S E E A (60+lO)+(30)+(65) =I65

*Costs shown on arcs are given in Table I . All separable costs are assumed to be avoidable if a system
is not utilized on a particular mission.

In the Figure 1 context, finding optimal systems is simply the classical prob-
lem of finding a least-cost route in a network. Proceeding from left to right, the
transition cost over any network arc is the separable cost of the system (node) in
achieving the mission at hand plus all joint costs of the system the first time the
 TABLE 2
-
W
4
00
Y
Primal Linear Programming Formulation of the Figure 1 Network*

Optimal
Solution

z = -160
xoc = 1
XOE = 0
XCD = 1
XCB = 0
XED = 0
XE.9 = 0
x, = 0
XDD = 1
XDA = 0
I Non-negativity conditions apply to all primal variates. IXBD = 0

*Objective function coefficients are the combined joint and separable costs shown on network arcs in Figure 1 . They are assumed to be negative such that the
objective is the maximize Z.
442 DECISION SClENCES [Vol. 9

system is encountered on the route. Alternate routes and costs are shown in
Figure 1, together with the optimal (uppermost) route shown with hash marks.
Costs of meeting all three missions range from a high of 220 to a low of 160, the
optimal being 160 with Systems C and D.
A primal linear programming tableau for the Figure 1 network is provided in
Table 2. In this case, each x-variate corresponds to a network arc, the optimal
value being x = 1 if the corresponding arc lies on the minimum-cost route and zero
otherwise. The solution shown in Figure 1 contains xoc= xcD=xDD=xDS= 1.
Hence, the optimal situation system choices are Systems C and D as shown in
Figure 1 and Table 2.

SITUATION I: JOINT COST ALLOCATION VIA PARAMETRIC

PROGRAMMING ASSUMING MISSION PRIORITY RANKING

Having identified the optimal systems, headquarters next proceeds to

allocate joint costs of optimal systems to missions that utilize such systems. In
our Figure 1 example, the optimal solution utilizes two systems in the following
manner:
a. Adopt System C to accomplish Mission 3
b. Adopt System D to accomplish Mission 2
c. Adopt System D to accomplish Mission 1
Since System D is used to accomplish more than one mission, its joint costs may
be allocated between both Missions 1 and 2. In this case, the two limiting ex-
tremes would be to allocate the entire joint cost of 50 to either Mission 1 or 2.
Without loss of generality, we initiufly assume that missions are ordered (1,
2, 3) in terms of cost allocation priority. Suppose that with Mission 1 having
highest priority, we decide to allocate all System D joint cost of 50 to Mission 1.
Managers or constituents of Mission 1 would immediately object on the grounds
that the Mission 1 cost becomes 50 + 20 = 70 when the mission could in fact be ac-
complished for 65 by choosing System A. Therefore, the upper limit of joint cost
allocation of System D to Mission 1 is 65 - 20 = 45 such that the System D cost of
Mission 1 is no greater than other system choices which are non-optimal when all
missions are considered jointly. Initial and revised joint cost allocations are il-
lustrated in Table 3.
In other words, managers and/or constituents of Mission 1 might object to
the joint cost allocation system that gives their mission higher priority in getting
dumped on with joint cost of a system that also benefits lower priority missions.
But they cannot protest on the grounds that their share of the joint cost is so op-
pressive that their total cost would be less under other systems that would not be
optimal for all missions combined.
The simple network in Figure 1 can be visually scanned to determine that the
Mission 1 share of the 50 joint cost of System D is equal to the difference in
Systems A and D marginal costs for Mission 1, i.e., 65-20=45. However, in
more complicated networks, the amount that a mission can absorb in a joint cost
19781 JOINT COSTS 443

