Expert opinions, FINANCE

How to distribute indirect expenses safely

The ability to allocate costs is one of the key competencies of the financier.

It is necessary to evaluate the effectiveness of business processes and business units from a financial point of view and to make important management decisions:

  • to start the production of new goods or the provision of a new service;
  • to reduce production volumes or to abandon a certain product;
  • to make changes to the product or service;
  • to reorganize business units;
  • – to open new sales points.

Performance is assessed by the CFO. The first thing he has to do is reliable determination of the income and expenses of the business. Unlike distribution of income by directions, process of distribution of expenses is complex and time-consuming. If the accounting detail methodology is incorrect,  then this affects greatly the correctness of the result of the profitability assessment  of divisions and, as a result, leads to erroneous management decisions.

How to allocate indirect costs?

Let’s look at the example of Alfa company, whose stores operate in three cities.

1. Select detail depth

Detail depth affects directly how accurately you can distribute expenses and calculate cost. If accounting is not automated, detail analysis is extremely labor intensive and often leads to a large number of errors.

It is important to account for revenues and expenses correctly, setting the level of detail with taking into account its decision-making methodology:

  • by subdivisions;
  • by types of activity;
  • by financial responsibility centers;
  • by product type.

Example: Alpha allocates costs to divisions to evaluate the profitability of individual stores. To conduct further management analysis with the required number of levels of detail, the company “Alpha” takes into account the costs as follows: region – store – item of expenses.

2. Determine revenues and expenses

The Alfa company recorded revenues for each store. Further expenses of the company should be divided into 2 types:

  • direct expenses, that is, related to a separate store and forming its cost  without a separate distribution;
  • indirect expenses, that is, related to several stores and to ensuring the work of the company as a whole.

Expenses are divided into direct and indirect ones, depending on which depth of detail is selected. For example, Alfa wants to evaluate the profitability of each store individually, therefore the total costs of region (e.g. transportation costs) will be considered indirect. If Alfa decided to assess profitability throughout the region – then total costs across the region would be considered direct.

To conduct a cost-effectiveness assessment and a plan-factual analysis, Alpha records the total cost for each of the divisions – direct and indirect costs in the respective subdivisions.

In this case, indirect costs per business unit are:

  • transportation expenses – RUB 1,870,800;
  • advertising – 1,318,400 rubles;
  • HR salary – 577,000 rubles.

Also possible indirect costs:

  • expenses of the management company;
  • central warehouse costs;
  • HR;
  • software costs;
  • expenses on the company’s website;
  • expenses for holding exhibitions;
  • salary of administrative and managerial personnel;
  • bonuses for managers;
  • expenses for operation and maintenance of transport;
  • lease payments for equipment and vehicles;
  • interest on loans and borrowings;
  • warehouse maintenance and operation costs;
  • salary of warehouse personnel;
  • utility, repair, insurance costs;
  • property tax on warehouse assets.

3. Determine the base in proportion to which distribution will take place

The distribution base is the component of the calculations in proportion to which the amount of indirect expenses is included in the cost price. This indicator is defined by company itself.

The distribution base is established depending on the business area, nature of expenses and other factors. The selected base should contribute to cost-effective cost-sharing. Examples are given below.

4. Allocate indirect costs

Expenses should be distributed according to understandable and transparent principles. In small business you can do this with Excel, but for medium and big business it will not be suitable, especially if the company needs consolidated reporting and detailed analysis. At the same time, automation of management reporting reduces significantly the risk of errors, increasing the reliability of reporting and saving time on its preparation.

Indirect cost allocation examples

At Alfa, the owner wants to see and analyze profitability

of each individual store. Itis not enough to determine revenue and direct cost price of sold goods, so Alfa makes a decision to distribute indirect costs in an automated manner.

For each expense item, the company has established a base that allows, in  an economically reasonable format, to account for indirect costs as part of expenses of each store.

Proportional to fixed coefficients

The calculation method is applied when the coefficients are known or easily identified.

For example, the company launched advertising in 3 regions in the ratio of 50% -30% -20%, and this ratio is used in the analysis of the distribution of expenses for advertising. Further, expenses are distributed by region, and within regions – in equal shares in stores.

Pro rata revenue/sales volume

This technique is useful for allocating expense types that depend on sales. Example is distribution of logistics costs pro rata point-of-sale revenue.

Pro rata to Payroll Fund

This technique is more often used when the main cost item are employees’ wages.

For example, in Alfa, HR expenses are distributed in proportion to the salary of the store employees.

Mixed circuit

This technique is used if costs are affected by several factors.

At Alfa, stores in the regions are located at different distances from warehouses.

The CFO changed the basis for the distribution of transportation costs, and under the new scheme they are distributed simultaneously proportionally to revenue and distance from the warehouse.

How to spend less on costs

Manual allocation of expenses by more than one employee is labor intensive, inefficient and risky. During the entry of data, the situation has time change, data become irrelevant, and the risk of errors makes the result even more unreliable.

Management accounting automation system allows you to distribute expenses with a high degree of reliability and relevance, and also reduces time costs of data processing. Important criterion in automation system selection is transparency of calculations. If you understand what share of expenses fall on the cost of each unit, then estimate of their financial efficiency will not be divisive.

By Ekaterina Danilenko, Head of Consulting Department, FinGrad – Financial Management

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