In traditional cost accounting, the term overhead refers to salaries and other expenses not associated directly with specific product units, service engagements, or sales. Overhead, therefore, refers to the cost of supporting manufacturing, service delivery, or selling.
In traditional cost accounting, the term overhead refers to expenses that are not associated readily with the production of particular product units, specific service engagements, or designated sales. "Overhead" means instead to the costs of supporting product production, service delivery, or sales activities.
Business firms plan, measure, and analyze overhead costs as transactions in specific expense-category accounts. As a result, overhead expenses ultimately impact Income statement profits. As "expenses" increase, "profits" decrease. Note that overhead can affect Gross, Operating Profit, and bottom line Net Profit.
Overhead Appears At All Levels of the Income Statement
Expenses that qualify as overhead can appear under all significant expense categories on the Income statement. And, not all overhead expenditures on the statement carry the name "Overhead." Some businesspeople, for instance, regard all entries under "Selling, General, and Administrative Expenses" as overhead, even though the statement does not label them as such.
The Overhead Role in Costing, Pricing, Budgeting, and Product Management
Companies that sell products or services must know their per-unit product costs. This cost information is essential when setting prices and it is crucial for managing the product portfolio effectively. The firm has a vital interest in knowing which products sell with acceptable Gross Margin and which sell at a loss. In product costing, however, overhead "muddies the waters" and makes it difficult to measure per-unit costs accurately.
In most cases, analysts estimate rather than measure per-unit overhead costs. Sections below show how cost accountants use cost allocation to assign per-unit overhead costs indirectly.
The discussion below also presents an alternative approach to overhead costing, Activity Based Costing (ABC). This approach, arguably, does measure per-unit overhead costs directly.
Overhead Plays an Important Role in Competitive Strategy
Business firms set "overhead" objectives when planning their cost structures. Overhead targets are in fact a vital component of the firm's high-level business strategy.
In competitive industries, business firms rightly call their highest-level business strategy a competitive strategy. Very briefly, this strategy explains how the firm differentiates itself from competitors and—through its business model—shows where and how the firm earns margins.
- Some companies plan to operate with very low overhead. These firms expect to earn higher margins than their competitors while charging the same prices as the competition.
- Low overhead strategies can, alternatively, enable the firm to differentiate itself in the market by charging lower prices. Low-price sellers can still earn the same margins as their high-price competitors if they operate with lower overhead.
Explaining Overhead in Context
Sections below further define and explains overhead in the context of three themes:
- First, overhead as an Income Statement item or items.
- Second, overhead as a costing conceptt.
- Third, overhead management and overhead targets as essential factors in competitive strategy,
- What is an overhead expense?
- Retail business overhead expense.
- Overhead in financial accounting and reporting
- What is the difference between fixed and variable overhead costs?
- The overhead challenge: Costing overhead.
- Overhead costing example: Traditional costing vs. activity-based costing.
- The business strategy sets overhead targets.
- Example Income statement with manufacturing, administrative, and selling overhead items
- Direct and Indirect Labor further explains the role of indirect costs in accounting.
- See Allocation and Apportionment for more on calculating overhead expenses in traditional cost accounting.
- See Activity Based Costing for more on calculating overhead under ABC.
- Business Strategy further explains the role overhead targets play in strategy.
In retail businesses, merchants usually distinguish between the costs of acquiring merchandise inventory from their suppliers, on the one hand, and their overhead expenses on the other.
Retail Business Cost Structure, Business Model, and Margins
Retail businesses use the term overheadwhen describing their cost structure and business model and margins.
When a retail business refers to its margin, it has in view the difference between what it pays to acquire goods for sale and the selling price of these goods to customers. Merchandise acquisition cost, however, is not overhead. Acquisition cost and selling price alone determine the firm's margin on sales. A retail merchant may, for instance, pay $6 per unit to acquire goods. The same items may sell to customers for $8 each. To the merchant, therefore, each sale earns a 25% marginon sales. The $2 earnings are 25% of the $8 selling price.
Out of the same margin, however, the merchant pays overhead expenses. Many business people, in fact, classify all merchant expenses, outside of product acquisition costs, as overhead, and these expenses do impact another margin, the firm's overall Net Profit margin.
In this context overhead can include the seller's payments for such things as:
Low Overhead! Low Overhead!