TABLE 3
lnitial and Revised Cost Allocalions of Optimal Systems in Figure 1

Optimal Initial Costs Revised Costs

Mission System Separable + Joint = Total Separable + Joint = Total

1 D 20 + 0 = 20 20 + 45 = 65
2 D 30 + 50 = 80 30 + 5 = 35
3 C 60 + o = x 60 + o = x
-
-
160 -
160
-
reallocation may be computed using parametric programming. To illustrate the
procedure, the dual formulation (initial tableau) of the Table 2 primal model is
presented in Table 4. The y-variates correspond to nodes (systems) in Figure 1.
For example, yo corresponds to System C utilized for Mission 3. The value of the
variate is the least-cost system route between the node at hand and the network
ending node (S). For instance, yo= 160 indicates that the least-cost route between
the beginning and ending network nodes is 160.
Dual constraints in Table 4 correspond to arcs in the Figure 1 network. Each
constraint contains an s-dual surplus variate, whose subscripts indicate which arc
the surplus variate and the constraint correspond to in the network. For instance,
sCD is the dual surplus variate corresponding to the arc between Nodes C and D in
Figure 1. The corresponding dual constraint is
yC3 - yD1+ sCD= 80-
The optimal dual solution is given in the final simplex tableau provided in
Table 5. The primal solution can also be derived from the first row of coefficients
in the final tableau. This final tableau will be used in applying parametric pro-
gramming to joint cost allocation.
Assume we are interested in allocating the System D joint cost of 5 0 between
Missions 1 and 2 that utilize this system. Let 6DD= -6, denote the tentative
amount of joint cost to be reassigned from Mission 2 to Mission 1. (Recall that
the entire System D joint cost of 50 was initially assigned to Mission 2.)
Parametric programming techniques are well known, e.g., see Wagner [ 16,
Chapter 51, Gass 13, Chapter 111, and Hillier and Lieberman [6, Chapter 161. In
this paper we will adopt a parametric programming technique similar to that
described by Wagner [16, p. 1301. The 6, joint cost reduction in Mission 2 cor-
responds to reducing the transition cost of 50 + 30 = 80 along Arc C-D in Figure 1.
This arc corresponds to the scD column of final simplex tableau coefficients in
Table 5. Similarly, the 600 increase in transition cost along Arc D-D corresponds
to the coefficients in the SOD column in Table 5. Using these two columns of coef-
ficients, together with the last column, we form the parametric programming
equations shown to the right of the tableau in Table 5. For example,
 TABLE 4
Dual Linear Programming Formulation of the Figure 1 Network
(Initial Tableau)

Optimal Solution:
W = 160 ye2 = 115
yo = 0 YE2 = 100
YB = 60 YO1 = 160
~ € 3 = 70 YAI = 165
YD2 = 40 ys = 160
 L
TABLE 5 3
00
Y
Dual Linear Programming Formulation of Figure 1 Network
(Final Tableau)
Tableau Column

SCD s z
--- _

8
Y
8
b
2

Optimal Solution:
w = 160 yD1 = 20 Soc = 0
yo = 160 y, = 60 SOE = 0
y a = 100 YO1 = 0 SCD = 0
YE3 = 90 YAI = 0 SCB = 0
yBl = 55 Ys = 0 SED = 10
446 DECISION SCIENCES [Vol. 9

yc3 = + + 6,xJ
100 6,.

= l00+(-6,,)+6,,

= 100-6u,+6,,

indicates that any System D joint cost reallocation will not affect the value of yc3
in the optimal dual solution. Since aDU= -bco, a quick inspection of the equa-
tions to the right of the tableau in Table 5 reveals (assuming 6cus0and 6 D u 2 0 )
that only the bracketed equation

limits the 600 cost allocation. That is, only if yDA remains non-negative will
Systems C and D remain optimal. Hence, 6DD545 is required, for if 6DD>45,
managers or constituents of Mission 1 would assert that Mission 1 could be
achieved at a cost less than 20+60D by utilizing some system other than System D
for Mission 3. Let

= 45

denote the maximum joint cost allocation that would leave System D as good as
any other system for Mission 1 . Similarly, let (Y denote the remaining joint costs
of System D. The joint cost allocation is

6* = min (a,6)

= min (50,45)

=45.

