Cost allocations- Easy method is not always right

After being a witness to a company’s boardroom profitability review, I began to wonder whether the current economic condition has given rise to a renewed focus area of cost management. Cost allocation is a managerial accounting process of assigning of common costs to cost objects. One key observation during our client’s SBU profitability review meeting was that each of the SBUs had a diverse product/service lines with widespread disparity in their profitability. The company was following a common cost allocation approach a deep-rooted belief that all costs must in some manner be fully allocated to the revenue generating units of an organization. This approach assumes that costs are proportional to the output which may be far from truth. For example, Cost of unbilled Resources who are not assigned to projects was being allocated on a lump-sum basis to all the SBUs. As a result of this, SBUs with lower headcount were undercosted and SBUs with higher headcount were overcosted. This was one of the reasons which had led to the widespread disparity in profitability across the SBUs that led to their goals go out of reach. Bad information was leading to bad decisions. Lump-sum allocation method is easier to implement, it ignores changes in activity levels. Lump-sum allocation method provides a very little tie-up between costs and volume of products / services actually consumed.

On the other hand, finer allocations based on actual activities involved in a process/SBU may reveal the right costs. Activity based costing (ABC) is a method that leads to lesser undercosting or overcosting of products / services. Activities in ABC could range anything from processing purchase orders, producing software using certain employee headcount, setting up machinery /equipment, inspecting finished goods, packing customer orders, etc. Although ABC implementation is costlier, the benefits derived far outweigh the costs. I would like to conclude that ABC employs the activity concept thereby providing satisfactory data to end-users such as how product/service is produced, how much efforts is needed to perform an activity and finally how much money is spent on performing this activity. Using the ABC model, it has been proven that concealed losses and pricing decisions can be analyzed.

-Pratibha Sharma

One thought on “Cost allocations- Easy method is not always right

  1. rrferro says:

    Pratibha Sharma, as an alternative to using the ABC model, I am favor cost drivers to the ABC model. Activity alone can be deceiving in understanding what driving cost. However, both methods have their shortcomings and a balance needs to be struck between them, human intervention. The departmental and benefits approach has its merits in allocation of support service such as IT where allocation of budgets follow resource allocation based on number of terminals or log-on assigned to the business unit or entity, project cost allocation on user request (department being serviced logistics, supply chain, operations, sales and marketing, etc.) resulting in multifaceted allocation basis. Ultimately, even with greater granularity in at some point the general pool runs out of drivers and activity bases for allocation and require allocation on some basis that has no relationship cause and effect. What are the choices: net asset investment in business unit, head count, total cost, or some kind of weight-average, or arbitrary discussion to penalize least favored sons over those in good graces?

    As indicated in your starting statement – Cost allocations- Easy method is not always right” I concur, and picking the wrong basis is not any better. In my analysis, I like to breakdown cost into their variations to make visible the impact of fixed allocations. Typically, fixed allocations removed from analysis to maintain apple-to-apple comparisons. As in all things business, you need to understand the structure of your organization to achieve workable and fair presentation.

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