Almost 30 years ago, in February 1997, the main headline of Forbes Magazine featured an article by Prof. Srikumar S. Rao from Columbia University, which showed that the lack of control over rising indirect costs could bring organizations to an end.
In the article, Prof. Srikumar cited the real example of a giant American company that found a growth opportunity with the bankruptcy of its main competitor. However, contrary to what it expected, it started making losses instead of increased profits!
Upon further investigation, this company surprisingly discovered that its “flagship” product was unprofitable, and other products it considered unprofitable were, in fact, the most profitable ones for the organization. This happened due to a poor allocation of indirect costs.
Allocating Indirect Costs
How could such a large and intelligent company make such a basic mistake? It was revealed that the organization was allocating depreciation and other indirect costs based on the direct labor cost.
A product that consumed 20% of direct labor also ended up taking 20% of depreciation and overhead costs. However, there was a major flaw here: labor doesn’t depreciate, machines do.
In areas where there is high labor consumption, less machinery is usually required. The moral of the story: products that consumed a lot of labor should have received less depreciation and overhead costs – exactly the opposite of what was calculated.
The danger lies in the fact that direct costs are easy to appropriate: it’s straightforward to know, for example, how much raw material is used in a product or how much cash is in a specific bank account. But what about indirect costs? How do we allocate them correctly and coherently, respecting a cause-and-effect relationship?
A failure in this process, in the medium and long term, is often the cause of business ruin. Improperly allocated indirect costs can be detrimental to your business.
Overhead costs, if not well allocated, can kill your business
It’s crucial to exercise caution with any cost modeling that mechanically allocates indirect costs.
And remember: depreciation is just one of many indirect items! Indirect costs can include everything from toilet paper in the bathroom to IT, HR, and support area costs. The “lazy” solution is to allocate them proportionally to production volumes, transactions, or revenue.
To complicate matters, these indirect costs are becoming more significant for several reasons. Among them, we can mention an increase in automation, which entails a clear “replacement of people with machines.” Additionally, the growing diversity of products, services, customers, channels, suppliers, and machinery (i.e., increased business complexity) results in higher indirect costs due to the increased administrative effort – the management effort needed to handle this complexity.
Historically, these indirect costs only increase. Consequently, the distortions caused by arbitrary apportionment also increase. It is common to find situations in companies where a product, believed to be the “flagship,” is unprofitable. On the other hand, products considered unattractive are often the most profitable for the company, responsible for maintaining the company’s margins in the black.
Solving the Indirect Cost Allocation Problem
Imagine three friends decide to go out for dinner. The first one is on a diet and orders a salad with mineral water. The second friend orders a delicious steak with wine, and the third orders lobster with sparkling wine and dessert. At the end of the dinner, they split the bill equally among the three friends.
Does this splitting seem fair to you? It is easy to identify and even find these distortions absurd. However, these distortions happen every day in many companies worldwide!
Now, if you were to ask for separate bills for each friend, where each one pays only for what they consumed, we’re talking about ABC, “activity-based costing,” which potentially eliminates these distortions in organizations and adequately addresses these indirect costs.
Resolving Indirect Costs through ABC Application
With some practical examples, it’s easier to visualize the weight of indirect costs and understand how activity-based costing allows us to identify and allocate them more accurately.
Example 1: Indirect Costs Generated by the Billing Activity
Take a simple billing activity: its total cost consists of the combined salaries and benefits of the people involved in this activity.
Traditionally, this total cost would have gone into a pool of “general expenses” to be arbitrarily allocated. However, with ABC, you divide this value by a non-financial measure, such as the number of invoices generated Thus, you obtain the cost per invoice. Count the number of invoices generated per product, multiply by this value, and allocate it to each product – this is the value of the “Billing” activity for each of your products. In addition to eliminating distortions, we achieve an important KPI (key performance indicator) for business management: the value of invoicing per issued invoice.
With this data, cost reduction studies, possibilities for outsourcing, and even monthly monitoring can be applied – something that simply would not be possible before activity-based costing.
Example 2: Indirect Costs Generated by the Employee Hiring Activity
The cost of this activity relates to the HR department’s effort specifically involved in hiring employees. It must be separated from other activities, such as payroll processing, employee evaluations, training, etc.
