Cost of Accuracy

Organizations, for the most part, tend to fall into one of two analytical camps. There is the small, non-public organization which undertakes the drudgery of keeping a set of books only to appease the laws of the land. Their extent of their financial analysis is determined only by way of having enough cash in the bank to make payroll. In the other camp are the public and government associated organizations that are steeped in financial analysis. These organizations live and breathe on the dicing and slicing of analytics.

After spending considerable time assisting organizations in getting a handle on profitability, I feel a certain degree of financial analysis is paramount to a successful organization. To the small organization, an exercise in financial analysis will direct the decision makers to those critical areas where change can be made. Interestingly, “what isn’t reported isn’t important”. I learned this mantra many years ago when assisting a professional services firm to get a handle on its profitability. Through very simple analytics it became blazingly clear which lines of business were profitable and which were a drain.

In the other camp, I feel that financial analysis has hit the zenith of analysis paralysis. It is almost as if the analysis is undertaken for the sake of analysis. In one organization where I had exposure, their level of analysis went down to the 1/1000 of a penny! One only has to stop and wonder where the sense in this is. With their technology, reports were run and the data keyed and re-keyed in to spreadsheets and databases to undertake such granularity in accuracy. I have to wonder the cost behind this degree of accuracy. Then with two resource competing opportunities, is one selected over the other because it was more profitable by more than 1/1000 of a penny.

One of the most intriguing aspects of this degree of analysis is the allocation of costs. I have found that so many organizations fall into the trap of ‘what was done before must continue’. It is almost like paying homage to the Mecca of the author of the analytical model. These firms often never question why they undertake their processes but perpetuate the same logic decade after decade. Although I don’t profess to be a cost accountant, I do feel that cost allocation should be based on a reasonable natural dynamic rather than a theoretical model, which often cannot be justified.

In reviewing the literature on overhead cost allocation, I have found that probably no subject in all of managerial accounting has as much controversy as direct costing. The theoretical argument of overhead allocation is between direct costing and absorption costing. Advocates of direct costing argue that fixed overhead costs related to the capacity to produce rather than to actual production. While the absorption costing school argues that each segment must bear a portion of all costs associated with its production. So, who is right?

In the reality, the debate often comes down to square footage of use in the production segment. I prefer to think of the production segment as either a manufacturing area where specific products are manufactured, or an office setting where specific types of work are undertaken. By way of an example an office segment in a professional services firm would be that area that houses audit, tax and accounting teams. The allocation model takes on a whole new tone when teams argue about office size and the allocation of common areas. Of course this is reasonable as each segment seeks to mitigate their cost of production and thereby justify their existence on the basis of profitability.

What happens to this model if the number of large offices is exceeded by the number of small offices? Are segments unfairly discriminated against because of the size of their office allotment and their related cost of common areas? Organizations can’t, logically, squelch this argument by undertaking leasehold improvement simply to put some type of ‘fairness’ to the allocation method through drywall and paint.

Recently I had such a debate with a very progressive management accountant on this topic. As we dialogued about the inherent flaws in the square footage model it became clear that a natural dynamic was at work. The conclusion we came to was based on reality; what is segment costs were not allocated by square footage, but rather by the number of FTEs in the segment. As the number of FTEs grows so will their space requirements and hopefully their profitability, as their growth would be driven by basic market demands. With this model, the overhead cost allocation per segment seems to be more objective.

Taking this dilemma a bit further, what happens if funding for a segment originates from two very diverse sources, how should costs be allocated then? The segment produces indistinguishable outputs but the revenue stream is from two very different sources. Given this situation the square footage model is blown out of the water as is the FTE model. Since separate funding sources dictate that costs be allocated one must find a natural basis, I feel, of allocation. Recently I was faced with this very situation. Through careful examination of the segment I found the natural differentiator; it was a unique characteristic of the users of the segment. As it turned out, there were users that had a behavior that could be traced back to one single funding source and other users to the other funding source. Once this model was applied, costs and revenue recognition became perfectly clear.

I believe that organizations need to closely examine their activities to ensure that each segment is adequately contributing to the overall health of the organization. The onus rests with the analyst to exercise reasonableness in overhead cost allocation and the level of granularity to be managed. More often than not the cost of extreme granularity outweighs the value of the analysis. More over recognizing the natural dynamic of the segment will lead the analyst to the true differentiator of cost. Relying on historical model or textbook musings will not lead to valuable information but rather a situation where the baby slips down the drain, following the bathwater!