Article Review “Overhead can kill you”
The article starts with an example of how company experienced huge losses instead of projected profits. The company was between two production options. As per senior vice president analysis, one option is considered to be money-losing while the second one is supposed to bring profits. The decision was based on the projection that the production facility with 11 million losses was supposed to bring 17.5 million of profit (Rao 1). Instead, it resulted in 20 million losses (Rao 1). Such miscalculation was rooted in a mechanical cost-allocation method. The cartoon on the first page is used as an allegory to this issue (Rao 1). The example represents a group of people in a restaurant where each orders a different amount of food but they paycheck by equally dividing on a number of people in a group. Three people order little amount of a plain food whereas the fourth one orders a three-course meal with drinks. Thus, a person, who consumes a lot, pays less, and persons who consume little, pay more. The real costs are disregarded.
The companies with diversified business and/or several divisions are used to allocate costs mechanically. This traditional approach originated in a time when the overhead was not that significant (Rao 1). However, such expense account such as executive training, consulting services, or law compliance activities rose significantly (Rao 1).In addition, the author illustrates the faultiness of depreciation method. In the example, depreciation is distributed based on labor used (Rao 2). However, machinery is an object that depreciates and not labor. In addition, Rao mentions practices when depreciation is calculated based on the revenue-generating ability. However, it does not equal to the wear out of equipment. Then Rao introduces the concept of activity-based costing. The example of the pipe-producing company indicates the outcomes of shifting from traditional cost-allocation to activity-based (Rao 2). Their production was sold to two main markets: domestic and export. When they calculated the costs of preparation the items for exporting, they realized that profitability of those sales became less due to costs incurred (Rao 2).
Therefore, the domestic sales became more profitable than exporting ones. Important point is that it was not evident by using the previous method of cost-allocation. The example of electronics distribution company demonstrates how understanding the costs can increase the sales (Rao 2). Company’s buyers know the price of each item and order them from where it is cheaper (Rao 2). However, there are costs of ordering, inspecting, and tying up capital in inventory (Rao 2). With the implementation of activity-based costing, it is appeared more profitable to order in higher volumes from this company. This way company significantly increased the number of buyers as well as revenues (Rao 2).
Overall, the article indicates that it is better to calculate costs and profitability separately by business activities rather than equalize them mechanically.The commonly used method is a straight-line …