Big Picture

Indirect Costs: Ex Ante Commitment Rather Than Allocating and Apportioning Ex Post

If ex-post allocating and apportioning of indirect costs can be done in a particular way, but just as well in another arbitrarily chosen way (see the various methods; splitting or sharing common costs ultimately into the unit-costs of individual products), then proven outcomes i.e. true integral unit-costs and consequently reliable profit margins simply do not exist. In other words, business economics and especially Management Accounting so far, does not offer any solution.

All sorts of calculations, step-down, reciprocal, whatever, yes indeed even the most extensive Activity-Based Costing-system, do not end up in satisfying results. Regardless of how many cost drivers are used within the best ABC-systems, ex post calculation stands or falls with the precision of the used ratios (these are set in one way or another), which are the very heart of the apportioning scheme. Even the best ones of those ratios (being really true at the time they were set) is like fresh fish; they will keep their qualities for just a short time.

However, organizations are living organisms. Life is change. It’s an ongoing process of allocating sub-tasks to the changing units that altogether form an organization that is very much alive. Managing is like flying a plane. Without real time data that is essential to give guidance and to be able to adjust (to be read off from at least some basic meters and for sure ‘costs’ is one of them) one would be flying blindfolded.

Cost Control

Knowledge of costs is essential to give guidance and to be able to adjust. The total cost for a period is the sum of its parts. Regarding the total cost in addition to its composition – the cost contribution for each company unit, for each product (or group of products) and for each customer (or group of customers) – who would not want to be well informed on these matters? An enterprise is the addition sum of a series of businesses. Get a start with cost control in just one business or a small part of a business, a single department. Discuss the matter with your employees and refuse either to confirm or deny any allowed standard cost unless you know and understand it fully as part of the whole. Imagine, for the time being, the rest is ‘terra incognita’.

Direct Costs versus Indirect Costs

Direct costs go straight to the product and indirect costs are all expenditures that cannot be identified with particular products. The latter costs are known as overheads. Cost apportionment is a process that is walking behind the facts. This process involves the splitting or sharing of a common cost (i.e. an ex post fact) over the receiving cost centers (ultimately individual products) on a basis that reflects the benefits received. The purpose of all allocation processes is a good one; they cannot be blamed upon their intentions. However, the job is too hard to be done. It cannot be done in a reasonable way. No method, not even the most extensive ABC-system, is able to cut and simultaneously to transform the whole (indirect costs) into acceptable pieces (supposed to be transformed direct costs).

The basic idea behind indirect costs (the idea that indirect costs can be converted into direct costs) is not a good one. Consequently it causes massive trouble everywhere signalling false unit-costs and ditto profit margins. Only small amounts of so-called ‘general costs’ are to be allowed for in order to run a business. All other costs have to be direct costs from the very beginning, otherwise they cannot come into being.

This is nothing new, it’s the well-known idea of ‘zero base budgeting’ all along the line. In addition general costs have to be accepted beforehand. Allowed standard general costs are part of the standard budget and the rest is a matter of budgetary control. A properly developed standard costing system is a tool of management. The base is Standard Costing culminating into the Standard Budget (containing all standard integral unit-costs).

Cost Allocation and Apportionment

Business economics offers no real solution to the problem of indirect cost allocation and also Activity Based Costing, nothing does operate really well in practice. On the contrary, people get confused or worse confounded by these methods. Also a fine tuned charging via so-called ‘cost drivers’ is no proof in itself. Proven causal relations only have felicity of expression. Traditional costing was previously criticized by Kaplan, Johnson and Cooper who published the concept of ABC (Activity Based Costing).

Most of the cost of a product is already captured at the time the product is designed. This vision is reflected in the Target Costing technique. Even then the problem is still what the cost price (target) is, can or should be. “Costs tariffs are implemented into the computation schemes and/or used formulae on a regular basis (Scheer, Hirschmann, Berkau).”

How to arrive at these costs tariffs? That’s the question. Scheer, Hirschmann and Berkau suggest, that one and the other can be substituted very precisely. “Data concerning the amounts of the various activities and the calculated costs belonging to the different parts of a process, are resulting into the mentioned costs tariffs (Scheer, Hirschmann, Berkau).” Well, this always was, and still is the main problem: exactly WHAT and HOW? Also Scheer, Hirschmann and Berkau do not give a clear answer to this vexed question, how to measure precisely? ABC is old wine in new bags.

Measuring Is Knowing, Guessing Is Missing and Gambling Is Paying

A bit of inefficiency is not a disaster. On the contrary. A little space is needed. Also to make mistakes. To learn from ones own mistakes. Especially manoeuvring space is needed. To be able to adapt the organization (a learning being) smoothly to changing circumstances by trial and error. For the record, this is not a plea to throw money over the bar. With regard to cost prices, it is about correctly allocating unavoidable indirect costs. Cutting into it does not make any sense.