Suppose that, in a given period, 10 people were hired. Out of these, 5 were for Production, 2 for Maintenance, and 3 for Sales. Therefore, the costs of this “Employee Hiring” activity should be distributed as follows: 50% to Production (which will subsequently be allocated to products, also by activities), 20% to Maintenance, and 30% to Sales.
Apart from being able to allocate the costs of this activity, we obtain a critical KPI for decision-making: the cost of hiring per employee – this value can be compared with the monthly expenses of the previous months, the company’s target, or even the cost of outsourcing this activity.
Applying Cost Reduction by Analyzing Direct and Indirect Costs
The potential here is not limited to indirect costs! Several direct costs, for example, production or customer service costs, can (and should!) be broken down by activities, as we will see in the examples below:
Example of Cost Reduction in Manufacturing
Imagine you work in a manufacturing company and have been tasked with cutting costs by 10%. What would you do?
The natural path here is to try to understand which actions you would implement for this cut, and for this, it is essential to understand how costs are currently distributed.
- Salaries: $300,000
- Benefits: $100,000
- Raw Material: $150,000
- Rent: $30,000
- Total: $580,000
With a lot of creativity, some possible options to reduce costs could include:
- Laying off employees
- Outsourcing employees
- Reducing benefits
- Changing raw materials (to a lower quality one)
- Renegotiating rent, etc.
Note that all these cost reduction options are linked to the information provided by the company. And since the only managerial information we have is the amount spent on these costs and expenses, we are limited to actions related to this!
Now… imagine for a moment if these same costs were broken down by activities, considering their direct and indirect costs. Some of them would undoubtedly include:
- Producing products: $150,000
- Delivering products: $100,000
- Moving materials: $80,000
- Preparing machines: $70,000
- Performing corrective maintenance: $60,000
- Resolving production issues: $30,000
- Reprocessing orders: $25,000
- Preparing sales reports: $20,000
- Production rework: $20,000
- Reorganizing pallets in the warehouse: $15,000
- Hiring employees: $10,000
- Other activities
- Total: $580,000
Note that some possible actions now include:
- Rethinking the plant layout (to minimize material movement costs)
- Understanding why the corrective maintenance cost is so high. Are we doing little preventive maintenance? Is the process correct? Did the employees receive adequate training, or are the materials and machinery used for this corrective maintenance appropriate?
- Reprocessing orders or reorganizing pallets: why is this happening? What events occurred that led to these reworks, and how can we minimize this?
- Benchmark: it is possible to understand the unit cost of each of the company’s various activities and compare it between units, with the market, with corporate targets, or even with a potential supplier in case the option is to outsource this activity.
Notice that instead of focusing on specific expenses, we are now also managing by activities, understanding how much each one contributes to the company’s results, proposing improvements, and conducting much more efficient management.
Example of Cost Reduction in Service Organizations
Now, imagine the same previous example, but applied to a bank and with an activity breakdown as follows:
- Credit Analysis
- Customer Collection
- Valuable Transportation
- Branch Management
- Department Coordination
- Deposit Transaction Processing
- Document Management
- Private Client Service
- Client Visits
After calculating the activities, including the correct assessment of indirect costs, it was discovered that the “Credit Analysis” activity cost $900,000 per year. If the total number of analyzed credits was 3,000, we can understand that the cost of each analysis is $300.
The first question to ask is: what is the value of each credit analysis? This is because the cost of the process is often more expensive than the actual cost of the credit being granted!
next, it is essential to consider ways to reduce these costs. Out of the $300 for each credit analysis, it was discovered that $50 was spent only on employees’ overtime while entering the credit requests into the bank’s old credit system. This specific task of entering requests could be outsourced for $10 per credit. With just this activity, a cost reduction of $120,000 is achieved.
Other options include rethinking the entire process, digitizing the requests, and even benchmarking between units to try to improve. And mind you, we are talking about a single activity. Learn more about how to develop a cost-reduction project.
Imagine this potential now applied to all the activities in your company – the possibilities are infinite!
Indirect Cost Allocation is Decisive for Business Success
While arbitrary allocation of indirect costs can be fatal for a company, accurate allocation can lead to significant increases in profitability through cost cuts based on precise data.
Just like the companies in our examples, your organization can also benefit from cautious and safe cost reduction by observing the costs of each activity in great detail to expand profit margins.
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