Reallocation and centralization of costs: perfect is the enemy of the good

In industry, as in other sectors of activity, the centralization of organizations is in constant development. The centralization approach has many advantages: promoting exchange, synergy, and standardization of processes. This tendency is often accompanied by a necessary reallocation of costs within the organization.
 
Fervent followers of centralization, such as VW or Exxon, must not neglect the limits of such a move. Centralization generates a risk of competition from more agile actors which take a decentralized approach. Obviously, some activities such as accounting, purchasing, and IT are particularly good candidates for centralization, or for a mutualization among multiple business units. Such an option is a means to harmonize practices like project planning or supply chain management, by establishing a unified decision line.
 
For companies that not only decide to centralize costs, but also redistribute costs internally, the approach should not be viewed simply as a response to management imperatives. Much more strategic, cost centralization and re-allocation guide structuring decisions for the company including:

  • Empowering operational teams to limit cost drift. For example, in case of a production rate decrease at a factory, of one or several products, the factories should be engaged to participate in the cost ownership by paying a fee for surface occupancy. This is a way to optimize space utilization by the end user.
  • Calculating the “intrinsic profitability” of a service based on its full costs – valuable information that eases decision-making in terms of make-or-buy and price positioning.
  • Identifying the margin of current programs and, where appropriate, determining potential losses to take accounting, financial or operational corrective actions (Loss Making Contract).

 
In order to decide on cost allocation, it is necessary to first consider the nature of costs. Costs inherent to corporate activities (such as legal, tax, treasury, and communications) are more difficult to allocate objectively and therefore allow greater leeway in consideration of where to allocate. On the other hand, shared service costs (including IT, real estate, HR, etc.) are more readily quantifiable per consumer and thus easier to allocate, although this limits flexibility in allocation.
 
After categorization of costs is considered, the next decision point is to select either a top-down or bottom-up allocation method. The first method is a centralized allocation approach (top-down) according to typology (e.g. infrastructure, HR, IT, intellectual services, etc.). The rules applied to it are simple, but often criticized as being far away from the reality of a given business unit’s activity. The second method favors a detailed (bottom-up) allocation according to the end user. The accuracy of the distribution requires a significant expenditure of energy and time which is not always proportionate to the results obtained. This is especially true when indirect costs are not considered in the management of the business unit’s costs, which is often the case (for example with corporate costs such as legal or communications).
 
Regardless of the method used, it is necessary to respect some basic rules:

  • A fresh start can allow for simplification of implementation. Many large companies have created complex models which are the result of a combination of approaches used in the previous years.
  • Favor a less accurate model which is updated regularly over a detailed method which is fixed for a long period of time without review.
  • The principle that “the one who consumes must bear the cost” is a mandatory motto to empower operational teams to self-manage costs.
  • The end users must be informed about their allocated costs, as well as the levers on those costs, in order to adapt them and cope with contextual evolution.
  • The allocation rules (and updates to those rules) must be clearly shared among operational teams to increase people acceptation.
  • Allocation mechanisms should be tailored to the business. Keep in mind that key differences exist between industries. Unlike the aeronautical industry for example, e-commerce may have an interest in making regular updates to its allocation mechanisms even if they are less accurate.

 
Finally, regardless of the choices that are made (precision of cost allocation, frequency of updates) it is necessary to be aware of the inherent limitations in the allocation model applied and quantify the margins of error to inform decision making.
 
About the Authors:
Olivier Paget is a partner in CYLAD’s Paris office; Arnaud Guerin is a Principal in CYLAD’s Paris office