Transparency vs. Complexity
Oct 16, 2014
This service company includes a group of highly paid professionals and a team of technicians that offer technical support for the services the company provides. These skill levels were generally grouped by department, but all were under the common control of the management team. Part of the CFO’s problem concerned determining the overall profitability of these individual departments.
Over the years, this company has tried many different methods of identifying costs by department and then allocating those costs among those departments in a fashion that resulted in a clear understanding by department managers. The goal was to determine which departments were the most profitable and to provide guidelines for each department manager. In theory, these guidelines would help managers control their department costs and achieve pre-determined goals related to firm-wide profitability and individual department profitability.
In the past, they have done a reasonable job of identifying the direct costs of each individual department such as wages and fringes, individual supplies and other direct costs of operating. The management team felt comfortable that these direct costs were properly accounted for by each department. The part of the allocation process that was causing the most difficulty was related to other overheads that were not specifically identifiable by department, but needed to be considered in the overall calculation of firm profitability. Many of these overheads were substantial in nature but did not offer an easily identifiable way of associating those cost to the various departments.
Some methods they have implemented previously involved allocating overhead on a labor hour basis. It was determined that by labor hour seemed to be the best option since the assignments mostly worked on a fixed price basis and they could readily identify labor. They also tried, with no success, a more specific identification of overheads by department. I suspect something similar through an ABC system. No matter what method they used, they were constantly being challenged by the problem that the departmental managers either didn’t understand or didn’t agree with the allocation methods. As a result, they were disinterested in management using that process and felt they were unfairly and disproportionately being assigned.
One of the most complicated systems they employed led to a problem in the engineering groups because they were constantly looking for precise calculations of what overheads should be assigned to their departments. In the end, they found it much more difficult to use a highly complex system that had numerous bases of allocation for apportioning cost that were based on arbitrary identifications of cost drivers. The conclusion was that the complexity necessary to support these specific types of allocations led to a lack of transparency for the department managers and therefore resulted in an ineffective system with which managers would not work.
After the current CFO reviewed all the past methods and the goals set forth by the management team, she decided that perhaps the best way to do this would be to allocate the costs that must be apportioned on the basis of the sales dollars.
Due to change orders and other adjustments in the development process which resulted in a varying sales prices from the original quote, it was difficult to identify by department the sales dollars at the end of the process. However, it was easy to identify sales associated with each department as part of the original quote. Meaning, department A could readily be identified as contributing 25% of the ultimate sales to customer XYZ as a part of this originally quoted project. Changes via change order as the project continued would result in varying sales prices. However, many of those changes only affected the amount of direct costs which could be readily identified to the project, and therefore, really had little to do with how the apportioned cost would be allocated at the end of the project.
The CFO then implemented an overhead apportionment process that included the development of an allocation at the start of the process based on the quoted profitability rates as part of the initial quote.
That accomplished two goals,
a. It made it very transparent for the department managers to understand with how much overhead they were being assigned.
b. It virtually eliminated the anomaly that had occurred in previous allocation methods where the firm lost money overall, but individual departments within the firm had made money.
This new process apportioned the overheads more evenly so there was far more consistency in the results of each of the departments related to the overall results of the firm.
Consequently, the management team was far more comfortable working with a system they understood and could anticipate how costs would be apportioned. This also drastically reduced the radical swings in the departmental profitability and the inconsistency with firm-wide profitability. These changes made the system far more efficient and it resulted in better use of the management’s time as far as managing to their individual department budgets.
This is one of the best examples I can think of where transparency was chosen over complexity with a significant benefit resulting from both cost control and firm-wide profitability.
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