Hence, we derive via parametric programming the joint cost reallocations shown
previously in Table 3.
Once the optimal choice of systems for multiple missions has been deter-
mined, parametric programming can be utilized to reallocate system joint costs
among higher priority missions. The advantage of the procedure described here is
that no mission receives a cost higher than any of the non-optimal system choices
for that mission. For example, the Mission 1 revised cost (separable + joint
costs) is

20+6*=20+45

= 65,
19781 JOINT COSTS 447

which is as good as the next-best choice'of System A which costs 65 to achieve

Mission 1. The Mission 2 cost is
30+(50-6*)=30+(50-45)
=30+5
= 35.

This is greater than the separable System E cost of 30 in achieving Mission 2, but
managers of Mission 2 cannot obtain System E for that cost unless Mission 1
managers could be persuaded to bear all System E joint costs of 60, which is
unlikely.
SITUATION 11: SENSITIVITY ANALYSIS UNDER ALTERNATIVE
MISSION PRIORITY ORDERINGS
An advantage of the joint cost allocation procedure outlined previously is
that it can also be solved under all other mission priority ratings in order to see
how sensitive total mission costs are to mission priority orderings. For the Table 1
illustration, there are six alternative orderings of the three missions. Both the net-
work formulations and resulting cost allocations for optimal system choices are
given in the Appendix of this paper. In general, there are M! possible mission
orderings, which for large M values may be unwieldy to totally enumerate.
Dynamic programming might be used to cut down on the total search procedure,
which is presently being investigated by the author.
In summary, the Appendix outcomes reveal the limits of mission costs shown
in Table 6. For example, under Mission 1 the separable cost is 20 using optimal
System D, leaving a joint cost allocation range of 35 to 45 depending upon the
mission priority orderings. Any cost allocation outside this range would prompt
mission managers to complain that their missions would cost less under non-
optimal systems choices. Similarly, the range is 5 to 15 for System D joint cost

TABLE 6
Sensitivity Analysis Cost Limits Under All Feasible Mission Priority Orderings*

Mission Orderings Mission Orderings

Optimal (2, 1 9 3 ) (2,3, 1) (3.2, 1) (1,2,3) ( 1 9 3 9 2) (3, 1.2)
Mission System Separable + Joint = Total Separable + Joint = Total

1 D 20 + 35 = 55 20 + 45 = 65
2 D 30 + 15 = 45 30 + 5 = 35
3 C 60 + O = x 60 + O = x
Totals 1160) [1601
*See Appendix.
448 DECISION SCIENCES [Vol. 9

allocation to Mission 2. Mission 3 does not involve an optimal system having

joint costs with some other mission.
The fact that a range of cost allocations is permitted gives top management
some discretion in joint cost allocation. It might be noted that a chosen cost
allocation scheme implicitly sets mission costing priorities. For example, in Table
6, the cost allocation scheme 65 to Mission 1 , 35 to Mission 2, and 60 to Mission 3
applies only when Mission 1 has a higher priority than Mission 2. The alternate
allocation scheme applies whenever Mission 2 has a higher costing priority than
Mission 1. Mission 3, priority, however, is irrelevant in this example since it bears
none of the joint cost.