It is not unusual for a retail business to claim or advertise that it can offer lower prices than its competitors because it has lower "overhead" costs. Low overhead" in such cases can mean, for instance, that the firm pays less than its competitors for retail selling space, or it pays less for warehouse inventory storage. And, it could also mean the firm pays less to its salespeople.
In any case, such messages are meant to enhance the buyer's sense of value by explaining how the firm can offer lower prices without sacrificing product quality.
Business overhead is viewed primarily as a business support cost. Businesspeople often begin explaining the concept by stating what overhead expenses do and do not do:
- In manufacturing, overhead refers to expenses not readily associated with specific product units. On the automobile assembly line, the employee installing windshields is not overhead because the firm can measure the labor cost for each installation, directly. However, the mechanic repairing assembly line machinery is an overhead expense.
- For companies that sell services, overhead refers to expenses not explicitly tied to specific service delivery engagements. The costs of acquiring and maintaining call center phones for customer service calls, for example, are overhead.
In business generally, overhead refers to costs not readily associated with specific customer sales, product units, or service delivery engagements. As a result:
- Salaries for executives, managers, and administrative assistants are overhead.
- IT support costs usually qualify as overhead because firms charge them to internal organizations or groups—not to individuals and not for specific product units.
Overhead Impacts Profits
Overhead expense impacts the firm's reported profits each accounting period. When "expense" spending increase, "profits" decrease. The Income Statement for the period shows the magnitude of this impact, accurately. Note first that this statement is merely an elaboration of the Income Statement Equation:
Profit = Revenues – Expenses
In brief, "Profit" is what remains after subtracting the period's expenses from the period's incoming revenues. A complete Income Statement example appears below as Exhibit 11.
Where is Overhead on the Income Statement?
Note in Exhibit 11 and in sections below that overhead expenses can appear under any of the significant Income Statement headings. Moreover, some Income statement "overhead expense" categories carry a name that includes Overhead, such as "Manufacturing Overhead." At the same time, many other overhead items are not so-named.
One obvious conclusion from these practices is that the distinction between "Overhead" and "Non-Overhead" expenses plays a minor role, if any, in structuring the Income statement. Nevertheless, cost accountants, analysts, and strategists must know where to find overhead expenses on the Income statement. That is because Income statement overhead figures serve as input data for specific exercises in product costing and strategy building.
- Firstly, product production overhead expenses appear above the Gross Profit line, where they impact all profit measures below: Gross, Operating, and Net Profits.
- Secondly, all other overhead expenses from the firm's core business appear below the Gross profit line, under Operating Expenses. These expenses impact Operating Profit and Net Profit.
- Thirdly, it is possible, for activities outside the core line of business to incur overhead expenses. Companies report this kind of overhead under significant headings below the Operating Profit line. These could include, for instance, "Extraordinary Items," or "Financial Revenues and Expenses."
In cost accounting, budgetary planning, and variance analysis, it is useful to distinguish between fixed overhead costs and variable overhead costs.
- Fixed overhead costs do not change as the number of units produced or units sold changes. Manufacturing "floor space rental" costs, or retail "sales floor space leasing" costs for instance, usually qualify as fixed overhead costs.
- Variable overhead costs do increase or decrease with changes in the numbers of units sold or the number of units manufactured. Manufacturing machinery electricity costs, for instance, usually qualify as variable overhead cost.
Fixed and Variable Overhead in Break-Even Analysis
When launching a new product, management takes a keen interest in knowing exactly how many product units they must sell for the product to break even. For this, the analyst calculates a break-even point—the unit volume for which total production costs equal total incoming sales revenues.
In a simple break-even analysis, the break-even point calculates from just three input variables: Selling price, total fixed cost, and variable cost per unit. Fixed overhead costs and variable overhead costs are of course part of these costs.
See Break-Even Analysis for example for more explanation and example calculations.
Some expenses from the firm's core line of business appear on the Income statement above the Gross Profit line. These are expenses specifically for producing (manufacturing) products the firm will sell. Or, they may represent expenditures specifically for preparing and delivering services. As a result, the expense total above Gross Profit may appear under several different names:
Cost of Goods Sold(CGSor COGS)
CGS covers the costs of producing goods for sale.
Cost of Services
Firms that sell services sometimes summarize service delivery costs under the heading "Cost of Services." These costs may include, for instance, labor, delivery vehicles, other service delivery equipment such as phones. Cost of Service may also cover the costs of floor space used exclusively for service delivery activities.
