Joint Cost Allocation for Multiple Lots

Author(s): Bala V. Balachandran and Ram T. S. Ramakrishnan

Source: Management Science, Vol. 42, No. 2 (Feb., 1996), pp. 247-258
Published by: INFORMS
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 Joint Cost Allocation for Multiple Lots

Bala V. Balachandran * Ram T. S. Ramakrishnan

NorthwesternUniversity, Evanston,Illinois 60201
Universityof Illinois at Chicago,Chicago,Illinois 60607

W Az e consider the joint cost allocation problem that arises when several lots or resources are
available to serve different products or divisions. We provide a two-phase model,
wherein the first phase the optimal set of lots to be acquired is chosen and given the optimal
set, and the products using each acquired lot is also determined. In the second phase, a stable
full cost allocation method is developed that will not induce the divisions to form coalitions to
reduce the allocated joint costs. Utilizing the optimal dual solution of the lot selection phase, we
provide a joint cost allocation mechanism based on the concept of propensity to contribute and
show that this allocation is also stable. If in the first phase there is a dual gap, then we show
that there is no cost allocation in the core. A numerical illustration is provided.
(Cost Allocation;Stability;CoreSolutions;Dual Methods)

1. Introduction relevant for economic decisions, at least in the short run.

The allocation of the joint costs of common resources
across the divisions or products that need and use
those resources is practiced widely in industry. This
practice is under greater scrutiny now, as firms are in-
creasingly recognizing the value of decentralization.
By creating autonomous units with delegated respon-
sibility toward personnel, administration, sales, and
distribution, companies are able to react quickly to
growing competitive global markets for inputs and
outputs. This trend has been extensively documented,
and the prototype of the future corporation is a shell
type corporate center with no unallocated costs. (See
Dumaine 1992, Business Week 1992 for experiences of
Johnson & Johnson, IBM, Asea Brown Baveri, and Du
Pont.)
Decentralization requires full allocation of common
costs. If the corporate center does not fully allocate costs,
then the operating divisions will impute lower costs to
the common factor inputs and consume the unallocated
resources excessively. (See Fuchsberg 1992 for the in-
creased personnel costs arising due to decentralization
and underallocation.) Atkinson (1986) documents that
over 70%of the firms allocate such common costs. Econ-
omists (Thomas 1974, Stigler 1966) maintain a view that
allocation of joint or common costs is arbitrary and ir-
0025-1909/96/4202/0247$01.25
Copyright X) 1996, Institute for Operations Research
and the Management Sciences
However, managers in both public and private sectors
recognize the need for cost allocation in product costing,
inventory valuation, and in the measurement of the de-
centralized unit's income. Modem cost accounting in-
novations have emphasized the need for full cost allo-
cation when advocating activity based costing and man-
agement. (See Turney 1990 and Cooper 1990 for activity
based allocation and its impact on the accuracy of prod-
uct costs.) In the public sector, especially in defense re-
lated industries, major cost recoveries are heavily de-
pendent on the allocated joint costs and transfer prices.
Thomas (1974) questions the usefulness of such alloca-
tions for decision making and emphasizes that alloca-
tions may only be "useful in reaching understandings
whereby individuals or organizations agree to distri-
butions of resources." Following Thomas (1974), sev-
eral researchers have examined different "mutually sat-
isfactory allocations" based on particular economic
principles or behavioral axioms. A few have used
mathematical programming approaches and duality
theory for optimal allocations, as seen in Kaplan and
Thompson (1971) and Kaplan and Welam (1974). An-
other group, (for instance, Moriarity 1975, 1976; Loud-
erback 1976; and Jensen 1977) defined certain sets of
axioms or objectives that allocation models should
MANAGEMENT SCIENCE/Vol. 42, No. 2, February 1996 247
 BALACHANDRAN AND RAMAKRISHNAN
Joint Cost Allocationfor Multiple Lots

