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Cost Allocations and the Financial Close Cycle

Philip Boken, Gary Callaghan, Eric Williams, Protiviti
Additional Contacts:
Paul Calamita, Jared Docter, Carl Waller, Protiviti

Source: Protiviti's KnowledgeLeader

As the economy moves toward recovery, businesses continue to be under pressure to plan for and achieve profitability goals. Accordingly, companies that have traditionally directed their energies toward top-line growth have increased their focus on cost. While cost management is often an operations-driven responsibility, finance is playing a growing role in supporting the capture and analysis of the associated data.

With the renewed focus on cost, organizations are refreshing their awareness of the impact of indirect costs on both margin and the bottom line. Consequently, they are developing a better understanding of the processes that support the capture, application and reporting of their indirect cost allocations. Experience shows that an effective allocation solution creates the foundation necessary to both identify and drive out inefficiencies, resulting in better margins, an improved bottom line and increased cash flow. In many cases, though, the more sophisticated the allocation methodology, the greater the downstream impact on financial reporting processes. Efficiency of the financial close cycle is at risk of being compromised when striving to achieve effective indirect cost-allocation reporting.

In many cases, the allocation of indirect costs to business units, functional areas or products can be overly complex, time-consuming and inconsistently applied, limiting the value the process provides to the organization. This shortfall in value can come about for a variety of reasons:

  1. Allocation strategies for indirect costs are developed without input from key process stakeholders.
  2. Allocation strategies are understood, but are out-of-date and/or not reflective of the current business environment.
  3. Heavy reliance on manual allocation procedures and work¬-arounds causes bottlenecks, re-work and delays during critical times (e.g., during the financial close cycle).
  4. Technology is used ineffectively.

Ultimately, flaws in the allocation process can lead to irrelevant, inaccurate, and/or untimely information about indirect costs. When defining and implementing allocation strategies, leading organizations are taking the time to consider the entire allocations process, including the impact of the capture, analysis and reporting of allocation information during the close cycle.  By striking a balance between reporting requirements and efficiency, operations managers and finance can identify opportunities for improvement, while not placing an additional burden on the close cycle.

Finance and IT personnel are typically responsible for operationalizing and administering the allocations process, often operating separately from other relevant process owners (e.g., business analysts, budget directors, product managers, and business unit [BU] leaders). If the methodology does not fully consider the broad business drivers, process dependencies and impacts of the allocation process, the organization will likely continue to struggle to appropriately interpret charges to its cost centers. This disconnect can impede the ability of the organization to forecast key metrics accurately and manage budget fluctuations, and can increase the risk of poor decision making by relying on incomplete, incorrect or faulty data.

  1. Inconsistent Application of Costs – A lack of standardization in determining cost pools and drivers sets the stage for inconsis¬tent application of allocations among BUs or functional areas. Process owners may frequently find themselves challenging the validity of certain allocations, and finance is continually placed in the position of having to defend the rationale for how allocations have been applied.
  2. Impact on Budgeting/Forecasting – Finance organizations are often constrained in providing timely and reliable forecast data and guidance to relevant process owners. Process owners need to understand the calculations and inputs that drive changes within their forecast, and they need clarity on how those estimates compare to previous periods. In addition, the budgeting and forecasting processes need to be consistent with the methods employed to allocate indirect costs to the individual businesses. By developing and retaining a deep understanding of the flow of actual costs and ensuring consistent application of the methodologies, process owners can simplify the integration of actual costs into their forecast analysis.
  3. Irrelevant Information – The allocation process needs to provide relevant information to the process owners in order to help drive desired behaviors. Key performance indicators should include indirect cost metrics generated by the allocation process. Otherwise, resource-consuming allocations may provide interesting but ultimately irrelevant information.
  4. Post-Allocation Support – Finance organizations may not be properly structured to provide support to the process owners relative to the shared indirect costs. As costs fluctuate and/or the dynamics of the enterprise change, finance should be in a position to provide the analytical support needed to comprehend how changes to the business affect indirect cost allocations.

Common Challenges
At its core, the challenge is how to allocate indirect costs accurately in an efficient and transparent manner. It is important to remember that the process neither begins nor ends with the application of allocations during the financial close. Our experience indicates that allocation-related issues materialize both (a) early in the process – as the BUs pull together their profit forecast – and (b) in later stages – when actual results are compared to budget and the allocation methodology comes under scrutiny.

