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 underreward 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 dis counting) 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:

1. The product achieves a negative contribution margin, and there is no opportunity to correct this situation.

2. The product is a quality disaster that will impair marketplace perceptions of the entire business.

3. 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).

Back: Overhead Allocations

[ HOME ]