How to allocate overhead? Let’s talk about it through this post. Corporations are required by Generally Accepted Accounting Principles (GAAP) to allocate (mathematically distribute or apportion) their overhead expenses to individual profit centers when they prepare information for the stakeholders, particularly the tax institution or securities commissions (absorption accounting in LIFO/FIFO calculations), and certain industry-specific regulatory authorities. There are numerous criteria that may be used as the basis for this calculation, including revenue, direct cost, units produced, direct labor dollars or hours, and square footage consumed.
It is presumed, incorrectly, that the methodology that must be used for regulatory compliance is also appropriate for intelligent management decision making. Nothing could be farther from the truth.
Problems That Arise from Overhead Allocation
The process of allocating overhead charges to individual businesses can lead to several problems within a company:
It Fosters Politics. The process of allocating overhead charges to individual businesses fosters political infighting. When an executive shines as a result of her contribution to the profitability of the business, this is a positive result. However, when costs are allocated, a manager who knows how to manipulate the allocation methodology can make his department’s performance look better by getting charges assigned to other operating units. When one profit center looks good at the expense of another, without the company benefiting at all, that’s politics.
It Inhibits New Product Introductions. Accounting methodology assigns a portion of the existing overhead to each new product when analyzing its profitability. This inflates the cost of the new product and causes the estimate of its contribution to profit to be severely understated. The analysis of a new product should include only costs that are incremental for that new product. Existing overhead that is not affected should not be included.
It Understates the Profitability of Business Beyond Budgeted Volume. Overhead allocations are assigned to all products, regardless of volume. When sales surpass budgeted expectations, the accounting department will continue to charge these allocations to the individual products even though the company has already generated enough business to cover the actual corporate overhead. These fictitious charges will continue to be added until the end of the year. This leads to a significant understatement of the actual profits of each business that has had sales above the budgeted number and may cause the company to under reward unit managers who surpass their sales budgets.
It Inhibits Marketplace Aggressiveness. Incremental business is really more profitable than the accounting information reveals. Larger customer orders permit longer production runs and more efficient raw material purchasing. Traditional accounting information does not recognize this. The ability to give price breaks on larger orders (volume discounting) because of these advantages cannot be recognized because overhead charges are assigned to all products.
It Overstates Savings from Eliminating ‘‘Marginal’’ Products. A company should never eliminate products from its mix except under the following circumstances:
- The product achieves a negative contribution margin, and there is no opportunity to correct this situation.
- The product is a quality disaster that will impair marketplace perceptions of the entire business.
- The company is near capacity and needs the space and machine time for more profitable offerings.
Eliminating a product with a positive cash flow results in the loss of that cash flow. Why is there confusion about this? Because our accounting systems tell us that eliminating a product will save the variable labor costs and the corresponding overhead assigned to the product. Labor costs, as anyone who has ever managed a factory will tell you, are more fixed than variable. They will not be reduced appreciably, if at all, when volume declines. And overhead will not be reduced because the building does not get smaller, nor do the staff departments (including accounting).
What About the GAAP?
Companies should continue to comply with their accounting responsibilities. Nothing that we are advocating here addresses regulatory issues at all. We are simply arguing that marketing and operating managers should receive the product and performance information that they need in order to make intelligent business decisions and judgments.
Effect on Profit of Different Allocation Methods
To explore these issues, let’s look at a company with three profit centers.
Royal Bali Cemerlang Income Statement below shows the annual results achieved by them. The company is very profitable and serves its customers well. Each of the three profit centers focuses on a distinct marketplace and performs as a semi-independent unit.
Each profit center has developed a pricing structure that fits with what is necessary and desirable in its marketplace. Some profit centers sell directly, whereas others sell through distributors or reps. The product mixes will certainly be different. For purposes of convenience, we will assume that each strategic business unit has sold 100,000 units of product.
This includes all profit center costs and expenses:
- These costs are specifically identifiable to an individual profit center. They include the costs of producing the product, operating and staff expenses, and the costs of any services or functions that the profit center out-sources to others.
- These expenditures are incremental to the profit center. They are not shared among the profit centers, and so they would disappear if the responsible profit center were not in business.
- These costs may be fixed or variable. They can be part of the product, or they can be support costs. They could include engineering, product design, and accounting, if these were dedicated to an individual profit center.
- The profit center management team must have some ability to control the costs for which it is responsible. While the management team does not control the purchase price of a natural resource, it can control the quantity purchased, mode of transportation, product source, and whether there is any value added to what is purchased.
This includes all the support efforts that are necessary if the entire organization is to function, such as accounting, legal, corporate staff, and management information systems. It also includes all spending that supports all of the profit centers combined and is really not divisible among them. For example, if all the profit centers were housed in a single building, this building would be considered part of the corporate overhead.
Gross profit percentages are gross profit dollars divided by revenue. Corporate profit is the cumulative gross profit of all of the businesses less corporate overhead.
An examination of how overhead allocations affect the perceptions of performance will be very valuable at this point. So, read on……….
If the corporate overhead is allocated on the basis of revenue, the result will be:
Because Profit Center A provided one-third of corporate revenue, it is charged for the same proportion of the corporate overhead. Remember that these corporate charges are not based upon the services that each profit center receives. The amounts allocated support the entire organization collectively.
Notice: On this basis, Profit Center C is losing money. This profit center contributed $200,000 to pay for corporate overhead and achieve corporate profit. It now must revise its strategy to eliminate losses that it neither caused nor can control. A more damaging result is the feeling on the part of company management that this unit will never be ‘‘profitable’’ and therefore must be eliminated.
