I frequently run into an issue with allocations. Specifically, an issue with confusing accounting allocations for something that is useful in decision-making. In accounting, allocations is:
the process of shifting overhead costs to cost objects, using a rational basis of allotment. Allocations are most commonly used to assign costs to produced goods, which then appear in the financial statements of a business in either the cost of goods sold or the inventory asset.
As an example, imagine this classic situation in engineering. BigCo is developing a new product line. My kid is 4 and obsessed with potty words, so we'll call it "Product Booger". Product Booger will cost about $1,000 of RND spending to get ready for market, and once it goes to market, BigCo expects it will sell around 500 units at $20 each. Each unit will cost $10 to manufacture. Should BigCo do this project?
Here is the super-basic analysis
If BigCo has the $1000 to invest and doesn't have other investments with a better efficiency ratio, they should do this project.
Now imagine that a super-eager young person comes along with an idea for a product extension based on BigCo product Booger. Product NoseGoblin is a derivative product that will cost $100 of additional RnD and should sell around 200 units at $16 each. Each unit will cost $14 to manufacture. It is safe to assume that NoseGoblin won't cannibalize any of Booger's sales or anything like that. Should BigCo do this project?
Here is this super-basic analysis:
So this NoseGoblin isn't as good as Booger, but it still has a positive return and recommends itself for investment if BigCo's alternatives don't have a better efficiency ratio than 1.0.
Then the accountants catch wind of NoseGoblin. They decide that it needs to carry a portion of the shared investment from Booger. Doing a classic revenue basis allocation--allocating the RND spending according to proportional revenue-- Nosegoblin picks up an extra allocation of $242 (at the same time, Booger looks $242 cheaper). A few months later, a new financial analysis is performed and NoseGoblin's financials look like this:
It is now a negative financial return. Kill it fast! Super-eager person's heart is broken.
This is not a made up situation. I have seen this happen. It gets even crazier when BigCo decides that everybody needs to carry a share of overhead allocations in financial analyses, too. Suddenly you see stuff like this:
Even though this project doesn't drive any additional SGnA, IT activities, shared technology development, new building construction, etc., GAAP rules require that these allocations get managed in the PNL so they tend to find their way into the financial analysis, too. Load in things like depreciation, taxes (which are usually so convoluted that trying to estimate the real tax impact of a new product is fool-hardy) and you're ready to start shooting down loads of good projects that fail to meet a corporate hurdle that completely misses the point.
Accounting allocations being used for decision purposes leads to bad decisions. When we do portfolio analyses, we keep them separate and link the spending through relationships and work hard to identify incremental spending. Only spending that is truly incremental is relevant in the analysis.
the process of shifting overhead costs to cost objects, using a rational basis of allotment. Allocations are most commonly used to assign costs to produced goods, which then appear in the financial statements of a business in either the cost of goods sold or the inventory asset.
As an example, imagine this classic situation in engineering. BigCo is developing a new product line. My kid is 4 and obsessed with potty words, so we'll call it "Product Booger". Product Booger will cost about $1,000 of RND spending to get ready for market, and once it goes to market, BigCo expects it will sell around 500 units at $20 each. Each unit will cost $10 to manufacture. Should BigCo do this project?
Here is the super-basic analysis
If BigCo has the $1000 to invest and doesn't have other investments with a better efficiency ratio, they should do this project.
Now imagine that a super-eager young person comes along with an idea for a product extension based on BigCo product Booger. Product NoseGoblin is a derivative product that will cost $100 of additional RnD and should sell around 200 units at $16 each. Each unit will cost $14 to manufacture. It is safe to assume that NoseGoblin won't cannibalize any of Booger's sales or anything like that. Should BigCo do this project?
Here is this super-basic analysis:
So this NoseGoblin isn't as good as Booger, but it still has a positive return and recommends itself for investment if BigCo's alternatives don't have a better efficiency ratio than 1.0.
Then the accountants catch wind of NoseGoblin. They decide that it needs to carry a portion of the shared investment from Booger. Doing a classic revenue basis allocation--allocating the RND spending according to proportional revenue-- Nosegoblin picks up an extra allocation of $242 (at the same time, Booger looks $242 cheaper). A few months later, a new financial analysis is performed and NoseGoblin's financials look like this:
It is now a negative financial return. Kill it fast! Super-eager person's heart is broken.
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| this what a GIS for "sad super eager person" finds for me |
This is not a made up situation. I have seen this happen. It gets even crazier when BigCo decides that everybody needs to carry a share of overhead allocations in financial analyses, too. Suddenly you see stuff like this:
Even though this project doesn't drive any additional SGnA, IT activities, shared technology development, new building construction, etc., GAAP rules require that these allocations get managed in the PNL so they tend to find their way into the financial analysis, too. Load in things like depreciation, taxes (which are usually so convoluted that trying to estimate the real tax impact of a new product is fool-hardy) and you're ready to start shooting down loads of good projects that fail to meet a corporate hurdle that completely misses the point.
Accounting allocations being used for decision purposes leads to bad decisions. When we do portfolio analyses, we keep them separate and link the spending through relationships and work hard to identify incremental spending. Only spending that is truly incremental is relevant in the analysis.