Table 1 Recently, a leading gasket manufacturer found it prof-

itable to procure multiple lots for their gasket products,
IncrementalProcessing Costs
where different product lines use different raw materi-
Lot
Lot# j Cost 1 2 ... n als (steel, rubber, cork, etc.). They found it worthwhile
to pile up such raw material inventory lots "to take ad-
1 JC1 /11 /21 I. l Inl vantage of economies of scale from different vendors"
2 JC2 /12 /22 I. 2 ... In2 so that the total costs were minimized. They were faced
with allocation of joint ordering costs of such multiple
j JCy lj 12j IiJ ... Inj
lots to their end products servicing original equipment
m- 1 JCm_1 /1,m-1 /2,m-1 ... li,m-1 ... In,m-i
manufacturers such as automobiles and agricultural
equipment. The firm had to select the optimal way of
m 0 /1m Im ... Iim Inm procuring the lots and had to decide on the allocation
of the ordering costs to the end products.
This paper considers the two problems-the selection
possess and provided models that satisfy their sets of of optimal lot set and allocation of common costs-si-
objectives. multaneously. The first problem is solved through a
Several models of allocation have been developed re- mathematical programming approach and several pa-
cently, based on game theoretic concepts such as the pers in the management science literature have mod-
core or Shapley value. These cost allocation schemes elled this problem and developed efficient algorithms.
have the stability property, such that the divisions shar- Crow (1972) considered an assignment method for a
ing the joint or common resources have no incentive to multi-mission system in a defense project with priori-
leave the common resource acquisition structure. Such ties, which was later extended by Jensen (1978) for sen-
allocation models are found in Jensen (1977), Hamlen sitivity of priorities via a parametric analysis of the lin-
et al., (1977, 1980) Balachandran and Ramakrishnan ear programming solution. Since linear programs can
(1981), Roth and Verrechia (1979), Gangolly (1981), and yield fractional solutions and optimal solutions can not
Hughes and Scheiner (1980), to name a few. All these vary continuously when integer values are required for
models are applicable only to the situation where a sin- variables, these methods are deficient. Further, stability
gle lot or resource is to be acquired for a group of di- among participants as defined through the game-
visions or products. Very little analysis has been carried theoretic core property may not exist in such allocations.
out for the case with multiple common resources. Many Sets of participants may have incentives to leave and
divisions may use the whole set of resources or lots, but form separate cost pools to acquire resources for only
all the divisions need not use the same common re- that set.
source. An alternate stream of current research has fo- This paper is aimed to reduce the gap that exists in
cused on the existence of a nontrivial role for allocations the multiple resource literature-between optimization
in resolving incentive conflicts in a multiple agent set- and cost allocation-and provides an allocation scheme
ting (Demski et al. 1988, Zimmerman 1979, Balachan- which has all the desirable stability properties enunci-
dran et al., 1988, Rajan 1992). These papers use hidden ated by Moriarity (1975). Secondly, we provide a model
action models in a principal-agent framework and show that eliminates the fractional outcome that can arise in
that some allocation of fixed common costs could re- the models of Jensen (1978) or Crow (1972). Our model
duce collusion problems. In this paper the common formulation and primal solution assignment generates
costs are not fixed and need to be solved first before an optimal integer solution. We use the algorithms pro-
allocation. Further in those papers incentive problems posed by Erlenkotter (1978) for the fixed charge prob-
arise due to effort aversion and private information. In lem which uses the optimal dual solutions. Thirdly, our
this paper the only incentive issue considered is the mo- model formulation provides the solution to both the
tivation of the unsatisfied divisions to form a separate problem of ex-ante lot selection from the existing set of
resource acquisition pool. feasible scarce lots and the problem of ex-post cost al-

