Fake Cost Drivers for Administrative Overhead

A recent discussion in an online cost modeling forum related to “Which cost drivers can you use to assign administration overheads to a wide product range in a manufacturing concern.” As the discussion evolved, one response said “it is best done through the driver of turnover of the product produced. … because the efforts of administrative departments are in proportion to the production / sale achieved.”

Several problems scream out from this discussion.

First, the cause and effect principle has been reversed. In this person’s company it appears that administrative cost is proportional to turnover. Why? Because turnover is how they have been allocating this cost! Of course, it’s proportional if that’s how they’ve been allocating it. But they have confused themselves by looking at cost first instead of taking a good look at operating reality.

Second, whenever a question is posed based on a department or departments, it’s obvious they have not identified the activities performed by people in these departments. In each department, people are actually doing a number of different activities. This discussion needs to center on cause and effect relationships in each activity.

Third, how is turnover measured? According to the Merriam-Webster dictionary turnover is “the amount of business done.” But, what is the appropriate measure of the amount of business done? Is turnover measured in units produced, direct cost, material cost, material weight, labor hours, labor cost, or the classic – revenue? Does selling price influence the amount of administrative overhead? Each of these measures will produce a very different cost picture. Unfortunately, without understanding the real work and real causes, the “effect” is fake and potentially misleading.

Cost allocation can give us a false sense of accuracy. Even repeatedly asserting that effort is proportional does not make it so.

How should this question be resolved?

First, identify the actual activities in these departments. Take them seriously. Understand the real work performed.

Second, identify cost drivers at the activity level. Ask a lot of questions to real employees about why they do the work and what causes them to do more or less of the activity. To get them thinking out of the box, pose extreme what-if questions such as “What would happen if you had ten times the number of products but the same unit volume?” “Why?” “How would your activity be impacted if unit volume dropped to one-half but with the same product mix?” Why? And so on.

Third, use this information to select real cost drivers and create your cost model. After you understand the real activities and their drivers, you may decide that collecting data for these activities would cost more than the additional insight to product cost.  You now have a choice and a modeling decision to make. But it is a decision that will be based on fact — not assertion. Your alternatives now deserve their own article.

Watch out for broad questions like this one. Dive down and look at the real work before making broad assertions and choices that will adversely affect decisions management must make. The purpose of costing is to help management make informed decisions. It is not just to distribute cost somewhere. Let’s do the job right because cost matters.

2 Responses to “Fake Cost Drivers for Administrative Overhead”

  1. yogesh says:

    Hello sir,
    Suppose there are different department , one is PPC , othet one is Purchase , & Last one is accounts, now i just want to know that first i have to Calculate the Cost incurred in each of the department and then i have to distribute them on Production Cost centre , please help me in this matter?

    • The first task in each case is to identify and understand the activities in each department, their cost drivers and their relationships to products and customers.
      I would also challenge one possible assumption in your statement, “distribute them on Production Cost centre”.
      Instead of allocating costs to other departments, see if the activities can be assigned directly to cost objects. Of course, you must follow the cause and effect principle.
      Check out some of my other posts on this topic also.