CONCLUSlON

A parametric programming method for allocating joint costs has been

described and illustrated in this paper. Table 3 contains the cost allocations of op-
timal systems in Situation I, where cost allocation priorities are Mission 1 (first),
Mission 2 (second), and Mission 3 (third). Cost allocations under alternate mis-
sion priority rankings are given in the Appendix. In Situation 11, where all mis-
sions have equal cost allocation priority, the cost allocation ranges are given in
Table 6. For example, the Mission 1 total cost may range from 55 to 65, whereas
Mission 2 costs may range from 35 to 45. As long as costs are allocated (or
transfer prices set) within these ranges, no mission can be achieved at a lower cost
by utilizing a system which is non-optimal in terms of all three missions con-
sidered jointly.
Parametric programming provides an automatic way of determining these
system cost allocation ranges. It will not set costs more precisely within these
ranges unless missions are ranked in terms of cost allocation priorities established
on some external basis.
Although the model applies to many types of cost allocation settings, it is not
a panacea for all cost allocation and transfer pricing problems. A major limita-
tion is that the P alternative systems are assumed to be independent in terms of
cost/performance. Systems are not allowed to interact, nor can they contribute
only partially to missions.
A second limitation is that parametric linear programming is limited by the
size and speed of electronic computing facilities available. Large problems having
hundreds of constraints may be impractical to solve, particularly under numerous
mission priority ranking alternatives.
A third limitation is that costs and performances of alternative systems are
assumed to be centrally known. I n decentralized organizations, detailed informa-
tion from scattered points in the organization is not easily and cheaply com-
municated to headquarters. Costs and benefits of communicating between central
headquarters and organizational sub-units are not included directly in this model.
Nor are problems of identifying missions, systems, and cost components of the
model considered directly, although it is assumed that such components would
have to be evaluated under any accounting and decision-making scheme for
19781 JOINT COSTS 449

choosing among alternative systems. Sensitivity analysis under changed condi-

tions is facilitated by use of the model.

REFERENCES

Abdel-Khalik, A. R. “On Gordon’s Model of Transfer Pricing System.” The Accounfing

Review, Vol. 46 (1971), pp. 783-787.
Crow, Robert T. “An Approach to the Allocation of Common Costs of Multi-Mission
Systems.” Naval Research Logistics Quarterly, Vol. 20, No. 3 (1972). pp. 431-448.
Gass, Saul 1. Linear Programming: Methods and Applications. New York: McGraw-Hill Book
Company, 1958.
Gordon, M. J. “A Method of Pricing for a Socialist Economy.” The Accounting Review, Vol.
45 (1970), pp. 427-443.
Gordon, M. J. “A Method of Pricing for a Socialist Economy, A Reply.” The Accounting
Review, Vol. 46 (1971), pp. 788-790.
Hillier, F. S., and G. J. Lieberman. Introduction to Operations Research. San Francisco,
Calif.: Holden-Day, Inc., 1974.
Jensen, Robert E. PHANTASMAGORIC ACCOUNTING: Research and Analysis of
Economic, Social and Environmental Impact of Corporate Business. Sarasota, Fla.: American
Accounting Association, 1977.
Kaplan, R. S., and G. L. Thompson. “Overhead Allocation via Mathematical Programming
Models.” The Accounting Review, Vol. 46 (1971), pp. 352-364.
Kaplan, R. S., and V. F. Welam. “Overhead Allocation With Imperfect Markets and Nonlinear
Technology.” The Accounting Review, Vol. 49 (1974), pp. 477-484.
Lange, Oskar. On the Economic Theory of Socialism. Edited by B. E. Lippincott. Minneapolis:
University of Minnesota Press, 1938.
Louderback, J. G. “Another Approach to Allocating Joint Costs: A Comment.” The Accoun-
ting Review, Vol. 51 (1976), pp. 683-685.
Moriarity, Shane. “Another Approach to Allocating Joint Costs.” The Accounting Review,
Vol. 50 (1975), pp. 791-795.
Moriarity, Shane. “Another Approach to Allocating Joint Costs: A Reply.” The Accounting
Review, Vol. 51 (1976), pp. 688-689.
Most, K. S. “Gordon’s Transfer Price Model for a Socialist Economy: A Comment.” The Ac-
counting Review, Vol. 46 (1971), pp. 779-782.
Thomas, A. L. “Useful Arbitrary Allocations.” The Accounting Review, Vol. 46 (1971), pp.
472-479.
Wagner, Harvey M. Principles of Operations Research. Englewood Cliffs, N.J.: Prentice-Hall,
Inc., 1975.