Cost of Sales
Companies that sell both goods and services sometimes identify all expenses above the Gross Profit line as "Cost of Sales."
Note that "Cost of Sales" expenses, when they above Gross Profit, are the costs these expenses are costs for producing goods or delivering services--not the cost of selling. (Selling expenses appear below Gross Profit as Operating Expenses).
Example Overhead Above Gross Profit
Exhibit 1, below, is an extract from the Exhibit 11 Income Statement. This Exhibit shows just the statement lines above Gross Profit:
Note in Exhibit 1 that Income statements for manufacturing firms usually include a Cost of Goods Sold category called Manufacturing Overhead. This overhead may consist of such expenses as floor space rent, insurance, as well as indirect materials costs and certain indirect labor costs.
For more on reporting manufacturing labor expenses, see Direct and Indirect Labor.
On the Income Statement, expenses from the firm's core line of business appearing below Gross Profit carry the name Operating Expenses. These expenses may, in fact, report as items in a single section with that name, "Operating Expenses." Note that this section sometimes has a more descriptive name, such as Selling, General, and Administrative Expenses (SG&A).
Also note that some firms report core business operating expenses under two sub-headings, in this manner:
General and Administrative Expenses
Exhibit 2 below is an extract from the Exhibit 11 statement, showing how Operating Expenses might appear on the Income Statement for a manufacturing company:
Where is the Overhead in Operating Expenses?
The term Overhead does not appear in the Exhibit 2 Income statement extract. Some business people nevertheless describe all such Operating Expenses (all SG&A Expenses) as "Overhead." That position is arguably defensible—at least for manufacturing firms and service providers. Not all businesspeople share that opinion, however.
The position that all operating expenses are "overhead" is less appropriate in retail business. Retail firms—retail merchants—do not manufacture goods for sale. Instead, they purchase merchandise inventory ready for sale. For this reason, retail business inventory purchase is an operating expense.
In any case, accountants generally prefer not to debate over which operating expenses are and which are not "overhead." For financial reporting, the classification of expenses as either "Overhead" or "Non-Overhead" is a non-issue. Financial accountants prefer instead merely to describe expense items under SG&A more precisely with designations such as the following:
The category "Administrative Expenses" covers office rental, secretarial salaries, utilities, and office supplies, for example. Income statement Administrative expenses also include the salaries of senior executives and managers.
Operating expenses that appear as "Retail Expenses" may include such things as store space rental, and the costs of store managers, accountants, secretaries, and other administrative employees who do not have a direct role in selling.
For companies that employ salespeople for direct selling. "Selling expense" refers to the costs of supporting salespeople and selling, which they cannot assign to specific customer sales. These can include expenses such as the costs of providing office space and mobile phones, or sales training.
Research and Development (R&D) Expenses
"Research and Development Expenses" do not support or cover the current product or service delivery sales. R&D instead refers to the development of new products and services.
Firms that produce products for sale must understand their per-unit product costs accurately. However, production costs typically include substantial overhead. To find the full per-unit product cost, therefore, they must discover per-unit overhead costs.
Why Try to Measure Per-Unit Overhead Costs?
On first hearing, the statement above may seem to be an oxymoron—a contradiction in terms and an impossible task for the analyst. Overhead, after all, is defined here and elsewhere as follows:
An expense that cannot be assigned directly or easily to individual product units.
The key words in this statement are "directly" and "easily." Cost accountants and business analysts do in fact try to estimate per-unit overhead costs for products and service delivery engagements—routinely. They may have to use indirect measures and seldom do they find the task "easy." Nevertheless, they must produce per unit product costs—including overhead—because the following activities require them.
Sellers have available quite a few different pricing models to guide them in setting prices. However, several popular pricing models require that sellers know their per-unit costs for producing goods or for delivering services. ImplementingCost-plus pricing, for instance, obviously requires full per-unit cost knowledge.
Sellers also need to know their per-unit costs accurately even when using other pricing models, such as Market-based pricing. In that case, the market—not the seller—determines prices. The seller still must decide whether or not even to bring a proposed product to market when it has to sell at market prices. That decision turns on the gross margin the seller projects for the product. And, gross margins are known only when full per-unit production costs are known.