If the allocation is based on units sold, Profit Center C will look even worse:
‘‘Turning around’’ Profit Center C is clearly impossible. While remedies for its problems will be proposed, its days are clearly numbered.
If corporate allocations are based upon direct labor (which is part of direct costs), all three of the profit centers will be profitable, as follows:
With this method of allocation, all three profit centers have achieved a ‘‘profit.’’
Which method is correct? Is Profit Center C profitable or not?
The answer depends upon which method of allocation happened to be selected by the accounting department. All are acceptable in terms of GAAP requirements. The accounting department will study the company’s operations and attempt to select the method or formula that it perceives as being most accurate.
However, the results will be the same: Decisions will be based upon the statistical method selected. Will these decisions improve the business, as many expect they will? Let’s look at some of those decisions and focus on what solutions would be in the best interests of the Royal Bali Cemerlang.
. Are all profit centers contributing to the profitability of the business? Absolutely yes. Each of the three has a positive contribution margin. Each is more than covering all of the costs and expenses associated with its individual business.
. How should Royal Bali management respond to excessive corporate overhead? Not by passing it on to the profit centers and asking them to figure out a way of paying for it. The best strategy for eliminating excessive overhead is to hold those departments accountable for their own performance and reduce their budgets and/or expect them to increase their achievement. Allocating excessive spending to operating units does not solve the problem. Instead, it asks the profit center teams to solve problems that they did not create and cannot control. Increasing prices and compromising on product quality to compensate for others’ inefficiencies are remedies that are no longer available.
. In which businesses should Royal Bali management expect improved profitability? Why not all of them? We do not know, however, if each of the profit centers can improve its profitability to the same degree. Perhaps 20 percent profit growth would be very easy for Profit Center B but absolutely impossible for Profit Center C. A 20 percent gross profit in Profit Center C’s market might be relatively better performance than 40 percent in Profit Center A’s market. We would have to benchmark each profit center against its respective competitors to determine what are feasible expectations. Achievement must be evaluated against potential.
. In theory, what would be the most favorable product mix? If Profit Center A achieves a gross profit of $6.00 per unit ($600,000/100,000 units) and Profit Center C achieves $2.00 per unit, expanding Profit Center A‘s business at the expense of Profit Center C would improve gross profit by $4.00 per unit (the gross profit differential). Keeping these numbers real simple, the ranking of these profit centers by gross profit dollars is:
Profit Center B: $7.00 per unit
Profit Center A: $6.00 per unit
Profit Center C: $2.00 per unit
However, if you rank the profit centers by gross profit percentage, the ranking changes:
Profit Center A: 40 percent
Profit Center B: 35 percent
Profit Center C: 20 percent
If you check your company’s financial statements, you will notice that in most cases, accountants rank product profitability by percentages, although it is their dollar impact that is most critical.
. Profit Center C has a gross profit percentage that is below the average for the entire Royal Bali organization. Should that be a cause for divestment? Royal Bali Cemerlang should never eliminate a business with a positive gross profit unless:
a. The lower quality of its products is damaging the other businesses.
b. Productive capacity is limited and can be used for more profitable businesses.
c. Supporting it requires too much, less profitable investment.
. If these three businesses are all profitable, why make choices at all? We do not have to make choices among these businesses if:
a. There is adequate capacity to allow all of them to grow.
b. The company can afford to provide sufficient financing to permit all of them to prosper.
c. The ROI for this funding exceeds the company’s discounted cash flow hurdle rate.
If the answer is no for any of these three parameters, then product mix choices should be made soon. These become strategic issues with long-term answers. Perhaps one of the profit centers should be sold to finance the others. The profit center with the most promising future should be financed by the cash flow generated by the more mature businesses.
. How do we evaluate the profitability of a proposed new business? Royal Bali Cemerlang is considering the addition of Product D. The annual forecast for this new business is as follows:
Annual Sales = 100,000 units
Price = $4.00 per unit
Direct Cost = $3.00 per unit
Incremental Gross Profit = $1.00 per unit
Capacity is more than sufficient to allow this product and the other three to grow for the foreseeable future. Product D is a very good product that has tested well. There might be some cross selling and other synergistic benefits with the other businesses, but these have not been included:
(a). If Royal Bali measures product profitability by gross profit percentage, the proposal for Product D will be rejected.
The gross profit percentage for Product D is below that for the company as a whole. Therefore, Product D will bring down the average. Prioritizing products by their gross profit percentage may be helpful if the company is near full productive capacity and outsourcing opportunities are not available. Otherwise, Product D will bring down the average and not be acceptable.
(b). If the company allocates non-incremental overhead and does so on the basis of units, the proposal to add Product D will be rejected.
Product Forecast D:
The company overhead of $1,000,000 will now be reallocated as follows:
(c). If Royal Bali Cemerlang is most concerned about the cash flow that will be generated by its decisions, the proposal to introduce Product D will be approved.
Implementing Product D will increase corporate profit from $500,000 to $600,000. Notice that a 10 percent increase in revenue results in a 20 percent increase in bottom-line profitability.
This is true even though Product D has a gross margin percentage below the corporate average.
When Royal Bali Cemerlang is reporting its results to others, adhering to generally accepted accounting principles is both required and desirable. It promotes uniformity and integrity of the numbers. This is especially helpful to bankers, security analysts, and others who rely on the company reports they receive. However, the decisions that will improve the performance and financial health of the company are those that improve its cash flow. The methodologies that are best for achieving this objective are different from but not necessarily inconsistent with GAAP. These issues should be explored in your company.