To allocate or not to allocate – is this the question?

An intermediate post to clarify a point

Part 1.5 in the series on using T, I and OE for key decision making

The previous post argued that the cost of capacity is not linear and it is also not continuous.  I did not deal with the fact that in too many cases there is no direct way to relate specific capacity consumption to specific products.  The remedy of cost-accounting in their efforts to calculate the cost of a product unit is to allocate the cost-of-capacity, which is not directly related to a product unit, based on some arbitrary parameter like the direct-labor.

Should we allocate the cost of the arena based on tickets or on the result of the match?

Activity-Based-Costing (ABC) challenges the older methods on that point.  ABC tries hard to relate every time capacity is consumed to its “cost-driver”, which could be a product unit, but also a new client and even an order.  Anything wrong with that?

The real mistake of ABC, and all the other cost accounting methods, is to associate the average cost of the specific capacity consumption to those cost-drivers.  The non-linear behavior of the cost of capacity causes a huge distortion in the ABC management information.  It gives the wrong impression that certain cost-drivers are too costly when there is a lot of excess capacity, while other cost-drivers look good, concealing the fact that they use capacity that is truly limited (and purchasing more is truly expensive), thus leading to flawed business decisions.

Of course, in order to convince organizations to stop assuming that every time capacity is consumed a certain cost is generated, we need to establish an alternative way to make sound decisions.  We need a good method to check whether a new opportunity/idea would improve the bottom-line or not.  We like also to have a good method to decide whether purchasing more capacity is profitable or we better give up some of the available capacity.  I promise to arrive to the solution in later posts.

Sometimes we need to allocate certain costs even when we use the TOC logic!

For instance, suppose your company has partnered with another company in leasing a whole floor of offices.  The reason is: the owner of the floor refused to lease part of it.  That space is a resource, and the total space is the limit of the available capacity of the space resource.  Any agreement between you and the other company on splitting the cost of the rent, and probably also some other capacities you use (cleaning, communication lines) is basically arbitrary and based on some allocation (the lobby and the lifts are certainly shared) of the space.

I’m going to raise more cases of allocation as a good-enough solution when direct calculations are not possible.