Product Portfolio Management
Companies that sell from an extensive product portfolio must know, for themselves, which products earn healthy margins and which sell at a loss. It is difficult or impossible to manage a product portfolio effectively without this knowledge. As a result, product managers and marketing analysts take a keen interest in knowing the full per-unit margins for individual products. This information is crucial for deciding which products to withdraw and which to update and re-launch.
Cost Control, Budgeting, and Planning
Every fiscal year, firms that manufacture products for sale and those that sell services develop an Operating Budget for the forthcoming year. For this, they must project incoming revenues as well as production costs. Production costs include the so-called direct costs to cover as well as quite a few indirect costs (production overhead costs), which they will eventually report under Cost of Goods Sold. These forecasts, in turn, depend mainly on expected production needs and projected sales volume.
From this, it follows that forecasting product production costs accurately requires precise knowledge of per-unit overhead costs.
Keep it Private! Per-Unit Overhead as Proprietary Information
For public companies, overall gross profits and gross margins are general knowledge. These are readily apparent on the firm's published Income statement. What the public does not see, however, are the firm's gross margins for individual product or service offerings.
Companies in competitive industries usually treat their gross product margins as sensitive proprietary information, which they hide from the public.
- Outside consultants find they must sign a non-disclosure agreement covering this information before they can work with the firm.
- New employees find, upon hiring, they must sign a similar agreement promising not to disclose this information should they leave the firm.
Product-specific gross margins and per-unit overhead costs are especially sensitive issues when an employee with this knowledge leaves the firm to work for a competitor.
Without a doubt, cost accountants can measure some of the costs that go into product production or service delivery easily and directly on a per-unit basis. These are called—not surprisingly—direct costs when they appear under Cost of Goods Sold. On an automobile assembly line, for instance, the firm knows precisely the employee labor time required to install the windshield each car. To find the per-unit cost per unit, the analyst multiplies labor cost per minute by the number of minutes in each installation.
Regarding the so-called indirect costs (production overhead costs), however, producing a cost figure is not so straightforward. To provide a per-unit overhead cost total, the analyst has available two different approaches:
- Estimating and assigning per-unit overhead costs with allocation.
- Measuring per-unit overhead costs directly with activity-based costing.
The costing example in this section and following sections shows first that each approach has a rationale, and second, those different costing methods can reach different conclusions about per-unit overhead costs and product gross margins.
Two Products With Different Production Needs
For this example, consider a costing challenge facing Autofirma Company. This firm manufactures and sells two product models, Model A and Model B. Exhibit 3 below shows how the two product models compare concerning certain sales and production factors:
|Comparing Products||Model A||Model B|
|1. Selling Price||Higher price||Lower price|
| 2. Materials |
|More materials purchase orders, smaller orders||Fewer materials purchase orders, larger orders|
| 3. Production |
|More production runs, smaller runs||Fewer production runs, larger runs|
| 4. Machine |
|More machine setups||Fewer machine setups|
|5. Packaging||1 Unit per package||4 Units per package|
|6. Direct Labor||More direct labor required||Less direct labor required|
| 7. Direct |
|Higher direct materials cost||Lower direct materials cost|
|Exhibit 3. Comparing product Models A and B production. The comparison suggests that the two models have different production processes.|
Two Products With Different Product Cost Structures
The comparisons in lines 2 - 6 of Exhibit 3 do suggest strongly that the two product models have different product cost structures. This conclusion implies that the total per-unit production cost is no doubt distributed differently among cost categories for each product. And, if these differences prove real, the two products very likely earn different margins.
When a firm produces different products, each with its product cost structure, managers usually take a keen interest in uncovering the actual profitability of each product. This information supports pricing activities, budgeting, planning, and effective product portfolio management in general.
While finding the per-unit direct costs is usually straightforward and easy, finding the per-unit indirect (overhead) costs is a different matter. For these, the firm must choose and apply a costing methodology. In most cases, this means choosing between traditional cost allocation and activity-based costing.
The example below shows some of the input data and typical results for both costing methods. For more in-depth coverage of the same case, see Activity Based Costing ABC. That article provides more detail on the input data, assumptions, intermediate calculations, and cost results for product models A and B
Input Data for Both Costing Methods
During one fiscal year, the firm produces and sells:
- 900,000 units of product Model A at $3.00 per unit
- 2,100,000 units of Model B at $2.00 per unit.
Direct Costs Are the Same Under Both Costing Methods
Direct costs for each product calculate in the same way under both costing methods. Exhibit 4 below shows the resulting revenues and "direct costs" for these sales.