248 MANAGEMENTSCIENCE/Vol. 42, No. 2, February 1996

 BALACHANDRAN AND RAMAKRISHNAN
Joint Cost Allocationfor Multiple Lots
location, once the optimally selected lots and the divi-
sions sharing the selected resources are known. Thus
this allocation scheme does not influence the decision
process in the first stage. Fourth, we use the "propensity
to contribute" concept developed by Balachandran and
Ramakrishnan (BR) (1981) and the optimal dual solu-
tion of the ex-ante lot selection problem to obtain a
unique cost allocation. As the dual solution has an eco-
nomically meaningful interpretation, the ex-post allo-
cation procedure that is developed lies in the core. This
guarantees stability, so that the overall total profit is
maximized without sacrificing either the divisional in-
centives or their independence. Finally we relate the
dual gap that may arise in the lot selection phase to the
subsidy that will be needed to ensure that the cost al-
location is in the core.
2. Multilot Model Development
For expositional ease, we adopt the same notation as in
the papers of Balachandran and Ramakrishnan (1981),
Moriarity (1975), or Louderback (1976) with one exten-
sion. An index j is used as a subscript for the lot number,
since all these authors consider only a single lot.
In this paper we consider multiple resources, lots, or
systems' where each one of these lots can be purchased
for a known cost. These lots are used by a group of
divisions, economic entities, or subsidiaries so that fur-
ther processing yields the final required products (or
satisfies a mission as in Crow's (1972) problem). So
there are two types of costs: joint cost of the lots and
further processing costs for each product. If a product
cannot be obtained from any specific lot, we define the
corresponding processing cost as a large number (infin-
ity). The firm also has the option of buying the input
for that product directly from the market. This direct
purchase cost is generally higher than the incremental
processing cost with some lot, before any allocation of
the lot cost. If it is not, we eliminate such products from
consideration since the raw material for that product
could be purchased directly. Thus, without any loss of
generality we assume that the direct market price is
'We will use the word "lot" in a generic sense. This model could be
used for other situations as well, such as systems, resources, support
centers, and common overhead facilities.
MANAGEMENTSCIENCE/Vol. 42, No. 2, February 1996
more than the incremental processing cost for at least
one resource. Similar to the single lot case, if a lot is
purchased for the production of a specific product, then
the entire required amount of that product can be pro-
duced by further processing the specified lot.
Let the number of lots for these resources or raw ma-
terials to be m - 1, and let j be a typical lot so that j = 1,
... ., m - 1. For the purposes of the model, let the exter-
nal market also be a lot corresponding to the decision
of "buying directly from outside or open market." The
external market will be labelled with index m, as the last
lot. Thus there are m lots, where the first m - 1 lots
correspond to the resources and the last one corre-
sponds to "market." The firm consists of n different di-
visions or products.
Let i be the index for a typical product or division so
that i1, .. ., n. Let
JC1:represent the joint cost of the resource or lot j;
(j= if . .. , m - 1),
Iij:be the incremental cost of further processing for
product i (i = 1, . . ., n) using lotj (j = 1,.. ., m - 1)
Iim:represent the cost of buying product i directly
from the external market.
Since there is no cost for the lot labelled m (market),
JCmwill be set equal to zero. The matrix of both joint
and incremental costs, as given in Table 1, describes the
variables.
3. The Two-Phase Model
The joint cost allocation problem for the multiple lot
case will be analyzed as a two-phase model consisting
of an ex-ante decision problem and an ex-post allocation
problem, given the decisions of the first phase. The first
phase involves the production or lot selection decision,
while the second phase is concerned with joint cost al-
location ex-post, given the production decision of the
first phase. The production decision is obtained by the
formulation of a "fixed charge" optimization model
similar to a fixed charge transportation problem so that
the total corporate costs are minimized. Then utilizing
the dual solution associated with this optimal solution
and the core theory presented in the earlier literature,2
2 For a full discussion of core and game-theory related definitions and
illustrations see Hamlen et al. (1977, 1980), Jensen (1977), and Bala-
chandran and Ramakrishnan (1981).
249
 BALACHANDRAN AND RAMAKRISHNAN
Joint Cost Allocationfor Multiple Lots
an allocation scheme is developed. This scheme has all
the advantages that Moriarity (1975) proposed, plus the
property of economic justification implied by the dual-
ity theory of optimization literature3 and the fairness
and stability properties of the core theory.
The matrix of costs presented in Table 1 identifies two
sets of costs. One is concerned with the fixed cost JCj,
which is incurred if lot j is bought to be used by any set
of products. Iijrepresents the incremental cost of further
processing. The problem of optimally selecting (1) the
lots to be bought and (2) the products assigned to use
the chosen lot for further processing, is similar to the
fixed charge transportationproblem discussed in the op-
erations research literature.This model has been formu-
lated for (1) "facility location" decisions and (2) further
"transportation"decisions given the facilities that are to
be opened from the decision in step 1. However, Erlen-
kotter (1978) has developed an efficient algorithm (a com-
puter code and performance results are also included in
the paper) which uniformly has achieved good compu-
tational results. We will make use of this algorithm and
show how the dual solution of this model has a meaning-
ful economic property for joint cost allocation.
Phase I: The Optimal Resource Selection Problem
The "Fixed Charge" Multilot Problem.
The firm's problem is to optimally select lots that should
be bought, from the available set of lots, and to opti-
mally assign the divisions or products to the selected
lots. This can be formulated as a mixed-integer pro-
gramming problem called the "fixed charge" multilot
problem. We use the expanded cost matrix (including
the market lot option as the source m) and a JC vector
of all joint costs as in column one of Table 1. Let uj be a
decision variable for the purchase or rejection of avail-
able lot j: Let
I1,if resource/lot j is purchased,
l 0, if resource/ lot j is not purchased,
= 1, if producti is made using resourcej,
xii 1 used to obtain an integer solution for IP. The dual so-
otewie
3 Dual approaches were used in allocation applications by Kaplan and
Thompson (1971) and Kaplan and Welam (1974) for linear and non-
linear programs. The dual approach for integer, fixed charge trans-
portation problems is fully discussed by Erlenkotter (1978).
250
With the costs defined in Table 1, the firm's mixed-
integer program (IP) is given by:
m n m
IP: Minimize ZIp= I JCju; + I I IijXi1, (1)
j=1 i=1 j=1
Subject to xij = 1, for i =1, ..., n, (2)
j=l
uj - Xi}2 O0,for i =1...,n and j ,... ,(3)
xij:2?O, fori=1,...,n and j=1,...,m, (4)
u1 Oorl, ..,m. (5)
forj=1,
The objective function (1) is the sum of the joint costs
of resources or lots as given by the first term and the
incremental processing costs as given by the second
term. The constraint set given by (2) implies that each
product i should be produced from some lot j or j = 1,
... . m - 1 or bought from outside (j = m). Constraint
sets (3) and (4) require that xijcan be zero, but if it is to
be one, then the associated uj must also be one. (A lot
cannot be used for production unless it is bought.) Con-
straint set (5) is obvious since we either buy or reject lot
j. However, in constraint set (4) we do not require xijto
be 0 or 1 but impose only nonnegativity. This relaxation
is acceptable as the optimal solution will have xij equal
to O or 1, because product i will be produced fully from
the open lot (uj = 1) with the least incremental cost.
If, in the integer program (IP) above given by (1) to
(5) we replace constraint set (5) by
0 < uj < 1 forj = 1, ...,m, (5')
and keep the other constraint sets (1) to (4) as they are,
then the resultant program is a linear program denoted
by (LP). This problem (LP) is called the "linear relaxa-
tion" of the integer program (IP). Exploiting the special
structure in the constraints, Erlenkotter (1978) used a
"dual ascent" algorithm for the associated LP to obtain
tight lower bounds for the IP. The dual of this LP is then
lutions lead to a good candidate primal solutions,
thereby giving an upper bound. Since Erlenkotter (1978)
has discussed the solution procedure to solve Phase I,
our aim here is to show that the dual method immedi-
ately gives a solution to Phase II, thereby yielding a so-
lution to the joint cost allocation problem.
MANAGEMENTSCIENCE/Vol. 42, No. 2, February 1996
 BALACHANDRAN AND RAMAKRISHNAN
Joint Cost Allocationfor Multiple Lots

