Accounting Internal Memo: Cost Allocation for Kai

To: KAI Board of Directors

From: Jin Kim, Taejon Branch Manager

Date: 16 October 2009

Subject: Cost Allocation for KAI

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Dear Board of Directors,

Thank you for sparing your precious time reading this internal memorandum. After a detailed investigation on the internal financial statements for the preparation of the operations report, I would like to propose that the Senior Management should perhaps consider altering the cost allocation system, which might not properly reflect the performance of each branch. For instance, there was a decrease in net income of Taejon Branch last year, generally because of the increased overhead cost allocated from the headquarters. It would be my great honor if you could kindly provide me the opportunity to express my concerns about the possible consequences of the current practice at the annual board meeting from the following three perspectives, mainly the misunderstanding of branch management efforts, the inefficient resource allocation and the inappropriate working incentives for employees.

To begin with, the current traditional cost allocation method sometimes couldn’t clearly show the efforts of the branch management team, though it is convenient and widely accepted. The costs of handling traffic accident cases would probably be a case in point, which are proportional to the number of accidents. When it comes to Taejon branch, despite the considerable achievement of cutting down number of accidents from 54 in 2007 to 31 in 2008, the amount of overhead costs allocated from the headquarters increased in 2008, which could not reflect the branch improvement in reducing number of accidents. Similar cases also apply to the overhead cost allocation of other teams for other branches. According to AccountingTools, the goal of cost allocation method is to either spread the cost in the fairest way possible, or to impact the behavior patterns of the cost objects1. Therefore, some changes in cost drivers may have to be implemented soon in order to encourage branch management to improve, thus bringing more profit for the whole company.

What’s more, it seems that using revenue as the cost driver for all overhead costs might have resulted in inefficient resource allocation for branches to some extent. Specifically, the proportion of overhead costs allocated is usually not consistent with that of resources allocated to each branch. Indeed, we have recognized that some of the allocated overhead costs, such as the costs of supporting the IT systems, are proportioned to revenue. However, for the majority part of the overhead costs, such as investment, marketing and general administrative costs, branch revenue may not be such a directly related cost driver. For example, the costs of payroll, personnel evaluation and employee training of the General Administrative Team, are actually proportional to the number of employees. In Taejon Branch, regardless of the efforts that the number of employees decreased from 82 to 45, the amount of GA costs allocated increased from 1.70 to 2.29 million USD instead. This would result in an inefficient human resource allocation, as the branch did not really benefit that much from headquarters’ human resource as was shown in official statistics.