The Effect of Insulating and Non-Insulating Cost Allocations on Risk and Cooperation

Abstract

Firms allocate shared costs for decision-making, control, and reporting purposes. One important choice firms face with regard to cost allocations is whether they should be insulating or non-insulating. Non-insulating allocations follow ability-to-bear principles and allocate costs based on relative performance measures, creating an inter-dependency between managers. On the other hand, insulating allocations are independent of relative performance during the period. In an experiment, we predict and find that, compared to participants in an insulating cost allocation condition, participants in a non-insulating cost allocation condition chose capital projects with greater risk, developed stronger group identification, and perceived their allocation method to be less fair. We also find that, as posited, both group identification and perceptions of fairness have positive effects on cooperation. We do not, however, find overall differences in cooperation between cost allocation conditions – essentially, the effects of cost allocation condition on cooperation operating through group identification and fairness perceptions offset each other. Collectively, our study and findings have important implications regarding the design and use of cost allocations to motivate desired attitudes and behaviors.