Proper Allocation Brings Three to Five Percent More Profit

If you have ever been a roommate with a colleague as a student or later in life, how did you share the following expenses: rent, electricity, phone, internet, HRT fee…? Was the method you used to allocate the costs important to you? If you had enough money and depending on your mutual relationship and agreement, perhaps it wasn’t. However, in business, as you know, every kuna counts. Therefore, identifying the consumption generator and then transparently sorting the identified costs is a key tool for understanding the costs and profitability of products/services or business activities and managing them.
We can imagine a very simple example where an individual buys a commercial building and rents it out to tenants. The owner of the commercial building must pay common maintenance costs such as lighting, heating of common areas (lobbies, hallways…), roof repairs, pest control. Since everyone in the commercial building benefits from these expenses, the owner allocates the costs to all tenants according to a certain key – most often based on the square footage of the space rented by each tenant. Similarly, we can imagine a manufacturing company as the owner of a building where each tenant represents a product (or department) of that company. Common costs are operational costs (electricity, water), accounting, human resources/HR, maintenance, etc., and these costs must be allocated to the products.

Unique Concept Given that departments and products attach common costs to themselves at different rates or in different amounts, the way costs are allocated significantly affects the company’s profit and the behavior of (production/organizational) managers. Therefore, the task of cost allocation is to ensure a fair and transparent distribution of all (direct and indirect) costs to the final products, clients, and/or departments based on causality and a unique concept.
This creates an effective cost allocation system that accurately tracks common production costs by products (or customers or departments) as the final cost objects that consume those costs, and it also enables management to make quality business decisions and greater profitability for the company. How much greater, entrepreneurs rightfully ask. According to projects conducted by Deloitte in our region, we can talk about an additional three to five percent impact on profit; working for global leaders, due to their complexity, we can say that this impact is slightly lower, two to three percent.
Total costs associated with the production of goods or the provision of services are not only direct costs, such as materials and labor, but also include indirect costs.

What is the Cost Allocation Model It is clear that support departments also contribute to the creation of products or services. Therefore, only when all the mentioned general, indirect costs are taken into account, and appropriately allocated to the final cost objects, can a true picture of the cost of products or services be created. Without access to accurate and up-to-date cost data, company management cannot make quality strategic decisions.
Throughout history, company operations have focused on monitoring direct labor and material costs as they were the largest part of the cost base. However, today, due to the increase in the share of various services in the total value of products, the scope and size of overhead/general costs (which can include marketing, research and development, procurement, depreciation, etc.) have significantly increased, leading to inaccurate allocation of general costs.

True Cost of Service In the traditional approach, general costs were allocated to employee costs. However, as general costs are increasingly less a result of direct labor, the allocation is inaccurate, which leads to incorrect perceptions of costs, i.e., pricing calculations for products/services. Therefore, many organizations today further focus on their shared support services to assess the level of services they provide, as well as the costs incurred in providing those services. In working with clients, we have found that companies often recognize the complexity arising from quantifying their operations when analyzing shared support services. These problems are particularly evident in the number of services provided by support services, activities conducted within those services, and the quantity of all categories of resources (costs) utilized in providing their service. Company management often believes that business units using these shared services do not have a perception (awareness) of the costs incurred by those services, but at the same time have a problem valuing the delivered value in relation to the costs allocated to those services.
The real challenge in solving this problem is enabling transparency in the allocation of costs across the entire business so that a clear link is created between the services provided and the resources consumed. Creating awareness of this key link allows organizations to calculate the true price of the service, thereby ensuring key information needed for decision-making in determining the best level of shared services in the organization.

ABC Approach There are many methods of cost allocation, one of which is ABC (Activity-Based Costing), which is a multi-layered allocation of costs based on activities performed in creating a product or service. Generally, the ABC approach categorizes costs as resources and allocates them to final cost objects based on the activities performed. Resources describe the types of costs incurred by the organization and where they were incurred (organizational unit). Activities describe how the organization used those resources during the creation/delivery of products and services, and cost objects mean products, services, customers, or channels that the organization produces or serves (as the final cost destinations). These three modules are connected through the use of resource and activity drivers that show the relationship between cost sources and the final cost object (according to the principle of causality), which are also allocation keys.
When it comes to cost transparency and regulatory compliance for companies that must have it, the principles of allocation apply equally to manufacturing and service companies. It is only necessary to clearly identify the cost base (direct and indirect, fixed and variable, FTE and non-FTE costs) and the principles according to which costs are allocated based on their causality and in proportion to it. A typical design of the ABC model consists of the following activities:
• analysis of the cost base and determination of cost groups
• identification of cost drivers
• analysis of activities
• determination of the cost allocation key (direct, indirect, additional).
In addition to linking the company’s costs with products and services through activities and processes, and doing so to create a profit and loss account by product or service, the ABC model allows for understanding the costs of individual processes (e.g., costs of processing a new contract) which can then be benchmarked against the same or similar processes in other companies. Therefore, such a method of allocation increasingly encourages organizations to manage activities rather than costs, i.e., to recognize costs simply as an outcome of undertaken activities (so-called Activity-Based Management).

Better Profitability Management In addition to insights into the exact amount of costs per final object, thoughtful allocation also enables the identification of the profitability of products and/or customers. Namely, profitability modeling combines sources of costs and revenues to gain a real insight into the profitability of targeted final categories. This is achieved by creating a profit and loss account, which would be an alternative to the classic, aggregated profit and loss account used for standard financial reporting purposes.
The resulting profit and loss account is structured to show revenues, costs, and resulting profit by individual products or customers. In this sense, profitability modeling firmly relies on cost (and revenue) allocation. The positive effects of managing product profitability based on this method can increase the profit margin by more than three percent.
It is important to emphasize that establishing a framework for managing costs and profitability requires alignment of corporate procedures and processes, organizational structure, and information technology.

Author: Gordan Kožulj