A Business Problem

There are many problems in business that people don’t think about very often. Some of them can cause problems if poorly managed.

A common one is how to allocate enterprise wide costs to specific operations.

Cost forms

The simplest allocation is for those that attach directly to a product or service. Easy enough. I shipped a widget and it had $2.00 of material and 4.00 of direct labour. Shipping cost was $0.50. By that reckoning, it cost $6.50 and it sold for $25, so all is well.

Unless I sell only widgets, the problem of profitability gets harder. Suppose I have four product lines.

How much to charge to each product line for the other unavoidable costs.

  1. Executive salaries
  2. Supervision
  3. Purchasing,
  4. Sales and marketing,
  5. Human resources,
  6. Rent or building depreciation
  7. Parking lot maintenance,
  8. Municipal taxes
  9. Engineering
  10. Accounting and finance
  11. Purchasing
  12. Transportation management
  13. Heat
  14. Hydro
  15. Insurance
  16. Janitorial services,
  17. Scrap management
  18. Machinery Repairs and maintenance
  19. Machinery lease costs or depreciation
  20. Shop supplies
  21. Office supplies
  22. Legal fees
  23. Interest expense
  24. Discounts
  25. And about a hundred others.

None attach directly to the product shipped, but they are required to allow the product to ship.

Allocating the indirect cost

There are two approaches. Do or do not allocate to product lines.

If you do not it may be hard to decide if a product is profitable. Maybe it takes up half the floor space but only contributes a quarter of the margin. Maybe it takes more supervision, or is often defective. There are lots of things that create uncertainty in how to allocate these costs.

I was once the treasurer at a country club. There were many costs relating to golf and to curling. The other costs amount to nearly as much as the total of those two. The question is how to allocate the others to develop fair membership fees? No matter how you do it there is another way that would benefit golfer over curlers or vice versa. One suggestion was by square footage. The curling rink is about a quarter of an acre and the golf course is about 200 acres. So curling should pick up about 0.5% of the cost. Ultimately we just charged what we thought was fair and Ideally was close to the most we could charge without losing membership.

It’s always a guess.

The problems that arise

There are three

How do you create a bonus plan for product line or division managers? If you do it based on profit after fully-absorbed costs, you are guessing. It might work, but probably not forever.

You cannot decide if a product line is profitable. Suppose you have a pretax profit of $1,000,000.

Take the widget line. Its margin is $18.50 per piece. Of your four product lines it sells the smallest share of total sales. If you guess at indirect cost allocation, you may end up with the widget line being unprofitable. So you kill it, right?

Does that shrink indirect costs? Probably not. Now those costs must be allocated to three product lines and it is not impossible that one of them will change from profitable to unprofitable. Should you kill it too?

Eventually you will end up with one product line and it will be unprofitable.

The thing you must notice is when you kill the widget line there is a negligible change in indirect costs, but you lose $18.50 of cash flow per unit sold. Where do you get that back?

Pricing problems can arise.

Suppose some one comes along and points out that you have extra capacity to produce widgets. Maybe you are at 65% of capacity. They offer to buy units that would take you to 90% utilized. They will require they be private labelled. They will pay $17.00 per unit. You look at your fully absorbed cost for widgets and notice it is $22.00. Should you take the order?

It looks like you will lose $5.00 per unit, but the guy in finance says take it. You won’t lose $5.00 per unit, you will make cash flow of $10.50 per unit and indirect costs won’t change in total. Maybe a tiny amount to design the new box.

Bonus and cost-volume-profit decisions are near impossible to make based on fully absorbed costs.

Don’t try.

The takeaway

Product decisions should relate to margin, potential for growth, filling a product sector, and defence from competitors. Indirect costs should be managed as a different function. There is never a good enough reason to allocate indirect costs to product.

When Steve Jobs returned to Apple in 1997, one of the first things he did is stop the idea of fully absorbed costs. Think as a team. If the company as a whole is not profitable, any specific product line doesn’t really matter much.

I help people have more retirement income and larger, more liquid estates.

Call in Canada 705-927-4770, or email don@moneyfyi.com

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