Every business leader should possess a fundamental grasp of accounting. It’s not about becoming an accountant; rather, it’s about acquiring enough knowledge to avoid being deceived or deceiving oneself.
There is one specific area where accounting decisions can lead you to make poor judgments and decisions if you don’t know better.
I’m talking about the allocation of overhead. While it might sound esoteric, this is one of those areas that can cloud your understanding of whether your business is making money or not and cause you to make some bad decisions.
What Is Overhead?
There are two elements when it comes to the overhead costs in your business.
The first are those costs related to making your offering, whether a product or a service. In manufacturing, for instance, your overhead costs might include the cost of the plant, maintenance costs, and insurance.
Most business leaders understand what overhead costs are. But where things get sticky is how the accounting department allocates those costs inside the business.
Allocating Overhead
Where overhead gets confusing is when it gets allocated to specific products or services. For example, if my business has $100,000 in overhead and I make 1,000 products, accounting might allocate $100 to each product.
Accountants traditionally do this, especially in manufacturing, by allocating a certain percentage of overhead per labor hour. This is just the way they are taught. That means if the business works the estimated number of hours, it will have covered its overhead by the end of the year.
This is a simple way to deal with overhead costs, but it doesn’t always work.
Going back to a manufacturing example. Let’s say we make two products: One is made mostly by machines and robots, using very little labor, while the other is very labor intensive. If your standard is to allocate overhead costs based on labor hours, then the product made by the machine will look like it has very little overhead allocated to it, which makes it seem very profitable compared to the labor-intensive product.
When I worked for a manufacturing company that allocated overhead on labor hours, I used to joke that I would buy a billion-dollar machine requiring no labor hours. That meant I would have no overhead allocated to it–making my product incredibly profitable. But I joked about this to show how absurd these allocations are. Ultimately, it drove incorrect capital allocation across the business.
While some organizations try to resolve this issue by allocating overhead based on machine hours rather than labor, it’s still an accounting mirage. It’s an arbitrary decision that could lead you to disastrous business decisions.
Looking At the Total Overhead
Your goal as a business leader is to avoid this accounting magic of overhead allocation by looking at the total overhead inside the business rather than by product or service.
Even in a service business like software, it can look like you are making giant margins if you allocate overhead based on hours worked. It just gives you a skewed view of the business.
Another example of why this doesn’t work is what happens when dealing with a difficult customer. If you spend many hours answering their questions and dealing with their concerns, you might have difficulty understanding if that customer is profitable to the business.
Ultimately, it is worth estimating the overhead absorbed by a product or customer, but this should be guidance for good business decisions and should not be the only factor.