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For many finance teams, allocations are an article of faith. But today, some companies are questioning their real value as a management tool. Who’s right?
Financial allocations and charge-backs have conventionally been used to understand the unit cost of a service or product (cost accounting), manage a shared resource (often IT or infrastructure), or view profitability of a given entity (fully burdened P&L). In theory, allocations create transparency into financial and operational business drivers, empower business leaders with facts on what is really driving costs and align managers on profit, not sales. Some business leaders try to use allocations to create a market-like environment for shared resources in a company by burdening managers’ P&Ls. They assume that if a manager is held accountable for their use of resources, they will only make the best and wisest use of them. In pursuit of this market-like environment though, companies have built allocations on top of allocations, ultimately obscuring the visibility they sought to achieve. As a result, some companies are now breaking away from the conventional wisdom and abandoning allocations. They are questioning whether they are an effective management tool, a crutch – or an obstacle. Should we use allocations and if so, when? Are they of value or are they really an academic idea that has failed in implementation?
Here’s the debate:
How else can we hold managers accountable for what they use of shared resources?It’s simple. Managers use shared resources. We measure their usage. Then we build it into their budgets through allocations. That’s just common sense Allocations actually obscure accountability.
In order to get to a fully loaded cost, companies have layered allocations on top of allocations so much that they have lost the direct connection to cost drivers. We should only hold managers accountable for what they control, then use equality decision making to allocate shared resources (e.g., IT and marketing spend).Allocations are a key part of understanding portfolio profitability.
We need to understand which parts of our business are truly making money and which are not. We can’t do this if we don’t allocate them their share of costs.Sure, but a forecast is not a portfolio evaluation.
Agreed, portfolio measurement is important and needs allocations. But other processes like forecasts and budgets are better when ownership is clear and accountability direct (no allocations) – leave the allocation models to the business development guys.Without allocations, our forecast is incomplete.
Knowing which parts of the business are responsible for which costs is a key input into our forecasts.Managers don’t own allocations in a forecast, they fight about them.
In reality, managers spend more time arguing over allocations rather than making valuable decisions. Assign this to a small group of people, examine it periodically and get out of the way of the forecast process. To truly manage our business, we need to fully allocate all costs.
We have to look at all costs across the business and employ use of full allocations in order to make smarter decisions about using shared resources.There is no value allocating any corporate costs.
Line management actions have little impact on corporate costs, therefore burdening managers with them borders on irrationality.
Miles Ewing, Principal, Deloitte Consulting LLP
Allocations have their place. But in my work, I see two of the same mistakes being made over and over by companies when it comes to using this accounting tool.
For starters, many use them as a core part of their regular management processes, like planning, budgeting and forecasting. Why is that a problem? Because allocations are complicated – they’re heavily layered, with distributed ownership. So in reality, the amount of labor required to create an accurate forecast that relies on allocations data just isn’t worth it in the end. I’ve seen plenty of companies that create exquisitely detailed forecasts and even P&L statements using allocations data, but when you ask them what it all means when it comes to decision making, nobody knows. What good is that?
The other common mistake companies make about allocations? They create what I call a pseudo-market for internal services, assuming that managers will make rational, market-informed decisions when consuming resources. In my experience, that’s okay when you’re working with clear, known quantities – the cost of localizing a product in a different language, for instance In that case, everybody knows how much it will cost and they can make decisions accordingly (however charge-backs used to manage these things often delay other things like the close and forecast). But the picture becomes murkier when you’re considering resources that managers are going to have to consume no matter what or the cost is more negotiable – like IT projects. That’s the moment when allocations tend to get in the way of smart decision making. In those cases, the market model is flawed – there really is no competition for some internal resources.
In both of these cases, companies may be abdicating key management responsibilities to an imperfect tool. Instead, they should implement a rigorous decision-making process to evaluate the distribution of shared resources across opportunities, not rely on allocations to make the decisions for them. This is really where management fails by trying to rely on allocations as a crutch for good decision-making. Allocations are at their best when used for unit cost measurement or periodically examining profitability: But allocations are often unleashed in day-to-day management, where they just tend to get in the way. Is that happening in your organization? If so, it’s time to put allocations in their place.
Nnamdi Lowrie, Principal, Deloitte Consulting LLP
Can companies survive without the use of allocations? The simple answer is No. Allocations do provide value when used appropriately, however in many companies there is a tremendous opportunity to reduce their complexity and still provide the business with simple, actionable information.
When allocations go wrong their unintended consequences can cause an incredible level of inefficiency within the Finance organization and business as a whole. Typical symptoms of allocations gone wrong include business owners not understanding the allocation and allocation recipients being unable to directly impact their value. This can cloud an organization’s view of business performance. As businesses evolve and grow, often times the complexity of allocations also grows, resulting in reduced transparency into key business drivers. In fact, the level of granularity and rigor sometimes applied to allocations places an emphasis on a set of assumptions that may not align to a company’s business strategy and management philosophy.
Allocations can also be a costly management tool. The effort and resources associated with developing allocation methods to spread costs, maintaining calculations and adjusting drivers can occupy significant parts of close and planning processing time.
The concept of a “fully allocated” P&L largely serves the purpose of both helping to approximate business views of profitability (e.g. regional profitability, business unit profitability, product profitability, etc.) and aligning spend with demand. CFO’s need a mechanism to manage spend and measure the economic return on every dollar spent, however, this can be achieved through diligent management of gross spend drivers and periodic reviews of high level allocated profitability.
Allocations do have their place. Their place is to provide leadership with simple views into profitability and not as a core day-to-day detailed management process.
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