Does allocating overheads add value to my business? 

The answer of course is, "It depends."  The classic industrial engineering definition of Value Added is, "actions or activities that change the form, the fit, the function of the product being manufactured and, this is important, the changes are something the customer is willing to pay to have happen."  These same criteria can apply to services.

Classic Industrial Engineering View of Value Added

Form:  Changing the nature of the material.  For example, turning plastic resin into plastic bags, cleaning clothes, , electronic deposits, etc.

Fit: Making something a different size or matching different things together.  For example: Cutting steel bars into rods used for construction supports in concrete, helping someone decide which wine is appropriate to drink with a meal, or designing a new computer program to calculate more accurate tolerances rather than doing it manually, etc.

Function:  Making something that operates in new ways.  For example: A die press, a cutting tool, a new type of door lock, an ATM machine, etc.

We have added a fourth element to the value added definition above.  Does an activity or service change the "information content" in such a way that customers would be willing to pay for it to happen?  For example: providing more readable and meaningful monthly account statements by a mutual fund company.

Cost accountants like to believe that overhead allocation does add value.  But does it?

Let's look for a moment at product costing and the allocated overhead.  Traditionally, a product's cost to manufacture equals direct labor hours at standard plus the material cost (also at standard) plus an overhead allocation. The allocated overhead is assumed to relate to all products equally.  It's an average cost!  Companies take all of their factory costs other than materials and labor (i.e., indirect labor, energy, space, material yields, equipment, etc.) and add them together in a big bucket called overhead.  Selling and Administrative cost are typically not included in overhead. Overheads are then typically allocated based on direct labor hours. Some companies use material dollars as the allocation base.

When this scheme was originally created it probably worked. Importantly, product lines within companies were fairly homogenous. Companies might have a high-end and a low end product, but in the good old days, high quality meant it took more time to make it and used more expensive materials.  That is not today's world!

Today, companies are making very different types of products in the same facility.  Higher quality does not directly translate to higher manufacturing costs.  Many customers ask for special services, some products by their nature incur more cost than others.  When a company claims, "That is my product's cost." they risk looking at a number that has nothing to do with reality if the overhead was allocated on an average basis.  Let's consider this new reality.

What is Product or Customer Profitability? 

Let's start with a product's normal selling price. 

For customer profitability ­– you need to deduct special promotions or discounts from this price.  You may also have unique selling costs to certain customers (e.g., dedicated sales staff, on-site personnel, product return rates often differ by customer group, etc.).  Selling costs that are unique to certain customers are not included in traditional cost accounting records.

For product profitability – companies may incur special engineering costs for some products, some lines have higher scrap factors or energy usage, dedicated equipment, facilities or technology all might belong to specific products.

If these costs are included in overall overhead and simply allocated to all products a company gets a misleading picture of profitability.

So what do you do? 

Don't implement an expensive Activity Based Costing system that duplicates the normal accounting systems.  Instead, periodically sit down and analyze your costs.  Once a year may be sufficient.  These costs do not change that rapidly. 

Simplify your accounting to Sales less Direct Labor and Materials at Standard for a Contribution Margin.  That is really what Goldratt suggests in his book, The Goal. Then, rather than the traditional Income Statement look at profitability by customer and product (for some companies one of these views may be sufficient).  Include the specific overhead costs that relate to individual products.  The net remaining number (call it contribution margin) is what is left over to cover the remaining unallocated overhead cost, as well as Selling and General and Administrative Costs.  A fairly simple calculation can be made monthly to restore overall numbers to Generally Accepted Accounting Principles (GAAP) for external reporting purposes.  For internal management reporting, GAAP principles do not apply.

Cost accounting for the most part falls into non-value adding but necessary to do category.  Companies should seek to do an accurate meaningful job here for the minimum costs. Please feel free to call us if you have a question on these concepts.  Rainmakers@ (847)251-3327