Phase II: The Joint Cost Allocation the objective function ZDP (since no wi1'sare present in
Suppose a solution to Phase I, solving the ex-ante de- ZDP). Thus we have the "Condensed Dual" (CD) given
cision problem of buying lots at minimal cost, has been below, which has eliminated the m x n constraints given
obtained, i.e., the uj's are optimally solved, for the IP in (8).
given by (1)-(5). We can then use the one-dimensional n
"single lot" methods considered for joint cost allocation CD: Maximize ZDP= V, (6)
by Jensen (1977), Hamlen et al., (1977, 1980), and Bal- i=l

achandran and Ramakrishnan (1981) (BR) to solve the n

Phase II problem. We use the rule that "each lot's cost Subject to I MaxIO,vi - Ii>)c JCj,
i=l
must be entirely paid for by the products using that lot."
Sets of products such that all members of a given set j= 1,...,m. (10)
use only one source (lot) can then be formed. Then the
Here wijhas been set equal to Max(O, vi - Iij>.Note that
cost allocation methods of the one lot problem, i.e., the
this program CD has only n variables since we elimi-
one we propose here, or the Shapley Value can be used
nated m x n variables wij. Further, it has only m con-
on a set of decomposed single lot problems. Our prop-
osition here is that the solution method used in Phase I straints, since m x n constraints given by (8) have been
dropped. Good solutions for DP are relatively easier to
offers an economically justifiable allocation mechanism.
find via CD, even though (10) is piece-wise linear in v,.
We show here that the ex-post allocation mechanism
based on the optimal decisions of Phase I lies in the core.
Further, the two problems have been integrated into one 4. Solution to the Problem
model, thus linking the two objectives simultaneously. From any dual optimal solution vi, we can form a pri-
mal integer solution through:
The Dual Method
n
We now present a solution method used for solving IP.
The "fastest" solution technique has been by dual based uj = O, if , MaxIO, vi - Iij < JCj, (11)
i=l
methods. The dual for LP (1)-(4) will be formulated
n
with the relaxed constraint set (5') instead of (5). Let vi, uj = 1, if , maxIO, vi - Ii) = JCj. (12)
i = 1, . . ., n be the dual variables of constraint set (2), i=l
and wij, i = 1, .,. . n; j = 1, . . ., m, be the dual variables
for constraint set (3). Then the dual program for the LP Let J* -j Iuj = 11. Then, set (13)
is I 1, if Iij = minkeJ Iij, and
n
l0 otherwise.
DP: Maximize ZDP= V,, (6)
(14)
n We can also form the following complementary slack-
Subject to Xwij c? JCj, forj = 1, .., m, (7) ness conditions connecting the dual and the primal pro-
i=l
grams:
iv'-wij c Ii>, fori=1,...,nandj=1, ..., m, (8) (uj - xi) maxIO, vi - Iij = 0,
wij 2 O, fori =,...,nandj = 1, ...,m. (9) i = 1, ..., n; j=1,...,m, (15)
Since the objective function contains only vi's and be- n
cause of the special structure in constraints (7) and (8), uj1[c1 - Y maxIO, vi-Iij) =,j=1,...,m. (16)
it is easy and computationally efficient to solve the dual
program, (DP). We can reduce the wij's to their lowest Equation (16) will be always satisfied if the solutions of
possible (nonnegative) values without violating con- (11) to (14) are used. Equation (15) will not be satisfied
straints (8) and (9) to achieve the maximum value for if more than one j E J*has vi > Iij,for any i. There will

