Almost 30 years ago, more precisely in February 1997, the front page of Forbes Magazine featured an article by Prof. Srikumar S. Rao of Columbia University that showed that the lack of control over rising overhead costs could literally kill organizations.

In the article, Prof. Srikumar cited the real-life example of a giant American company that found a growth opportunity with the bankruptcy of its main rival – but, contrary to what he imagined, it turned into a loss-maker, not a profit maker! Upon investigating a little further, this company incredibly discovered that its “flagship” was actually loss-making, and other products that it thought were loss-making were actually the most profitable products of the organization. And this was due to a misallocation of overhead costs.

Allocate overhead costs

How could such a large and intelligent company make such a basic mistake? It turned out that the organization was allocating depreciation and other overhead costs based on the cost of direct labor; a product that consumed 20% labor ended up taking 20% depreciation and overhead as well. But there is a big mistake here: labor does not depreciate, machines do; where there is a lot of labor consumption, generally less machinery is required. Moral of the story: labor-intensive products should have received less depreciation and overhead (and not the other way around!) – exactly the opposite of what was calculated.

The direct costs are easy to appropriate; it is very easy to know how much we have, for instance, of a raw material in a product or for example of a Bank Cashier. But what about the indirect costs? How to allocate them in a correct and coherent way, respecting a cause and effect relationship?

Great caution is required with any cost modeling that mechanically allocates overhead costs. And remember: depreciation is just one of many indirect items! Overhead 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 turnover.

To complicate matters, these indirect costs are becoming more and more representative and for several reasons: increased automation, with the clear “exchange of people for machines”, but also with the fact that the increased diversity of products, services, customers, channels, suppliers and machines (i.e. the increased complexity of the business) brings with it, embedded, an increase in indirect costs due to increased “administrative” effort or management of this complexity.

Historically these indirect costs only increase – and consequently raise the distortions caused by arbitrary allocations; it is very common to find in companies situations where a product that they imagine to be the “flagship” in reality are unprofitable; on the other hand products that they believe to be the “ugly duckling” are often the most profitable products of the company and those responsible for still being able to keep the company’s margins in the black.

How to solve the cost allocation problem?

Imagine that three friends decide to go out to dinner. The first one is on a diet and orders a salad with mineral water. The second friend orders a nice steak with wine and the third orders a lobster with sparkling wine and dessert. At the end of dinner, they ask for the bill, which is divided equally among the three friends. These distortions happen every day in many companies all over the world!

Now if you ask for a bill for each friend, where each of them will pay only for what they consumed, we are talking about ABC, the “activity-based costing” that potentially ends these distortions in organizations and gives a proper treatment to these indirect costs as well.

But how to apply ABC in practice? 

Take a simple Billing activity: its total cost is the combination of salaries and benefits of the people involved with this activity. This total would traditionally have gone into an “overhead” pool to be allocated arbitrarily. However, with ABC you divide this value by a non-financial measure such as the number of invoices generated. Now you have cost per invoice. Count the number of invoices generated per product, multiply by this value and allocate by product – this is the value of the Billing activity in each of your Products. Besides eliminating distortions, we get an important KPI or performance indicator here for business management that is the value of invoicing per invoice issued – with potential for cost reduction studies, outsourcing possibilities, and even monthly tracking – something that simply would not have been possible before ABC.

Another example: HR activity “Hire Employees”: the cost of this activity is related to the effort of the HR area specifically with the hiring of employees (among so many others like Payroll, Evaluate Employees, Train Employees, and so on). Suppose that in a certain period 5 people were hired for Production, 2 for Maintenance and 3 for Sales; therefore, the costs of this activity “Hire Employees” should be distributed 50% to Production (which will later be allocated to Products, also by activities), 20% to Maintenance and 30% to Sales. Besides being able to allocate the costs of this activity, we gain an extremely important KPI for decision making, which is the cost of hiring employees – this value can be compared with the monthly expenses of the last months, the company’s goal or even the cost of outsourcing this activity.

Now imagine all this potential with all the activities in your company. The possibilities are absolutely endless!

Also read: 5 steps for designing an effective cost management project.