All product related companies can pin-point exactly what revenues relate to which product. But to allocate cost and more specific indirect production cost is often a challenge. Allocating direct and indirect cost to the business gives companies more insight into the profitability and helps them to make better strategic decisions.
We often are asked to tackle this problem for clients. In this blog we will explain how we are able to help our clients to fully allocate their costs to any business area they prefer. To illustrate we will use the case of Carbery, a dairy production company based in Ireland.
What kinds of cost allocation exist?
The biggest variance of cost allocation is between indirect and direct costs. Direct costs are directly related to the service or product. Indirect costs are expenses that cannot be completely and clearly allocated to a single product, but they have a certain relationship and do affect the profit of your products. Examples of indirect costs are management salary costs, insurance costs and electricity costs.
Indirect and direct cost allocation can be done through a variety of ways, namely proportional, activity based or cost rate.
Proportional allocation
Proportional allocation assigns a percentage of the cost to a specific product/department. The percentage is based on one or multiple drivers of these costs and is often revised annually.
Activity Based allocation
The performance of a specific product is the basis for the allocation, for example the number of units produced with a production company. Activity based allocation is the most detailed and time-consuming way of allocating and could change on a more frequent basis because of its nature.
Cost Rate allocation
The cost is allocated with one cost rate from a cost pool to the products and/or services. The basis for cost rate allocations is based on numbers like revenues or direct costs for a specific product.
Business challenge at Carbery
At Carbery foods the P&L calculations and allocations were done based on multiple Excel models to prepare Management Accounts. The main pain points in the Excel model for Carbery were:
- Time consuming process to fully generate an allocated P&L
- The data was hard to track due to a spaghetti of formulas and different formulas used among different departments.
- Data was coming from multiple sources and could be adjusted on multiple places, which made it hard to track changes in the final report where the data was coming from.
In their Excel model there were concerns about data accuracy, completeness of information and the relevance and preparing the Management Accounts was time consuming. The model got too big and too complex to manage in Excel. Carbery decided to implement an allocation solution that automates as much as possible.
Indirect cost allocation at Carbery
Agium EPM built a cost allocation model in Carbery’s OneStream XF application. In the model different P&L lines are allocated based on product defined ratios, production ratios, sales ratios or as a combination of multiple ratios. The goal is to use the most accurate ratio which comes closest to the relationship with the underlying products.
Example: Cheese administration cost
At Carbery , administration costs related to the product are the basis for allocation only if the department is producing cheese. Therefore, these costs need to be allocated based on the cheese they use. The non-cheese departments are allocated based on a pre-fix ratio. A production ratio per cheese determines the allocation for the cheese departments.
The screenshot below shows where users can define an allocation method per department. The department in the example is called ‘Cheddar’ and its allocation methods are visible in the right column. In the first column the P&L line items are listed. In the second column specifications per line item. You can read that the allocation method for unspecified Other Admin. Costs are AT1 for the Cheddar department.
In the screenshot below you will find in the first column a P&L line account (‘Other Admin’) and in the second column a specification (‘Redundancy’) for that line item. For each of these P&L specifications an allocation method can be defined per department (Cheddar).
The allocation types in the screenshot are the following:
- allocation type 1 (AT1) = Proportional allocation (% of total costs)
- allocation type 4 (AT4) = Activity based allocation (units vs total units)
- allocation type 8 (AT8) = Combination of Activity based and Proportional allocation
At Carbery the cost rate allocation is not used but it can easily be implemented in the future. The activity-based allocation (Production and sales unit) ratios are calculated by the system, using specific performance drivers, like sales units, product stock and production volumes.
At Carbery we implemented 11 allocation types with different ways of input, from manual input or with automatic data imports. Direct input and import are specifically defined, because the allocation types are also used for data security. The allocation type defines where data can be manually input and where datacells are locked.
Multiple allocation types per cost line demands flexible allocation
Some cost lines apply different calculation per product due to the different nature of the products. So cost A could from be allocated on a production ratio and cost B could be allocated based on sales ratio. The need for various allocation methods asked for a flexible allocation solution. In the future other methods could be needed and implementing these other methods have to be easily done.
The allocation approach from Agium EPM for the Carbery case is making the allocation model as flexible as possible, making sure the risk of errors is limited. The allocation ratios and therefore the allocated amounts can easily be calculated differently if required. Per cost line, specification & department combination can be decided how the costs should be allocated out. The allocation is on a YTD, but each cost, specification or department combination can be set to a periodic based allocation as well. This makes it very flexible in the use of the envisioned model.
The key take-aways
The Carbery case is a great example of how you can prepare such Management Accounts with an allocation model in place. The following benefits are the main take-aways from this customer case:
- More insight into the cost and profitability of products and processes
- Speed up the allocation process
- Analyse the outcome in detail
- Improve data reliability with the right Workflow and locked data
Are you ready to talk about allocation for you management reporting?