Exhibit 4 shows that the analyst has produced product-specific direct costs on a per-unit basis. Line 9 of Exhibit 4 shows that Model A has a per-unit direct cost of $1.25 while Model B has a per-unit direct cost of $1.00. The per-unit direct costs will contribute later to product-specific gross margin calculations.
Note that per-unit direct costs will be the same under both costing methods.
|Comparing Products||Model A||Model B||Total|
|1. Units Produced & Sold||900,000||2,100,000||3,000,000|
|2. Selling Price / Unit||$3.00||$2.00|
|3. Direct labor Cost / Unit||$0.50||$0.50|
|4. Direct Materials Cost / Unit||$0.75||$0.50|
|5. Sales Revenues [ = 1 * 2 ]||$2,700,000||$4,200,000||$6,900,000|
|6. Direct Labor Costs [ = 1 * 3 ]||$450,000||$1,050,000||$1,500,000|
|7. Direct Materials Costs [ = 1 * 4 ]||$675,000||$1,050,000||$1,725,000|
|8. Total Direct Costs [ = 6 + 7 ]||$1,125,000||$2,100,000||$3,225,000|
|9. Direct Costs / Unit [ = 8 / 1 ]||$1.25||$1.00|
|Exhibit 4. Sales revenues and direct costs for product models A and B. Direct costs appear in lines 6 - 9. Direct cost figures are the same under both costing methods.|
Note that Exhibit 4 says nothing about overhead cost items such as indirect labor. These are absent from the table because the firm has not yet costed overhead for individual products. Certainly, Model A has a greater per-unit direct labor cost than Model B. However, per-unit product costs are still unknown.
To find total production costs for each product, Autofirma must now find product-specific indirect (or overhead) costs. The indirect cost results in Exhibit 5, below result from a simple method called production volume based (PVB) cost allocation.Note incidentally that some analysts will refer to this approach as traditional cost accounting.
Major Steps in Cost Allocation
The significant steps in PVB are the following:
- The PVB process starts with the firm's overall total cost for each indirect cost item. The process purpose is to allocate these totals to different products. Here, for instance, the overall total for indirect labor was $1,422,500.
- The firm allocates total indirect labor cost to product models A and B based on proportional usage of production factors which are known directly, on a per-unit basis. In this case, the company allocates indirect labor costs referring to each product's consumption of direct labor resources.
- Total direct labor costs for this accounting period were $1,500,000 (Exhibit 5, line 6).
- From these figures, Autofirma finds that total indirect labor costs were 94.8 % of total direct labor costs. That is, $1,422,500 / $1,500,000 = 94.8%.
- For product Model A, direct labor costs are $450,00. The indirect cost allocation for A is 94.8% of this, or $426,750.
- For product B, direct labor costs are $1,050,000. The indirect cost allocation for model B is 94.8% of this, or $995,750.
Example Cost Allocation Results
These allocated cost estimates for each product Model appear in line 11 of Exhibit 6. Note especially the per-unit gross profit and gross margins for each product model in Exhibit 6 lines 15 and 16.
|Model A||Model B||Total|
|9. Units Produced and Sold |
[Exhibit 5, line 1]
|10. Total Direct Costs |
[Exhibit 5, line 8]
|11. Total Indirect Costs |
[Allocation shown above]
|12. Revenues Per Unit |
[Table 5, line 2 ]
|13. Direct Costs / Unit |
[ = 10 / 9 ]
|14. Indirect Costs / Unit |
[ = 11 / 9 ]
|15. Gross Profit / Unit |
[ = 12 − 13 − 14 ]
|16. Gross Profit Margin |
[ = 15 / 12 ]
| Exhibit 6. Gross profit and gross margin calculation for each product, using|
traditional cost allocation for indirect costs.
Models A and B Bottom Line Under Traditional Cost Allocation:
- Per-unit indirect costs for Models "A" and "B" are both $0.47 (Exhibit 6, line 14).
- Equality between product models must result because indirect costs for both products use the same allocation rate ( 94.8%) applied to the same direct labor rate ($0.50 / unit (Exhibit 5, line 3)
- Each Model "A" unit sold earns a gross margin of 42.5%. Model "B's per-unit gross margin is 26.3%.
- Conclusion: Model "A" is more profitable than "B."
