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Overhead Allocation

Have you ever noticed that the simple words “overhead allocation” can strike fear in the hearts of owners and financial managers?

Overhead allocation is often viewed as:

  • Terribly complex.
  • Time-consuming.
  • Never accurate.
    So… why bother!

Let’s start with the why bother part. Why bother is because you will never know if a profit center or division is making or losing money unless all overhead costs are allocated. This knowledge should be a large enough incentive to proceed with the process.

Next, let’s deal with the time-consuming objection. Overhead allocation is only time-consuming when the allocation system design is too detailed. As with all business procedures, overhead cost allocation should be pursued with a cost-benefit mentality.

It’s far too common for brilliant controllers to design a meticulous allocation process that eventually drives staff crazy with a net result that no one wants to spend the inordinate amount of time doing what it takes to get the costs allocated! A much better approach is to settle for a more broad-brushed system. You may be surprised at how little gets sacrificed in the way of accuracy, yet the method is far easier to administer and live with each month.

Use these steps for your allocation process:

1) Make sure all direct profit center expenses are going to the individual profit centers. For example, ask your liability insurance carrier to identify premiums by source. Your carrier can easily tell you how much of your premium is for trucks versus stores versus bulk plant, etc. By taking this direct approach to as many expenses as possible, you can often seriously trim the amount of true overhead that must be dealt with through allocation.

2) Settle on a formula basis. The common choices are:

  • Sales dollars.
  • Gross margin dollars.
  • Gallons/volume.
  • Employee count.
  • Personnel hours.

Your choice of basis will rest largely on the profile of your business. A retail-only company may find that personnel hours works extremely well, while a company that owns several cardlock sites would not find this method appropriate.

With the help of an excel spreadsheet, “test” these five basic allocation methods. Apply each method to all expenses, coming up with a total allocation number to be distributed to each profit center for each method.   For each method, see how the allocation distribution affects the bottom line of the various profit centers. Use the reasonableness test to determine which of the five methods best fits your organization.

Do not, repeat, do not be tempted to apply different allocation bases to different costs thinking a more complex method will produce better accuracy. If you fall into this trap, you will be creating a complex system that forces you to make an allocation basis decision every time a new expense is added.

The worst nightmare occurs when a company uses all five methods simultaneously on various costs. Over time, no one knows how or why the allocation was done. It is all too easy for the allocation to become arbitrary, or worse, simply discontinued when no one can figure out how the system works.

Instead, use the same method for all expenses, then see which method produces the most overall reasonable result to the profit centers.   Another way of looking at this is that you don’t care if one individual cost is a little overstated and another is a little understated as long as the bottom line for each division looks intuitively reasonable.

When running profit center reports, use one-line cost allocation, rather than expense by expense reporting. This will allow you to avoid ugly line-item nitpicking. The one-line approach prevents no-win arguments about individual costs between profit center managers and headquarters accounting staff.

In fact, to get total buy-in for any cost allocation system, it’s wise to involve profit center managers in the allocation method selection process. If each manager understands the allocation choices and the necessity for an efficient system, you will eliminate resistance, ignorance and the hard feelings that often appear when allocation is done autocratically.

Finally, if your company offers bonus compensation linked to profit center performance, it’s best in any allocation scenario to use pre-allocation profit as the bonus target.   In this way, employees’ bonuses are unaffected by changes in administrative costs that are usually out of their direct control. Caution must be used, however, to set targets high enough to insure profits for the company after administrative cost allocation.

In summary, most owners and managers are firmly convinced of the need for separate profit centers within their companies.    All of this effort is for naught, however, if headquarters overhead does not get allocated to those divisions so that owners and managers can see the true bottom-line of each profit center.

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