Problems That Arise from Allocation Process

The process of allocating overhead charges toindividual businesses can lead to several problems within a company.

It Fosters Politics

The process of allocating overhead charges toindividual businesses fosters political infighting. When an executive shinesas a result of her contribution to the profitability of thebusiness, this is a positive result. However, when costs areallocated, a manager who knows how to manipulate the allocation methodologycan make his department’s performance look better bygetting charges assigned to other operating units. When oneprofit center looks good at the expense of another, without thecompany benefiting at all, that’s politics.

It Inhibits NewProduct Introductions

Accounting methodology assigns a portion of theexisting overhead to each new product when analyzing its profitability.This inflates the cost of the new product and causes theestimate of its contribution to profit to be severely understated.The analysis of a new product should include only costs that areincremental for that new product. Existing overhead that is notaffected should not be included.

It Understates theProfitability of Business Beyond Budgeted Volume

Overhead allocations are assigned to all products,regardless of volume. When sales surpass budgeted expectations, theaccounting department will continue to charge these allocationsto the individual products even though the company hasalready generated enough business to cover the actual corporateoverhead. These fictitious charges will continue to be addeduntil the end of the year. This leads to a significant understatementof the actual profits of each business that has had sales above thebudgeted number and may cause the company to underreward unitmanagers who surpass their sales budgets.

It InhibitsMarketplace Aggressiveness

Incremental business is really more profitable thanthe accounting information reveals. Larger customer orders permitlonger production runs and more efficient raw materialpurchasing. Traditional accounting information does not recognize this. The ability to give price breaks on larger orders(volume dis118 counting) because of these advantages cannot berecognized because overhead charges are assigned to all products.

It OverstatesSavings from Eliminating ‘‘Marginal’’ Products

A company should never eliminate products from its mixexcept under the following circumstances:

1. The product achieves a negative contributionmargin, and there is no opportunity to correct this situation.

2. The product is a quality disaster that will impairmarketplace perceptions of the entire business.

3. The company is near capacity and needs the spaceand machine time for more profitable offerings.

Eliminating a product with a positive cash flowresults in the loss of that cash flow. Why is there confusion aboutthis? Because our accounting systems tell us that eliminating aproduct will save the variable labor costs and the correspondingoverhead assigned to the product. Labor costs, as anyone who has evermanaged a factory will tell you, are more fixed than variable.They will not be reduced appreciably, if at all, whenvolume declines. And overhead will not be reduced because the buildingdoes not get smaller, nor do the staff departments (includingaccounting).