Many cost analysts do not always trust traditional cost allocation methods to distribute indirect costs fairly among products. The PVB allocation example above, for instance, assigns indirect labor costs to products by referring to their use of another resource, direct labor. In most such cases, however, the connection between the use of an "overhead resource" and a directly measured resource ("direct labor") is less than sure.
The product comparisons in Exhibit 4 above, for instance, would lead many to expect Models A and B to have entirely different resource usage profiles. However, absent more data on product resource usage, there is just no way to know whether or not per-unit "direct labor" is a suitable stand-in for "indirect labor." In such cases, analysts sometimes turn to another costing methodology, Activity-Based Costing (ABC).
ABC stands on the premise that analysts can, in fact, measure the so-called indirect costs directly, given more data on the production activities required by each product. The example immediately below describes in principle how this works, as well as the results of an ABC costing analysis of product Models "A" and "B."
The example below shows some of the input data and typical results for both products under ABC. For more in-depth coverage of the same case, see Activity Based Costing ABC. That article covers in detail the input data, assumptions, intermediate calculations, and cost results for Models A and B
Direct Costs Are the Same Under Both ABC and PVB Allocation Costing Methods
Direct costs for both product models are the same under both traditional PVB allocation costing and ABC. For direct costs, accountants calculate per-unit values from (1) product-specific use of the direct cost item, and (2) the number of product units produced.
Sales data and direct costs for product Models "A "and "B" appear above as Exhibit 5.
Assigning Costs to Activity Pools
Turning to overhead cost items (the so-called "indirect items"), note that each overhead cost contributor in ABC is called an activity pool. Specifically, an activity pool is the full set of all activities needed to finish a task. The set of operations required to perform production machine set up, for instance, is the machine set up activity pool.
Total activity pool cost, for each product, requires finding cost drivers (CDs) for each pool. In the case of machine set up, the single CD is the labor cost per set up, which in this example is $1,500.
With activity pool cost drivers known, the analyst can then begin to differentiate Models A and B from each other by counting machine setups for each product model number. And, from that, it is easy to calculate product-specific activity pool costs. In this case:
- Product model A required 150 machine setups at $1,500 each. Total overhead cost for Product A machine setup was therefore 150 x $1,500 = $225,000.
- Product model B needed 100 machine setups at $1,500 each. Total overhead cost for Product B machine setup was therefore 100 x $1,500 = $150,000.
Finding Total Overhead Costs for Each Product.
In this example, machine set up is just one of five overhead cost items. The full analysis includes activity pools for (1) machine setups, (2) purchase order processing, (3) product packaging, (4) Machine testing and calibration, and (5) maintenance and cleaning. The analyst finds costs for activity pools 2-5, for each product, just as the analyst found machine set up expenses.
For the cost sums for all five overhead activity pools are as follows:
- Product Model A, the total overhead activity pool cost: $870,000.
- Product Model B, the total overhead activity pool cost: $552,000
Finding Per-Unit Overhead Costs for Each Product
The company considers now per-unit overhead costs by dividing the total overhead activity pool cost, for each product by the numbers of product units produced and sold (Exhibit 5, line 1).
- For product model A, the total overhead activity pool cost of $870,000 divided by 900,000 units gives a per-unit overhead cost of $0.97.
- For product model B, the total overhead activity pool cost of $552,000 divided by 2,100,000 units gives a per-unit overhead cost of $0.26
Exhibit 7 below shows how these costs contribute to the Activity Based Costing based profitability calculations for each product.
|Model A||Model B||Total|
|22. Units Produced and Sold |
[Table 2, line 1]
|23. Total Direct Costs |
[Table 2, line 8]
|24. Total Overhead Costs |
[Table 5C, line 21 ]
|25. Revenues Per Unit |
[ Table 2, line 2 ]
26. Direct Costs / unit |
[ = 23 / 22 ]
|27. Overhead Costs / Unit |
[ = 24 / 22 ]
|28. Gross Profit / Unit |
[ = 25 −26 − 27 ]
|29. Gross Profit Margin |
[ = 28 / 25 ]
|Exhibit 7. Calculating product model-specific gross profit and gross margins with activity-based costing.|
Conclusions: Activity-Based Costing Example.
- ABC finds different per-unit overhead costs for each product. By contrast, traditional cost allocation showed the same per-unit indirect (overhead) cost for Models A and B.
