Performance effects of insulating and non‐insulating cost allocations in stable and unstable production environments

Abstract Firms allocate significant amounts of common costs, and these allocations have implications for performance evaluation and remuneration. Non‐insulating cost allocations distribute costs based on same‐period relative performance, creating a contemporaneous interdependence between managers that in turn adds uncertainty to the link between effort and performance. In contrast, insulating cost allocations are independent of relative performance during the period and can thus be determined with greater certainty ex ante. In an experiment, we predict and find that managers' effortful performance in a stable production environment—where the pre‐allocation return for effort is constant—is higher when costs are allocated via an insulating allocation compared to when costs are allocated via a non‐insulating allocation. We further find that in an unstable production environment—where the pre‐allocation return for effort can vary from period to period—there are no differences in performance between the allocation methods when managers face a lower return for effort. Conversely, when managers face a higher return for effort in this environment, performance is greater when costs are allocated via an insulating allocation. Taken together, overall performance in the unstable production environment is greater when managers work under insulating cost allocations, suggesting the net effects of cost allocation methods are similar in each type of production environment. As such, our study identifies an important cost—lower effortful performance—of using non‐insulating methods to allocate common costs.