Then less is immediately produced. Without making (unavoidable) costs, it does not happen. We give out, imagine $ 10, necessary indirect costs, for the production / sale of each unit of product A. Incidentally, of course, without knowing, because that amount of money is hidden in some sum of indirect costs, for product A and also other products. If that $ 10 per unit of product A is not spent, if it is cut, less of product A and/or other products will be made. As a result of a (no longer) good working allocation key (an invisible error in the system of attribution, somewhere in a formula), that $ 10 ends up in the cost price of product B.

Wrongly (but nobody knows that) it is a fact that product A is $ 10 too LOW priced and the price of product B is the same $ 10 too HIGH. That can remain without consequences for years. As long as, here at product A, we spend ten money units, while there at product B, the same ten money units, we get them extra through the sale of products B, at a selling price normally rising above the (admittedly ten money units too high priced) cost price. The jug returns to the well until it breaks. Figuratively: doing something dangerous or wrong for a long time, until it finally goes wrong. Until the numbers of products A and B start diverging.

Shifts in the range. Noted down, July 28, 1988 when the transnational company Philips was still called Philips’ Gloeilampenfabrieken: “First half-year, turnover 25.5 billion guilders, profit 338 million guilders. A turnover that is 9 % higher in volume, including a money turnover increase of more than 5 %. Selling more and more, but it is becoming less and less profitable. What is not true here? The production prices may be incorrect. Some too high, others too low. Of the latter a lot will be sold, ergo, a high turnover. And the higher the turnover, the lower the profit. With which the riddle is solved.”

Indirect costs of which by definition it is not known in advance on which products they will be spent. It is about correctly allocating unavoidable indirect costs to the right products. By necessity always more or less arbitrary allocation keys. Finally, it should never be forgotten that the cost prices thus determined are subject to a certain degree of inaccuracy and, above all, unreliability.

The reverse can of course also happen. That here (with product A) we have to spend fewer and fewer 10 money units and (with product B) we get more and more 10 money units extra. Sometimes companies suddenly make profits, never seen before, while not understanding where it comes from. Perhaps the cause lies in shifts in the range; in addition to the visible profit margins (add a big question mark to them), there are also invisible margins, inherent in the above mentioned inaccuracy and unreliability of the cost prices.

The Solution: Measure, At The Source

The best solution to problems in general is to remove those problems. Eradicate them in root and branch. Or even better: do not let problems arise. If indirect costs are high (see the beginning of this article, indirect costs are costs not associated with a particular product) then a problem has arisen and as soon as it is manifest, it is henceforth actually no longer easy to solve. Beforehand, cost meters must be built in when allocating the tasks and establishing the mutual relationships (organizing, the formation of the organization).

An organization can be compared with a train. A train is also full of meters; without measuring instruments it is irresponsible to drive it. Admittedly, in the past it was quite a hassle to measure and especially to record the measurement data. It meant high additional indirect costs. The medicine being worse than the disease. But nowadays? Once money is spent somewhere, it can be measured and recorded quickly and easily for on what and exactly how much money is spent. Piece of cake. Only a little computer power is needed, some data collection system. What you need to know, ….  measure. It is already an old adage: MEASURING Is KNOWING, GUESSING Is MISSING and GAMBLING Is PAYING.

Conclusion

The allocation/distribution of costs is surrounded by major dangers that directly threaten the survival of organizations. A wrong allocation can remain without consequences for years but suddenly bring disaster.

In business economics, there is nothing that can be done about it. Partial Calculation, Equivalence Number Method, Addition Methods, Production Center Method, and also Activity Based Costing, nothing works really well in practice. On the contrary, people have turned away from it. Worse than not knowing is wrongly being informed about the profit margins of the various products.

How profitable is every product? Within an airline company, each route? The profit as well as its composition, the profit contribution of each department or division, of each product or part of the assortment, of each customer or district or market segment, who does not want to know that well? It is only by measuring that it can be known. Use The Profit Formula® to measure period profit Exactly, Quickly and Easily.


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Jan Jacobs

Jan Jacobs

Independent Researcher Business Economics
Jan Jacobs, an independent researcher in the field of business economics and author of The Profit Formula®: The Way to Easy Profit Measurement. I have more than 20 years of experience as a lecturer in business economics in higher day education and also in evening education for adults at SWOT (Stichting Wetenschappelijke Opleidingen Twente).

As a subject teacher, I have always been critical of what was in many Business Economics textbooks. I am the author of The Profit Formula®: The Way to Easy Profit Measurement, Budgetary Control: Scientific Perfection Business Economics, and Banking World Finance Credit Crises: Tips, Facts and Editorials about what happened and what needs to be done.


Jan Jacobs is an opinion columnist for the CEOWORLD magazine. You can follow him on LinkedIn, Amazon, and JBAdatabank.