MANAGEMENT SCIENCE/Vol. 42, No. 2, February 1996 251

 BALACHANDRAN AND RAMAKRISHNAN
Joint Cost Allocationfor Multiple Lots
be a dual gap as ZDP < ZIp,and ?7 discusses this situ-
ation. Until ?7 we will assume that there is no dual gap.
Dual Program Solution Methods
Though the dual program can be solved by regular
mathematical programming methods, as the problem
has a special structure, we can use a simple, easy-to-
understand process to obtain the optimal solution. Er-
lenkotter (1978) has used the dual ascent and dual ad-
justment procedures. For full details the reader is re-
ferred to Erlenkotter (1978). Here we shall describe only
the dual ascent procedure as it helps us in the solution
to the allocation problem and also since we make use
of it in the example.
The Dual Ascent Procedure. As the objective func-
tion contains only vi's, they must be increased to their
maximum values subject to constraint (10). The vi's can
be initiated to the lowest value of Iijin each column of
Table 1. The left-hand side of (10) will be zero as no Iij
is > vi. The vi's will then be sequentially increased to
the next higher value in each column so that constraint
(10) will not be violated, or to the highest value possible.
We cycle through the columns until none of the vi's can
be increased. This is the dual ascent procedure. The dual
adjustment procedure further improves the solution or
alters it to reduce the complementary slackness viola-
tions of (15).
Erlenkotter (1978) and Morris (1977) have demon-
strated that in this type of problem, almost in all cases
the LP solution itself is an integer solution. From the
theory of duality, at the optimum, Z DPof the dual pro-
gram is equal4 to Z LP.But if the primal solution for LP
turns out to be integers in uj, Z DP= Z I in (1). Since we
have solved the DP given by (6) and (10) we have v*,
the optimal solution to the dual program. The dual so-
lution v* facilitates the joint cost allocation problem as
one scheme we can use is:
Rule: v* is the cost allocated to product i.
The total costs will be fully allocated with this scheme.
4In this section, we will assume that the dual optimal solution leads
to a primal feasible integer solution. If this is not true, then the game
theoretic properties that we derive for the allocations may not hold.
This situation is shown for some cases in ?7.
252
This is so, since the optimal primal objective value
(which is source costs plus the incremental costs) is
equal to the optimal dual objective value, 1n=, v*, by the
duality theory.
The economic justification is that v* is the cost of hav-
ing constraint i in (2) of LP, which is =1xij = 1. The
constraint means that we have to make product i fully.
So product i must incur that cost. All the properties enu-
merated by Moriarity (1975) are satisfied. Let J*be the
set of open sources. Let j(i) be such that
4ij(i)= Min Iij =si. (17)
jeJ
The sum of the allocated joint costs in each group using
the same source is the cost of that source,
E [Vi Si,] = JCk,
i;j(i)=k
from the dual constraint (10) by definition.
The most important property of the allocation we
want to consider is the question of stability. If the allo-
cation scheme offers no incentives for the divisions to
break out and form subgroups or coalitions then our
scheme will be stable. This is precisely the game-
theoretic concept of core. Let N denote the index set of
j = 1, ... , n. An allocationiv is in the coreif the total cost
allocated to any coalition S C N is less than or equal to
the costs that coalition S will incur if it goes alone. We
can prove that our dual based allocation is in the core.
THEOREM1. Cost allocationsbasedon any dual optimal
solution v* are in the core.
PROOF. See the appendix.
Thus we see that dual solution based allocation
schemes are economically defensible, and are not sub-
ject to the criticisms of sterility and arbitrariness in al-
locations discussed by Thomas (1974). However, there
is a problem, as the dual solution to the problem may
not be unique. This occurs because the primal solution
can be highly degenerate with many basic variables tak-
ing zero values. There may be whole space of optimal
dual solutions. To find an unique solution that avoids
"arbitrariness"for the allocation problem, we can make
use of the "propensity to contribute" factor suggested
by Balachandran and Ramakrishnan (1981).
MANAGEMENTSCIENCE/Vol. 42, No. 2, February 1996
 BALACHANDRAN AND RAMAKRISHNAN
JointCost Allocationfor Multiple Lots
5. Allocation Procedures
An alternate set of allocation methods have been pro-
posed in accounting literature without using the core
concept. These methods produce unique allocations and
are based on the concept of imputations (see Shubik
1991, p. 141, for a summary). The core may not exist in
many problems (see ?7 for some cases), but imputations
always exist as they guarantee only that no individual
division has an incentive to use another source in any
proposed allocation. But there are many imputation so-
lutions, and several authors in management accounting
literature (e.g., Hamlen et al. 1977, 1980; Jensen 1977)
have suggested the use of alternate minimum cost as a
basis for allocation.
For each product let bi be the alternate cost that it will
incur if it does not use the source assigned to it based
on the minimum independent cost. Let si denote the in-
cremental cost Iij incurred by product i in the optimal
solution as defined in (17). For product i, si is the base
value for allocated costs, and it also has to take a share
of the fixed cost of the source it is using in the final
allocation. Let the share of the source costs be ri so that
the final allocation ai is si + ri. As enunciated in Bala-
chandran and Ramakrishnan (1981) for the single lot
case, the propensity to contribute (PTC) is then defined
by:
PTCi
(Propensityto)
contributeJ
.bi Si (18)
_ ( Least cost by \ (Incremental\
alternate methodsJ V cost
We can use the PTCs as the weighting factors within
each group. The difficulty in applying this method in
the multiproduct case is that the least cost by alternate
methods is difficult to characterize. The main purpose
of this section is to propose a definition of this cost. Let
j(i) be the lot assigned to product i as defined in (17)
and J* be the set of open sources. Let bq be the incre-
mental processing cost using the second-best open
source for product i, i.e.,
b= Min (IIi.
jEJ*,j*j(i)
MANAGEMENTSCIENCE/Vol. 42, No. 2, February 1996
b. cannot be greaterthan b', as division i can always use
another open source to get the next best incrementalcost.
This is analogous to using I,r (the alternatesource cost) in
Louderback's1976 method, for the one-lot problem.
Also, if biincreased excessively for product i, it might
be optimal for the division to consider buying an un-
used source after paying the fixed cost of that source.
The dual procedure can be used to check this. Source j
will be bought if the vi's change such that the slack on
constraint (10), viz.,
n
iC1 - max(O, vi - Ii),
i=l
becomes zero. We can first use the base value si's for
vi's and obtain the slack on each unused source. Thus,
for each unopened sourcej i J*,let,
qij= Ij + JCj- S max(O, Sk - Ikjl. (19)
k*i
Division i will suggest opening source j if the allocated
cost is increased to qij.We have to find the minimum of
all such values over all j * J (analogous to finding the
second-best among open sources), so that
14= Min(qij). (20)
j0r
The maximum alternate cost bi must be the minimum
of 14and bq so that product i will not switch to some
other open source or go out and try to open a new
source. Then biQmin(I4, bq). Let H(i) be the set of prod-
ucts using the source of product i, denoted by j(i). So
H(i) = (k:j(k) = j(i)). Within groups we can use the
PTC's derived from bi using (18) as the weighting fac-
tors so that the final allocation is:
a=
bi- si
Hbk - S) + Si.
JC1(i) (21)
-k C=HU) ( k SO)
We can easily show5 that lkeH(i) (bk - Sk) 2 JCj(i).So from
(21), ai c bi. As bi = min(I4, bq), bi c bqand bi C 14. The
For any dual solution, vi, as there is no dual gap, from (15), vi
b?. The primal solution assignment (11) imply vi < Iij + JCj
-Xk*i maxi0, Vk - Ikjl for every unopened source j. From (20), bK= Iij
+ JCj - -k*-imaxi0, Sk - IkjI for some unopened source j. V1k 2 Sk, the
lowest cost among open sources as otherwise Vk can be increased with-
out violating any dual constraints. This implies vi _ bi and v,i bi.
From (12), for the open sources the dual constraint is binding and Sk
- Ikj(i) for all k i H(i). So XkEH(,) (Vk - Sk) = JCj(i) < XkEH(i) (bk - Sk).
253
 BALACHANDRAN AND RAMAKRISHNAN
Joint Cost Allocationfor Multiple Lots

