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Corporate Finance

Making Sense of Allocated Overhead Costs

March 10, 2023
Manufacturing executives have more control over these operations expenses than they might realize.

As a former corporate controller and senior vice president of operations, I have experienced both sides of allocated overhead. I have learned manufacturing executives have more control over costs allocated to their operations than they might realize.

For decades, companies have optimized manufacturing costs by implementing offshore production strategies, automation and process improvement. But clearly, these are not the only costs impacting finished goods. Recessionary pressures are forcing companies to heavily scrutinize their entire cost structure, and overhead rates are a significant part of the equation.

There are four key talking points and action items with which manufacturing executives can engage their administrative and financial counterparts to positively impact allocated overhead.

1. Request in-depth explanation of each allocated cost

Detailed discussions should be scheduled at least annually at the executive level to understand overhead allocations. All questions should be answered with a high degree of clarity regarding allocation assumptions and cost calculations, as well as the nature and purpose of the costs themselves.

Cost drivers and internal pricing need to be understood so costs can be compared to outsourced pricing. This will require overhead managers to calculate the cost of their internal service and deliverables, a practice that will aid them in their own cost optimization efforts. 

Never forget that cost allocation does not constitute cost optimization. Costs should be optimized as much as possible prior to allocation.

2. Negotiate value propositions for each allocated cost

A fundamental purpose of cost optimization is to fully exploit the value of every cost. Once the nature of each allocated cost is completely understood, value propositions should be negotiated with overhead leadership. Gone are the days when manufacturing teams have to settle for generic services that don't meet their critical decision-making needs. For instance, if manufacturing reports produced by overhead teams need to be tweaked or customized, this value-added improvement should be delivered quickly.

Furthermore, for overhead value to be truly measured, the operational or manufacturing recipients of overhead services should periodically score or rate the deliverables they receive. This will help overhead service providers know how to offer ever-increasing value to their manufacturing counterparts. This approach will open cross-functional lines of communication and deter organizational dysfunction. 

3. Jointly develop a cost optimization plan

Just as manufacturing costs are expected to be optimized, so should overhead costs. With ever-present pressure to contain costs, there is no better time than now to develop a corporate cost optimization plan. This comprehensive plan should set annual cost optimization targets throughout the organization, address high-impact/high-risk costs and assign teams their cost optimization responsibilities.

Cost optimization planning should consider that "50% of current work activities are technically automatable,” which includes countless overhead office tasks. Furthermore, just as manufacturing process efficiency can be improved through Lean Six Sigma principles, business processes can be substantially streamlined as well.

4. Establish cross-functional 360 employee evaluation 

Generally, cross-functional service is reciprocal, which greatly impacts internal efficiency and cost. For example, an accounts payable team can only generate and mail a check to a vendor once the requesting employee has submitted an invoice approved for payment to the accounts payable team. Both parties must serve one another to produce the intended outcome.

Periodic 360 employee evaluations which overlay cross-functional reciprocal service relationships throughout an organization offer tremendous insights into bettering internal efficiencies. Internal customer service is, after all, the organization's lifeblood. Manufacturing and overhead employees who assist one another should evaluate their respective service levels to improve their understanding of mutual needs, and thus continually optimize the cost associated with their service value. Poor evaluations will uncover payroll costs that need to be optimized or eliminated.

Overhead cost allocations should never be a mystery, nor should these costs become unmanageable. Through good communication, negotiation, planning, and evaluation, these costs can be successfully managed and optimized.

Steve Norman , principal consultant of Optimize Overhead, has over 25 years of consulting, overhead and operations leadership experience, successfully implementing numerous multimillion-dollar cost optimization solutions. His unique approach to robotic process automation governance was featured by Gartner. 

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