Question

Allocation of common costs. Evan and Brett are students at Berkeley College. They share an apartment that is owned by Brett. Brett is considering subscribing to an Internet provider that has the following packages available:
Package Per Month
A. Internet access............................................... $75
B. Phone services............................................... 25
C. Internet access + phone services................. 90

Evan spends most of his time on the Internet ("everything can be found online now"). Brett prefers to spend his time talking on the phone rather than using the Internet ("going online is a waste of time"). They agree that the purchase of the $90 total package is a "win—win" situation.

1. Allocate the $90 between Evan and Brett using (a) the stand-alone cost-allocation method, (b) the incremental cost- allocation method, and (c) the Shapley value method.
2. Which method would you recommend they use and why?

Answer 1

Answer:

1. Evan Brett

Stand-alone $67.50 $22.50

Incremental (Brett primary)$65.00 $25.00

Incremental (Evan primary) $75.00 $15.00

Shapley value $70.00 $20.00

2.The Shapley value approach is recommended.

Explanation:

Evan Brett

Stand-alone $67.50 $22.50

Incremental (Brett primary)$65.00 $25.00

Incremental (Evan primary) $75.00 $15.00

Shapley value $70.00 $20.00

a. Stand-alone cost allocation method.

Evan: $75/$75 + $25×$90

=3/4 ×90

=67.50

Brett: $25/$75 + $25 ×$90

=1/4×$90 = $22.50

b. Incremental cost allocation method.

Let assume that Brett (the owner) is the primary user while Evan is the incremental user:

User Costs Allocated Cumulative Costs

Allocated

Brett $25 $25

Evan 65($90 – $25) $90

Total $90

This method may lead to some dispute over the ranking because Evan pays only$65 despite his prime interest in the more expensive Internet access package while Brett could argue that if Evan were ranked first he would have to pay $75 due to the fact he is the main Internet user. Which means Brett would only have to pay $15.

Assume Evan is the primary user and Brett is the incremental user:

User Costs Allocated Cumulative Costs

Allocated

Brett $25 $25

Evan 65($90 – $25) $90

Total $90

c. Shapley value (average over costs allocated as the primary and incremental user).

User CostsAllocated

Evan ($65 + $75) ÷2 = $70

Brett ($25 + $15) ÷2 = $20

2. The Shapley value approach is the best, therefore it is recommended because it is fairer than the incremental method due to the fact that it avoids considering one user as the primary or major user and allocating more of the common costs to that user. It also avoids disagreement about who is the primary user which is why its allocates costs in a way that is close to the costs allocated under the stand-alone method but takes a more comprehensive view of the common cost allocation problem by considering the primary and incremental users that the stand-alone method ignores.