Table2 the lowest independent costs for each product. Table 3

shows the dual solution for the first three iterations:
IncrementalProcessing Costs Ij
Producti
The dual ascent procedure is complete. The currentso-
Lot
Lot # Cost lution is also optimal. Let J*= (2, 3, 4) and assign products
j JCj 1 2 3 4 5 6 7 1, 2, 4, and 7 to source 2, products 3 and 5 to source 3, and
product 6 to source 4 (open market). Since among open
1 50 60 180 100 00 100 20 105 sources J*,only one source is available through the condi-
2 60 55 110 00 80 100 30 100
tions vij - Iij> 0, for all i, the complementarityslackness
3 70 65 co 50 100 40 40 0

4 0 80 160 120 140 50 25 170 conditions (15) and (16) are satisfied. Hence we have a pri-
mal optimal solution. The minimum independent costs are

si = 55 110 50 80 40 25 100 for i = 1,...,7.

allocated cost is less than the independent cost of the sec-
ond-best open source for each i, and the minimum cost
incurred to open a new source. This PTC based allocation
scheme a is an alternative to the core allocation. To sum-
marize, the essential differences are:(1) the core allocation
may not exist in some situations (see ?7) while a always
exists, (2) the core allocation may not be unique while a is
unique, and (3) core satisfies group rationalitywhile a sat-
isfies only individual rationality.
Illustration of the Allocations
The following example illustrates the dual method and
the allocation procedure. Consider the data in Table 2
associated with symbols of Table 1 for three lots and
seven products.
Source 4 corresponds to the alternative of directly
buying from the outside market. A cost of ooimplies that
the product concerned cannot be served by the resource
mentioned in the row. Further, the underlined costs are
Allocation of Costs
The maximum allocations that can be charged to each
division i based on open set (2, 3, 4) are:
V = 65 160 120 100 50 30 170 for i = 1, ...,7.
Using the si's we can calculate qil, the maximum slack
of the only closed source, j = 1, as:
qil = Ij + 50 - I maxI0, Sk - Ikl = bK.
k*i
The maximum allocations that can be charged to each
product based on closed sets are:
= 105 225 145 oo 145 70 150 for i = 1, ...,7.
bK
Note that it is optimal only for division 7 to go for
source 1 if source 2 is not available by offering to pay
45 for the joint costs. Division 7 will be willing to pay
the rest of the joint cost 5 as it benefits by going to

Table3

Slack = JCj- Dualsolution v',

max10,Sk -Ikji
Iteration k*i 1 2 3 4 5 6 7

1 50 55 110 50 80 40 20 100
60
70 '-' = 455
2 45 60 160 100 85 50 25 100
0
10 v i= 580
3 35 60 160 110 85 50 25 100
0
0 ,i= 590