- In other words, ABC reports here that Model A uses more activity pool resources than Model B.
- Product-specific gross profits and gross margins result from adding the following figures:
- Per-unit direct costs (Exhibit 6, line 13).
- Per-unit indirect costs (Exhibit 7, line 27).
- ABC thus finds product B more profitable than product A. Model B's gross margin of 36.8% for B compares with Model A's gross margin of 26.1% (Exhibit 7, line 29).
Exhibit 8 below has per-unit profitability estimates for Autofirma's Model A and Model B.
Product Gross Margin
|Model A||Model B|
|Margins Under Traditional Cost Allocation ||42.5%||26.3%|
|Margins Under Activity-Based Costing||26.1%||36.8%|
|Exhibit 8. Different costing methods lead to different product gross margins. Traditional allocation approach finds product Model A more profitable than Model B. Activity-based costing finds Model B more profitable than Model A. The differences between methods are due entirely to differences in overhead (indirect) costs.|
Key Differences Between Costing Methods
The Autofirma example illustrates some of the critical differences between cost allocation and activity-based costing.
Amount of Data and Analysis Work
- For ABC, the analyst must understand in detail the activities that constitute overhead support. The analyst must also know the resources they consume and their cost drivers.
- The analyst can apply traditional cost allocation knowing only two items, total overhead cost, and a simple allocation rule.
Activity-based costing, in other words, is more data intensive and more labor intensive than cost allocation.
ABC Differentiates While Allocation Aggregates
- Activity-based costing recognizes that different products may use overhead components differently. One product model may need more maintenance work and resources, for example, while a different product consumes relatively more maintenance resources, for instance, while another model may require less maintenance but relatively more production set up work.
- Allocation methods often put indirect components into fewer categories or even a single class. Traditional cost allocation often uses a single allocation rate for all products.
Activity-based costing, in other words, makes finer distinctions between support activities and between individual products.
Direct vs. Indirect Measurement
- Note that ABC results reflect actual cost driver consumption for each product model. These costs, in turn, enable the analyst to find per-unit overhead costs for individual products.
- Cost allocation begins with accurate knowledge of total overhead cost. However, this method distributes that total to individual products based on indirect measures of that cost.
As a result, activity-based costing usually succeeds in turning so-called indirect costs into direct costs.
Should the Firm Move From Traditional Costing to ABC?
For the profit and profitability figures in Exhibits 6, 7, and 8, most businesspeople will probably see the ABC results as more accurate than allocation-based results. Most will no doubt be confident that the ABC-based figures more closely reflect actual production costs and margins.
In such cases, management will no doubt ask: Does the improved costing accuracy justify the higher cost of applying activity-based costing? That is a question that local administration must investigate and answer to its satisfaction before committing to a complete move to activity-based costing.
Business firms in competitive industries rightly call their high-level business strategy a competitive strategy. Very briefly, this strategy explains how the firm differentiates itself from competitors and—through its business model—shows where and how the firm earns margins. As a result, when a firm chooses a competitive strategy, it is at the same time setting target levels for overhead in its business model.
During the strategy building process, company leaders will ask questions like these:
- Is the proposed strategy viable?
That is, "Can we earn acceptable margins with this strategy?
- Is the proposed strategy realistic?
That is, "What is the likelihood we reach target profits and target margins?
The firm builds a quantitative example of business model implied by the strategy, to address such questions. The overhead concept plays a central role in providing credible answers. Understanding this role begins by understanding first the overhead implications of the firm's possible strategic choices. Exhibit 9 below summarizes these choices.
Choosing a Competitive Strategy
Textbook presentations on business strategy usually refer to several ideas underlying Michael Porter's approach to describing the business strategy. Their best-known presentation appears in Porter's books Competitive Strategy1 (1980) and Competitive Advantage2 (1985). Exhibit 9, below, shows the four choices available to strategy builders under Porter's system.
|Source of Competitive Differentiation|
|Cost Leadership||Product Differentiation|
|Broad||Cost Leadership Strategy||Broad Differentiation Strategy|
|Focused||Cost Focus Strategy||Differentiation Focus Strategy|
|Exhibit 9. Michael Porter's Four Generic Competitive Strategies|
Regarding the horizontal axis in Exhibit 9, firms that choose a "Product Differentiation" strategy can look forward to a business model very different from the model that results from choosing "Cost Leadership.
