Understanding Traditional Overhead Allocation on an Income Statement
The problem in many businesses using traditional overhead allocation is that their overhead expenses or operating expenses don't cleanly tie to products or services. Without good allocation of overhead or operating expenses, businesses can't accurately determine which products make money and which don't. To really understand how to improve your spending, you need to understand how overhead allocation traditionally works. To give you an example, take a look at the income statement.
|Less: Cost of goods sold||3,000|
|Total operating expenses||6,000|
Suppose that in this imaginary hot dog stand business, you sell two different products: a regular hot dog for $2.50 and a super-duper chilidog for $4.00. Suppose also that you sell 2,000 of both of these products. Therefore, the $13,000 of revenue shown in the income statement actually represents $5,000 in sales of regular hot dogs and $8,000 in sales of chilidogs.
Further suppose that you can break down the cost of goods sold as follows:
Buns: Each bun costs you $0.15. This means that you spent $300 on buns for regular dogs and $300 on buns for the chilidogs.
Dogs: Each hot dog costs you $0.40. This means that you spent $800 on hot dogs for the regular hot dog product line and another $800 on hot dogs for the chilidog product line.
Chili: Each serving of chili for the chilidogs costs you $0.40. (A serving is three heaping tablespoons of chili, as you enjoy telling customers.) This means that you spent another $800 on chili for the chilidog product line.
Given this information, you can create an income statement that shows revenues, cost of goods sold, and gross margin by product line. Furthermore, note that the second statement does something very traditional by allocating operating expenses using a simple rule. The operating expenses are simply split right down the middle, allocating $3,000 of operating expenses to the regular hot dog product line and $3,000 of operating expenses to the chilidog product line.
|$2.50 Hot Dogs||$4.00 Chilidogs||Total|
|(2,000 sold in each product line)||5,000||8,000||13,000|
|Cost of goods sold|
|$0.40 hot dogs||800||800||1,600|
|$0.40 of chili for each chilidog||—||800||800|
|Total cost of goods sold||1,100||1,900||3,000|
|Total operating expenses||3,000||3,000||6,000|
If you examine the second income statement, several pieces of data suggest that there's money in them there chilidogs. For example, look at the sales revenue. The income statement shows that chilidogs generate $8,000 of sales revenue, whereas regular hot dogs generate only $5,000 of sales revenue. Now look at the gross margin. The income statement shows that chilidogs generate $6,100 of gross margin, whereas regular hot dogs generate only $3,900 of gross margin. Finally, look at the net profit. Based on a simple split of overhead or operating expenses, the net profit from the regular hot dog line equals a measly $900, while the net profit from the chilidog product line equals a whopping $3,100.
It seems pretty clear that you should sell more chilidogs and fewer hot dogs. In fact, you may want to give up on selling regular hot dogs and concentrate on chilidogs. You may also decide that your chilidogs are priced too high; perhaps you could shave the cost a bit on these. You may also decide that the regular hot dogs are priced too low; perhaps the price on these should be bumped up a bit.