Summary by Manuel Pagan
Master of Accountancy Program
University of South Florida, Summer 2002

Cost Allocation Main Page | Responsibility Accounting Main Page

This fable was written to demonstrate the difficulties involved in allocating overhead to divisional units. The fable also shows the arbitrary nature of overhead allocation, as well as its lack of importance in overall profitability.

The fable begins at the door of a supermarket chain. An accountant (name is not given) meets an old acquaintance, Hal, who is a banker and trustee of an estate. The estate that Hal is responsible for consist of a five-store grocery chain. The recently deceased owner of the grocery chain bequeathed the chain to his wife, however, the grocery chain isn’t making a profit and consequently the wife is not receiving any income. Hal wants the accountant to attend a meeting with all the store managers and help evaluate the stores. The accountant reluctantly agrees to help.

The grocery chain consists of five stores spread around five nearby cities. These five stores share a central warehouse, as well as a general office. Each store on an individual basis makes a profit:

Individual stores: Sales – COGS = Gross Profit – Store Expense = Profit

However, once the warehouse and general office overhead is subtracted the company as a whole just breaks even. All that is earned at the local level is eaten up by the warehouse and general office expenses:

Whole company: Sales – COGS = Gross Profit – Store Expenses – Overhead = Zero, 
as indicated in the table below adapted from Greer's Exhibit A.

The meeting takes place in the general office of the grocery chain. Attending the meeting are Hal, the accountant, the five store managers, and the treasurer. Hal’s main preoccupation is finding the most accurate method of allocating the overhead so that he can identify the problem store(s) and "fix" them. Each manager, however, has their own interpretation of how the shared overhead should be allocated among the stores. Consequently, each store manager’s interpretation results in the most profit for their store, little profit for one or two other stores, and huge losses for the remaining stores. Below is each manager’s overhead allocation, followed by his or her reasoning for said allocation.

Ash argues the all the stores benefit equally by having a central warehouse and office. Because all the stores benefit equally, all the stores should share the same burden. Therefore, all the stores should be allocated an equal share of the overhead.

Budd agrees that all the stores benefit equally, however he believes differences in store size should be recognized in spreading overhead costs around. Reasons being the larger stores place a greater burden on the warehouse and office, whereas the smaller stores place less of a burden. As a result, the stores should be allocated overhead on the basis of sales volume.

Clay argues that he is being cheated. Clay purchased a property with excellent growth prospects and a cheap rent. But he is charged a theoretical rent based on appraised value rather than actual rent (which for Clay is much lower). He believes the overhead should be adjusted to reflect this.

Dan believes the individual stores should be charged with central facility expenses in proportion to their individual usage of the facilities. He’s fine with sharing equally in general office expenses, but he wants warehouse costs to be allocated based on number of deliveries made.

Eck, who was the most recent store added to the chain, believes that overhead should be allocated based on the incremental increase in overhead for each store added.

After listening to the store manager’s argue their points, Hal turned to the accountant and ask him for his advice. The accountant said, "compute each store’s percentage of total store profit, and then distribute the overhead on those percentages." This is akin to an income tax; your overhead is a result of your ability to pay. One of the store managers blurted the obvious fact that no store would show a profit under this method. The accountant gleefully agreed.

"All allocations discussed at the meeting have some merit," said the accountant. "They all bring out factors that are important, but if you publish the results for individual stores, calculated on any basis, someone is bound to get the wrong impression and come to a wrong conclusion." Hal then asks, "how do I make money in a chain of stores. How do I find which store is profitable and which is not?" The accountant presented the following thoughts:

· Making money has very little to do with allocating overhead costs. As is
   plainly obvious in the meeting, any allocation technique is inherently
   arbitrary.

· Each allocation method serves some purpose, but not all purposes.

· Trying to evaluate a company on a unit basis won’t lead to a helpful
   conclusion. Due to synergies, the whole can’t be evaluated solely by
   looking at the parts.

· He draws an analogy to Chop Suey. You don’t derive pleasure from the
   individual ingredients: the tidbits of pork, the bean sprouts, the water
   chestnuts, the soy sauce, etc. You possibly may not even enjoy each
   item individually. Only as a whole, when mixed by a good chef, do you
   get a tasty meal. Furthermore, evaluating each ingredient independent of
   one another would lead you to results that are not consistent with the final
   product.

· You shouldn’t let the evaluation of the mixture lead you to a
    misevaluation of the individual elements.

· The accountant further expounds that any allocation will have its pros
   and cons. Rating and evaluating performance based on an arbitrary
   allocation will result in supporters and vocal dissenters. It will polarize the
   individual units and compromise the whole enterprise.