Typical challenges include:

  1. Precision – Finance organizations need to ensure that cost allocations are processed accurately. Off-line calculations present the greatest concern due to the risk of human/spreadsheet error and lack of transparency. Even automated processes present risks to accuracy if not administered appropriately.
  2. Lack of Corporate Direction – Accounting and IT departments need to have senior-level sponsorship relative to the allocation of costs. Organizations that lack these frameworks can spend significant time arbitrating internal debates over specific allocations. Such debates are often left unresolved, and can resurface on a regular basis, further compromising efficiency.
  3. Lack of Training and Support – Training for allocation solutions (both process and technology) often does not receive appropriate priority. As a result, process owners can be ill-equipped to interpret data and typically require substantial support from the often resource-constrained finance and IT departments to maintain the process.
  4. Timing – The charging of indirect costs across the organization can be time-consuming, even where automated solutions have been deployed. In many situations, the allocation of indirect costs occurs late in the close cycle. Since allocations can be a multi-step effort of cascading dependencies, by the time the final reports with allocations are included, it may be too late for the process owners to react.
  5. Multiple Allocations Solutions – The existence of multiple solutions, within and across technologies (e.g., spread¬sheets, ERP systems, EPM systems) can present further complexities and inefficiencies. This can cause additional confusion for process owners in understanding the allocation calculations.

The Role of Technology
We often find that companies with appropriate supporting technologies either are not utilizing them for their intended purpose, or have not properly implemented them. Many still rely on spreadsheets or other “off-line computing tools” to administer at least a portion of the allocations process, further increasing the risk of error and internal control failure.

Current technologies offer many benefits that can support and help to sustain an efficient and effective cost allocation process. Many financial systems have integrated functionality that allows allocations to be performed in tighter time frames, with greater and verifiable accuracy.

Appropriate application of technology can increase the repeatability and predictability of the cost allocations process. Most notably, allocation drivers can be centrally maintained, providing a more effective support mechanism for analysis of actual results.

Key Indicators of Need
Developing an awareness of the challenges specific to an organization’s allocations process is an important first step in designing, implementing and sustaining meaningful improvements. The following
symptoms may be indicative of improvement opportunities:

  1. Lack of a formal allocation strategy/policy (or lack of adherence to existing policies)
  2. Lack of alignment with relevant process owners pertaining to the accuracy and validity of cost allocations
  3. Lack of horizontal ownership for allocation processes and technology
  4. Inconsistent allocation methodologies
  5. Multiple allocations performed on multiple systems and spreadsheets
  6. Disparate, aging, non-scalable systems

Developing an Allocations Strategy
Organizations benefit by taking the time to plan how best to implement an indirect cost allocation methodology. Various considerations should be made when doing so:

  1. “How Much of What, Why and When?” – These are questions that can and should be answered by an organization’s allocations strategy. This strategy should encompass the allocation policy, the appropriate allocation drivers and a periodic review of the allocation solution(s) and their relevance.
  2. Allocations Policies – Successful organizations invest time in developing policies that both guide and align activities across businesses and functions on the expectations for financial stewardship. A properly designed policy should set the tone for the entire organization regarding the approach and methodology for the cost allocations process to:
    1. Provide proper guidance on which costs are to be allocated and when
    2. Allow for consistent application of cost pools and drivers for each allocation
    3. Establish linkages to the budgeting and forecasting cycle
    4. Identify the critical systems where cost allocations occur
    5. Identify the key functional support staff and ownership of the process
    6. Provide for communication mechanisms among finance, IT and process owners to avoid misunderstandings
    7. Drive intended results and behaviors by developing and implementing KPIs that incorporate allocation results through individual and team performance metrics
  3. Appropriate and Logical Allocation Basis – The development of allocation strategies requires up-front analysis of the drivers and cost pools for each indirect cost. From this, a basis for allocating the indirect costs can be derived. It should be acknowledged that one cost is not the same as another cost. Therefore, the basis for allocation can and will vary from one cost to the next. The al-location basis should be determined using logical relationships between cost pools and drivers, while at the same time balancing the degree of complexity required to perform the allocation.
  4. Ongoing Allocations Maintenance – Periodically, cost allocations procedures and design should be challenged, identifying opportunities to add value to the business and improve the efficiency and effectiveness of the solution. Review strategies to ensure that the cost pools allocated are relevant and holistic.

Getting Started

  1. To get started, organizations can begin with a current-state diagnosis, developing both the case for change and a road-map for improvement:
  2. A review of corporate strategy to determine if appropriate indirect cost guidance and policies have been established
    Identification of key performance metrics for indirect costs
  3. Development of a comprehensive allocation strategy for indirect costs to ensure that accurate and relevant key performance metrics are produced
  4. Assessment of the current state of the allocation landscape (e.g., types of allocations, departments involved, and method¬ologies for cost pools and drivers)
  5. Review of the budgeting and forecasting procedures to identify gaps between the existing process and future indirect cost allocation requirements
  6. Evaluation of current technological capabilities to identify options for optimizing existing tools vs. implementing new applications

To address the increased need for timely information regarding profitability and performance, organizations are increasingly relying on finance to provide value-added insights beyond the traditional financial close.

When addressing the most common issues associated with the cost allocation process, organizations can realize tangible impact on the efficiency, timeliness and accuracy of the related processes. By working together with the business managers, finance can play a key role in helping the organization ensure that the most relevant cost data is captured and compiled so that the resulting information is adding value to the decision-making process.

Focusing on a combination of people, process and systems levers, allows organizations to drive greater transparency and consistency into the information they use for decision making and ultimately realize greater value from their reporting cycle.

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