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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.

With a lot of creativity, some possible options to reduce costs could include:

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:

Note that some possible actions now include:

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:

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.

Fill out the form below and find out how!

Cost reduction in companies is always a goal, but it is becoming an urgent need as organizations’ margins shrink worldwide. Some contributing factors include government pressures, rising taxes, new competitors, increasingly demanding customers, issues now such as ESG (environmental, social, and corporate governance), shortages of skilled labor, and supply chain problems.

Therefore, reducing costs and expenses is the top priority for companies. And when we talk about reducing costs, we immediately think about laying off employees.

What is the difference between costs and expenses?

Before we start, let’s clearly understand the differences between costs and expenses. Then, we will discuss the reasons why we are looking to make a cost reduction in companies.

What is cost?

Cost is any value applied in producing a product (in the case of manufacturing companies) or in providing services (for service organizations). Some examples of costs are labor, raw materials, inputs, as well as the amount spent on the production of this product or the provision of this service with electricity, maintenance, depreciation of machinery and equipment, cleaning, and conservation materials, among others.

In addition, costs can be classified into:

What is an expense?

Expenses include all the amounts spent by the company to keep it running.

Usually, the expense is related to everything spent in the area of sales, finance, administration, human resources, systems, marketing, and the BackOffice in general. Therefore, expenses are a type of expenditure that has no direct connection with the company’s “core” activity, such as producing goods or providing services.

However, even if they do not contribute directly by generating new items to be marketed, expenses play an important role and certainly their use can have an influence on increasing the company’s revenue.

And in turn, expenses can be classified as fixed or variable:

In this context, it is worth noting that expenses are costs and expenses in general. And typically, when someone talks about reducing costs they are talking about “reducing expenses”, but in a “colloquial” way. Thus, it is worth remembering that it is also essential to analyze the possibilities of reducing expenses in the organization.

Want to understand in more depth? Click here and read 5 tips to improve your expense and spending control.

Why reduce costs?

The question above is very simple, right?

But its answer is inversely proportional, proving to be extremely complex.

Reducing costs is one of the greatest allies of profitability. Every company seeks to reduce costs without measuring efforts, but as we mentioned, it is a very complex task. We must be aware that when reducing costs, we must always be cautious not to cause negative impacts and end up in deficit.

To better understand how to adopt a cost reduction strategy without negatively impacting your results, click here and read our full article.

Reducing costs in companies is not an easy task

Were companies that attempted cost-cutting satisfied with their initiatives?

Not always: research by the US Conference Board found that of all the companies that have tried to cut costs:

A study by Deloitte showed that 75% of companies that laid off employees to reduce costs had to rehire others for the same positions within one year.

Another survey, this time by McKinsey, showed that only 10% of cost reduction projects were successful three years after implementation.

But why did these reduction initiatives fail? Surely because of the lack of a better understanding of how resources were consumed in organizations. The natural consequence of not measuring properly is the inability to manage well.

How to reduce costs in companies efficiently?

To solve this problem, see 8 actions that will reduce your costs and, consequently, increase your profits:

  1. Set goals
  2. Be careful with false impressions
  3. Analyze your costs in percentages
  4. Use a reliable recording system
  5. Re-evaluate your tax regime
  6. Learn to negotiate with suppliers
  7. Hire qualified professionals
  8. Invest in marketing actions

But the main lesson of all is: understand your costs.

Not understanding exactly how much a product, service, customer or channel costs ends up damaging the entire decision chain of companies! Definitions such as what prices and tariffs to practice, which customers to serve, what discounts we can grant and what commissions to pay our salespeople among many others go through a real understanding of costs and the ability to measure them properly!

Did you know, for example, that between 20% and 40% of products and services make a loss? And that 20% of customers are loss-making? See more on the subject in this article dedicated to service costs!

So, it raises the question: what actions will we take immediately after identifying bottlenecks in our organization?

Sergio Marchionne, the former CEO of Fiat/Chrysler, played a significant role in the company’s revival in the 90s. Besides being a great manager, Sergio Marchionne has always had a great sense of humor. After the launch of the Fiat 500e electric car (better known as the “cincoecento electrico”) Sergio went public and asked, “Please don’t buy our cincoecento!”.

A few months earlier the Fiat 500e had been launched with much pomp and circumstance, consuming many millions of Euros with the promise of being the great European competitor of Tesla and with the advantage of being extremely economical. The product launch experienced many delays, and when it was finally ready, only a few units were sold. Studies showed that the loss for each unit sold was 20,000 euros!

Undoubtedly, understanding costs and establishing strategies to control them are significant challenges in company management. And this cannot be overcome if we do not have a clear ability to make the best decisions, with well-defined methods, processes, and appropriate methodologies for the significant challenges that lie ahead.

Do you need help with cost reduction in your company? Fill out the form to talk to our experts!