254 MANAGEMENTSCIENCE/Vol. 42, No. 2, February 1996

 BALACHANDRAN AND RAMAKRISHNAN
Joint Cost Allocationfor Multiple Lots
source 1. bi, the maximum charge is the minimum of
b7 and b,, i.e.,
bi = 65 160 120 100 50 30 150 for i = 1, ...,7.
Hence the propensity to contribute PTCi = bi - si
PTCi = 10 50 20 50 for i = 1, 2, 4, 7
PTCi = 70 10 fori = 3,5
PTC6= 5
For source 2 we have I PTCi = 130 and r, = 10 60
= 4.6 and so on, to get ri = (4.6, 23.1, 9.2, 23.1) for i
= 1, 2, 4, 7. For source 3 we have L PTCi = 80 and ri
= (61.3, 8.7) for i = 3, 5 and r6 = 0. So the final allo-
cated costs are
ai = si + ri = (59.6, 133.1, 111.3, 89.2, 48.7, 25, 123.1)
for 1, .. .,7.
7. Dual gap and the existence of
core solutions
In ?4 we assumed that the optimal dual solution leads
to an integer primal solution that attains the same ob-
jective value. From the theory of duality, the optimal
dual objective value will equal the optimal objective
value of only for the unconstrained primal program
(not restricted only to integer solutions). While in many
applications the dual gap may not arise (see Tables II-
VI in Erlenkotter 1978), the interesting question is
whether we can obtain stablefull cost allocation schemes
if there is a dual gap. In this section, we will first illus-
trate this situation with an example and derive a general
result connecting the dual gap and the existence of core
allocation solutions. Consider the following example in
Table 4.
It is easy to see that the optimal dual solution is vi
= 100 for i = 1,2,3, and the optimal dual objective value
is L vi = 300. The constraints (10) are binding for j = 1,
2,3, but not for] =4. The corresponding primal solution
is uj =forj = 1, 2, 3 and ai =only if Iij< oofor j = 1,
2, 3. Note that the primal objective value Ej JCj1u
+ Ei Ej Iijaijalso equals 300. But the optimal primal in-
tegersolution is to open and use only source 4 for all the
products. The primal objective value is 330, and there is
a dual gap. As all the products are identical, the only
MANAGEMENTSCIENCE/Vol. 42, No. 2, February 1996
Table4
Lot# Lot Cost
i Jjc 1 2 3
1 100 50 50 0
2 100 50 0 50
3 100 0 50 50
4 210 40 40 40
equitable full cost allocation rule is to allocate 110 to
each product. But this allocation is not in the core, as any
two divisions can acquire an appropriate source and
service themselves for a total cost of 200 while they are
charged 220 in the joint cost allocation procedure. It is
clear that there is no cost allocation that is in the core
for this example.
We will analyze the existence of core solutions in' a
specialized setting where all the products are identical.
In that case, a source's cost structure depends only on
its capacity expressed in the number of products that it
can serve. Let s (1 c s c n) denote the capacity and
JC(s) denote the joint cost of a source that can serve a
maximum of s products at an incremental cost of I(s)
for each product that it serves. Without loss of gener-
ality we will assume super additivity, i.e., for 1 c k c s,
iC(s) + sI(s) c [JC(k)+ kI(k)I
+ [JC(s - k) + (s - k)I(s - k)]. (22)
If super additivity is not satisfied, then the source of a
given size s never needs to be considered and can be
replaced by two sources of capacity k and s - k with
lower total costs. Note that the cost structure described
in Table 4 satisfies super additivity. The Iij matrix of
Table 1 can be completed as follows: for sources of size
s, the independent cost Iij is I(s) for s products and
equals m for the rest of n - s products. With this cost
structure we can show the following.
THEOREM 2. Forthecaseof identicalproducts,a corefull
costallocationruleexistsif andonlyif thereis no dualgap.
The intuition behind the theorem can be seen by ob-
serving that, as the cost function is super additive, the
primal optimal solution is to choose the largest capacity
255
 BALACHANDRAN AND RAMAKRISHNAN
Joint Cost Allocationfor Multiple Lots
source of size n. The total cost will be JC(n) + nI(n).
The full cost allocation to each product is vi4 = JC(n)/
n + I(n). Is this allocation a feasible solution in the dual
program? If for sources of size s, v I(s), then con-
straints (10) of the dual program will not be binding. If
for sources of size s, vi > I(s), then constraint (10) is:
s(JC(n) + I(n) - I(s)) c JC(s).
n
Combining these two cases, we can see that there will
be no dual gap if and only if
JC(n) Cs
)+I(n) )+ I(s) V s, 1 c s c n.
n s
But note that this is also the condition for a coalition of
size s not to break away from the whole group and ac-
quire a source of size s only for the coalition. The allo-
cated cost to the coalition s(JC(n)In + I(n)) should be
less than JC(s) + sI(s), the cost for the coalition alone.
Since (23) implies that allocation v* is in the core, the
theorem is proved.
For the situation with symmetrical products, the es-
sential condition is (23), which says that the product
costs computed using the full costing method must be
decreasing as the capacity increases. If this is true, then
there will be no dual gap, and there are cost allocations
that are in the core. If there is a dual gap and if the firm
wants to preserve stability, then the firm must subsidize
joint resource acquisition. The minimum subsidy
needed is the dual gap.
Various economic rationale for allocating common
costs (relating to pricing for usage to reduce congestion
costs, etc.,) are provided in Banker et al. (1988), Miller
and Buckman (1987). Cohen and Loeb (1990) show that
firms facing price competition will bid as if they are
planning to allocate fixed costs completely ex-ante.
These papers assume that one agent, i.e., the central
headquarters, can decide on the allocation scheme and
ignore the motivation of the individual divisions to ac-
cept the cost allocation. The results of this section com-
plement the result of those papers as we show that a
subsidy (equal to the dual gap) will be required if tidy
allocation methods are to be used. But once the firm
starts subsidizing common resource acquisition, then all
the advantages of decentralization, accurate product
256
costs, etc., outlined in the introduction, may be compro-
mised.
8. Conclusion
We have provided a two-phase model which simulta-
neously handles the acquisition-assignment decision of
multiple lots (ex-ante) in Phase I and the joint cost al-
location (ex-post), given the optimal selection of lots in
Phase I. Utilizing the optimal dual solutions of the lot
selection problem, a joint cost allocation mechanism
based on the concept of propensity to contribute is pro-
vided. This allocation is shown to be in core if there is
no dual gap. For the case of identical products, we also
(23)
show that if there is a dual gap, then there is no core
full cost allocation rule.
The existing literatureessentially has considered differ-
ent cost allocation schemes for a single lot case. Here we
consider multiple lots and prove stability, a concern that
does not arise with one lot. Further,these cost allocation
schemes are done on an ex-post basis, while here we dis-
cuss ex-antedecisions as well. Severalcriteriafor evaluating
cost allocation schemes are discussed in the literature,but
the emphasis has been on (1) rationalityand fairness and
(2) neutralitywith respect to decision making (Hamlen et
al. 1977, p. 616). However, most of these models consider
the product/purchase decision independent of the cost al-
location problem. Our model permits the simultaneous
analysis of ex-ante producdiondecision and ex-post allo-
cation mechanisms. Further,our allocations satisfy all the
criteriaenunciatedearlierand those of Moriarity(1975).We
combine the richness of duality theory, the stability of the
core, the incentive compatibilityrequirementsof game the-
ory, and the propensity to contributeaspects appealing to
fairness.Finally a numericalillustrationis provided, based
on the algorithm presented in the paper.6
6
The authors would like to thank the referee and the editor for their
valuable comments.
Appendix
THEOREM1. Allocationsbasedon any dual solution are in the core.
PROOF. For any allocation v to be in the core, no coalition should
have any incentives to break away and incur lower total costs. Let S
denote any subset of products and let c(S) be the minimum cost that
the coalition will incur, if it acquires a separate set of resources. Sup-
MANAGEMENTSCIENCE/Vol. 42, No. 2, February 1996
 BALACHANDRAN AND RAMAKRISHNAN
Joint Cost Allocationfor Multiple Lots

