Of Increasing Importance – Allocation of Home Office Expenses to Segments

In today’s environment of prolific acquisitions and mergers, the equitable allocation of home office expenses down to its segments, and then further down to the segments’ allocation of intermediate home office expenses to lower level operating units, has become quite important.

Cost Accounting Standard 403 (49 CFR 9904.403) establishes the criteria for the allocation of home office expenses to the segments of the organization. The standard directs that such expenses be allocated on the basis of the beneficial or causal relationship between supporting and receiving activities. The allocation process can be divided into the following three parts:

• Those costs incurred at the home office level solely for the purpose of a specific segment (e.g., legal expenses, etc.) are to be charged directly to the benefiting segment.
• Expenses not directly charged, if significant in amount, are to be grouped into logical and homogeneous expense pools and allocated based on the services furnished to or received by the receiving segment (e.g., human resource costs allocated by the head count in each segment, etc.).
• Residual expenses (those not allocated above) are to be allocated to segments based on use of what is called the “three-factor” formula. Use of this allocation method only applies if the residual expenses which are not specifically identifiable with any activities of the segments exceed the following amount based on revenues for the preceding year.

• 3.35% of the first $100 million
• 0.95% of the next $200 million
• 0.30% of the next $2.7 billion
• 0.20% of all amounts over $3 billion

The three-factor formula is the arithmetical average of: (1) the segment’s percentage of payroll dollars to the total payroll dollars of all segments; (2) the segment’s percentage of operating revenue to the total operating revenue of all segments, and (3) the segment’s percentage of the average net book value of tangible capital assets plus inventories to the total average net book value of such assets for all segments.

The resulting average of these three percentages (factors) are used to allocate the residual home office expenses to each segment. When residual expenses do not exceed the above criteria, the expenses can be allocated in any manner that is equitable and reasonable.

On February 13, 2008, a Staff Discussion Paper was issued by the Cost Accounting Standards Board (Federal Register, Volume 73, Number 301, Page 8260-8262) inviting comments on whether the thresholds stated above should be revised. The thresholds have not been revised since they were promulgated in 1972.

Proposed threshold adjustments recommended by the Aerospace Industries Association, based on the Consumer Price Index, would raise the amounts shown above to approximately $470 million, $390 million, $12.6 billion and $14.0 billion respectively. Another consideration proposed by the DoD is to obtain actual statistics of various companies to reflect the impact that economic changes, industry changes, and the advent of acquisition reform have had since 1972.

Public input is requested by April 14, 2008. See the Federal Register for details and key questions to be answered.