TxM 049 Section 5.4 Suggested basis of attribution of overheads and production costs in a cubic business model environment Created by James on 7/4/2013 11:18:19 AM
One of the points made in previous sections relating to the philosophies and operational practices recommended for a JAR&A SEPT Financial Taxonomy (Cubic Business Model and Group-Wide Chart of Accounts) is that journal entries in the General Ledger should be cut to a minimum.
1. Journal corrections fall away
Experience indicates that in a properly configured and properly implemented SEPT GL environment journal entries to correct posting errors hardly occur.
2. Operational people distrust journals
Probably the biggest single reason that most operational managers and supervisors do NOT use the General Ledger for management information and decisions is because of the presence of management journals such as proportional overhead distribution, split invoices, etc.
Frequently the basis of attribution of these journals is not made clear or is disputed and, as a consequence, most managers and supervisors ignore reports from the GL and maintain their own records which reflect the reality of their part of the business – which generally is the real view anyway.
Part of the SEPT concept is to provide an alternative method of allocating overheads and introduce disciplines to minimize or prevent split allocations.
This document outlines a proposed method for allocating overheads that builds on the logic and structure of the JAR&A SEPT Cubic Business Model and Group-Wide Chart of Accounts.
3. Post to the unit that incurred the cost
Since in most cases we are concerned with expenses I will use language relating to costs.
The fundamental principle is that the costs should be posted to the unit that incurred them, or that signed the order. Provision should be made for the complexities of the real world and for notional accounting business units, with real designated managers, that account for:
- Location costs that cannot be allocated directly to function – electricity is frequently an example – generally there is one set of electricity meters serving the entire location.
- Function costs that cannot be allocated to specific locations – for example the development of Human Resources policy incurs external costs which cannot be allocated to a particular location and which should be applied across the entire enterprise or at least across all locations.
- Corporate costs that cannot be allocated to locations or functions – for example much of your financial balance sheet such as bank accounts, debtors control account, etc frequently are located here.
These and other rules are determined as the model is constructed in the GL Builder tool.
4. Functions are categorized into major categories
In general I recommend that Functions are divided into the following categories:
- Revenue is categorized separately so that all operational business units have costs allocated on the same basis without having revenue distort the operational financial reports – this does NOT impact the macro corporate financial statements which are driven off the Master Chart of Accounts
- Core – the essence of the business (the strategic heart of the business) e.g. the factor
- Core – support, that which we do to make sure the essence of the business operates effectively e.g. the technical service and engineering staff who look after the machines in the factory
- Some clients separate out "Sales, Marketing and Distribution" although these can be separated out using other techniques
- Administration – all the other stuff which is not core or core support e.g. business administration, finance, etc
Some clients use the same categorization in the Chart of Accounts.
These major categories of functions provide a mechanism for consolidating and rolling up costs off overhead business units onto production business units and then tying them in to revenue.
The following sections explain how this works. As you develop understanding of how this model works you will be able to add in additional layers of cost distribution.
5. Build the model OUTSIDE the General Ledger
In the steps that follow please see this model as built either in a spreadsheet (OK for prototyping but NOT recommended for long term operation) or in a model in the Data Warehouse and Business Intelligence environment which is what is recommended.
Alternatively this can be constructed in a consolidation tool.
The model should be modular and incremental and designed in such a way that all cost drivers, ratios, etc used in the model can be quickly and easily changed to allow scenario computations to be performed. Cross casting and other spreadsheet quality control techniques and disciplines are VITAL – the bottom line of the income statement must always be the same at all levels of the model as a minimum quality check, there are many others that should be incorporated.
6. Corporate costs independent of location and function
Take the costs from the cell named "Corporate costs independent of location and function" (bottom right above) and spread them over the entire model on a pro-rata basis using appropriate cost drivers.
7. Location costs independent of function
Take the costs from the "function" named "Location independent of function" (third row from bottom) and spread them UP THE COLUMN over the functions for that location only.
8. Function costs independent of location
Take the costs from the "location" named "Function independent of location" and spread them ALONG THE ROW over the locations for that function only.
9. Administration costs
Take the costs from all the cells corresponding to functions categorized as "Administration" and spread them UP THE COLUMN over the Core Support and Core functions above them.
10. Core Support costs
Take the costs from all the cells corresponding to functions categorized as "Core Support" and spread them UP THE COLUMN over the Core functions above them. This leaves you with only Core functions and Revenue Functions. If you have categorized "Sales, Marketing and Distribution" separately you would distribute them up the column first.
11. Core costs onto Revenue
Take the costs from all the cells corresponding to functions categorized as "Core" (which now contain the ENTIRE spread of costs) and spread them UP THE COLUMN over the Revenue functions.
If you have been thorough and accurate in the determination of cost drivers, which costs to apply them to and how to distribute them up the model this should leave you with a very precise activity based computation of net profit contribution for each of your major revenue streams.
This model will take significant work to develop and calibrate but, provided it is well designed and well built, it will provide you with a learning environment in which you will progressively gain greater insight into the real cost dynamics of your enterprise.
With a well-designed model it is now possible to produce income statements for each cell which show the attribution of overheads to that cell in such a way that the custodian of that cell may engage with the model and management and assist in making the model more precise over time.
Fundamental to this approach is that performance incentives are ONLY computed based on the measures over which the manager or supervisor has direct control plus an agreed logic for the overheads IF it is intended that the manager should influence other parts of the organization to manage their contribution more effectively.
This approach allows the organization to progressively build more complex and more reliable costing models based on accurate measurements linked to cost driving activities and become a learning organization!!
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