pose that when coalition S is alone it acquires the set of resources Cooper, R., "Does Your Company Need a New Cost System," in B.
denotedby J. Then, Brinker (Ed.), Emerging Practices in Cost Management, Warren,
Gorham & Lambert, Boston and New York, 1990.
c(S) = E MinIIij+ X JCj. (24) Crow, R. T., "An Approach to the Allocation of Common Costs of
ies Ji-I jl
Multi-Mission Systems," Naval Res. Logistics Quarterly, 19, 3
Once the set of resources J is bought, each product will be produced (1972), 431-448.
from the source in J that has lowest incremental cost Iij.The first term Demski, J. S., D. Sappington, and P. T. Spiller, "Incentive Schemes with
in (24) is the total incremental processing cost and the second term is Multiple Agents and Bankruptcy Constraints," J. EconomicTheory,
the total source cost. Allocation v will be in the core only if 44 (1988), 156-167.
Dumaine, B., "Is Big Still Good?", Fortune,April 20, 1992, 50-60.
c(S)X v vi VSCN, (25) Erlenkotter, D., "A Dual-Based Procedure for Uncapacitated Facility
ieS
Location," Oper. Res., 26 (1978), 992-1099.
where the vi's are the allocated costs based on a dual allocation and Fuchsberg, G., "Decentralized Management Can Have Its Draw-
N is the set of all products. backs," WallStreetJ., December 9, 1992.
As the dual solutions satisfy constraints (1), we have Gangolly, J. S., "On Joint Cost Allocation: Independent Cost Propor-
tional Scheme (ICPS) and Its Properties," J. AccountingRes., 19, 2
Y, MaxI0, vi -Iij} JC; forj =1,. M.m (1981), 299-312.
ieN
Hamlen, S., W. Hamlen, and J. Tschirhart, "The Use of Core Theory
Adding these constraints for j E J, in Evaluating Joint Cost Allocation Schemes," Accounting Rev.,
July (1977), 616-627.
X X Max(O, vi - Iij jICj. (26) , and , "The Use of Generalized Shapley Allocation
iGN je
je1
in Joint Cost Allocation," Accounting Rev., April (1980), 269-
Let ](i) be defined such that, 287.
Hughes, J. S. and J. H. Scheiner, "Efficiency Properties of Mutually
= Min(IiiJ.
Ii,j-(i) (27) Satisfactory Cost Allocations," Accounting Rev., 55, 1 January
jel
(1980), 85-95.
Then from (26) we have, Jensen, D. L., "A Class of Mutually Satisfactory Allocations," Account-
ing Rev., October (1977), 842-856.
X Cjc2 Kaplan, R. S. and G. L. Thompson, "Overhead Allocation Via Mathe-
E (Max(O, i- + E_ MaxO0, i- Iij)
jel ieN jel,j*j(i) matical Programming Models," Accounting Rev., 46 (1971), 352-
364.
X Max(O, vii,- I,())I E Max(O, vi - I,j(j) since S C N
and U. Welam, "Overhead Allocation with Imperfect Markets
ieN ieS
and Nonlinear Technology," Accounting Rev., July (1974), 477-

ieS
vi - I Ii,j(j)
ieS
X vi - I Min(Iij from (27),
ieS ies JeJ
which proves that vi's are in the core from (24) and (25).
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Acceptedby BruceMiller;formerDepartmentalEditor;receivedFebruary1991. This paperhas beenwith the authors 19 monthsfor 1 revision.

258 MANAGEMENTSCIENCE/Vol. 42, No. 2, February 1996