Strategy 1. Product Differentiation
Firms that choose "Product Differentiation" try to bring uniquely desirable products and services to market. In other words, they attempt to:
- Communicate desirability, exclusiveness, superior design, or high quality.
- Create new products or services.
- Add unique features or capabilities to existing products.
- Sell at lower prices.
Implementing a "Product differentiation" strategy inevitably calls for relatively high overhead levels in the firm's business model.
Strategy 2. Cost Leadership
On the other hand, firms that differentiate via "Cost Leadership" focus on minimizing their production and selling costs. As a result, the firm can charge industry average prices and still earn attractive profits and margins because its costs are lower than competitors' costs.
However, firms using cost leadership may also add an element of product differentiation by selling at lower prices than their competitors. They can do so and still realize healthy margins because their costs are lower than competitors' costs.
Implementing a "Cost leadership" strategy calls for relatively low overhead levels in the firm's business model.
Reality Check: Overhead in the Business Model
The strategy is ready for implementation only after it validates with a quantitative business model. The model is meant to show whether or not a proposed plan can bring desirable sales revenues, margins, and profits.
Here, the challenge is to build the quantitative model implied by the strategy that is realistic and credible. For this, the strategy builder refers to the firm's strategic business objectives, knowledge of the operating environment, and understanding of the market. The model derives from this knowledge, along with realistic sales and cost assumptions.
Two strategies, Two Different Business Models
In basic form, the business model representing a particular plan looks like a simple version of the Income statement. The model builder forecasts "Sales revenues" and then, from these, subtracts forecasted "expenses." This calculation produces figures for profits and margins—gross profit, gross margin, operating profit before taxes, and operating profits and margin after taxes. When the firm decides to implement the strategy, the model becomes the cornerstone of the firm's business plan.
Exhibit 10, below has the business models from two different firms, each testing the viability of its competitive strategy.
Exhibit 10. The quantitative business models for two strategies, from two different firms. Alpha corporation has a "Product differentiation" strategy that results in relatively higher overhead costs. Beta Corporation has a "Cost leadership" strategy that relies on lower overhead costs. In this case, both look forward to a bottom line net profit margin of 5%
Is the Alpha Strategy Viable? Will Alpha Corporation Succeed?
Alpha Corporation chose a "Broad Differentiation" strategy. The firm intends to differentiate itself as follows:
- Strong branding emphasizing product quality, "cutting-edge" design, and desirability. Branding efforts will communicate the qualities central to the firm's value proposition.
- Unique product features and capabilities. For these, Alpha aims to achieve market penetration and market leadership by being "first to market."
- With successful branding, moreover, Alpha believes it can charge premium prices and still sell successfully in an extensive market.
Alpha's model in Exhibit 10 shows the likely results of applying this strategy: Gross margins for products and services are relatively high (37% and 30%, respectively). However, Alpha's overhead for selling, administration, and overhead are also relatively high. Therefore, despite the high gross margins, the overall after -ax net (operating) profit margin is only 5.0%.
Alpha leadership will now ask whether or not Net profits of $7,505,000 and a 5% Net Profit Margin are acceptable.
- If such results are acceptable, Alpha can now build a business plan based on its model.
- If, however, the Alpha leadership finds these results unacceptable, the firm will look for ways to apply still more overhead to improve differentiation, and at the same time improve sales revenues forecasts.
Is the Beta's Strategy Viable? Will the Beta Strategy Succeed?
The Beta corporation has chosen a "Cost Leadership" strategy, targeting a broad market. For this, Beta will differentiate itself from competitors by selling at prices below industry averages. Success with the plan depends on keeping overhead expenses low.
With this strategy, Beta expects lower gross margins than Alpha for products and services (21% and 10%, respectively). Nevertheless, Beta's model still forecasts $8,505,000 and an after-tax Net profit margin of margin of 5.0%.
Beta leadership will now ask whether or not Net profits of $8,501,000 and a 5% Net Profit Margin are acceptable.
- If such results are acceptable, Beta can now build a business plan based on its model.
- If, however, Beta leaders are not satisfied with such results, the firm will look for ways to reduce overhead costs still further, to improve forecasted profits and margins.
Exhibit 11, below, is an example Income statement with a typical level of detail for the Annual Report.
1. Porter, M.E. Competitive Strategy, Free Press, New York, 1980.
2. Porter, M.E. Competitive Advantage, Free Press, New York, 1985.