Ask any CFO how their business allocates overhead, and you’ll likely get a confident answer. Ask how accurate that allocation actually is, and the conversation gets uncomfortable fast. The truth is that most finance teams are doing overhead allocation wrong — not because they lack skill, but because they’re using a method designed for a different era of business.
The Traditional Approach and Why It Fails
The most common approach to overhead allocation is the "spray and pray" method: take a pool of indirect costs — rent, utilities, management salaries, IT — and spread them across products, services, or clients using a single driver. Revenue percentage. Headcount. Direct labour hours. The numbers balance. The P&L looks clean. And yet, the margin data is almost certainly wrong.
The problem is that indirect costs don’t behave like a single uniform pool. A product that requires intensive technical support and custom logistics consumes far more overhead than a standard product shipped in bulk — even if both have the same revenue contribution. When you allocate overhead by revenue percentage, the standard product subsidises the complex one. You think your margin on the complex product is healthy. It isn’t.
The Four Most Common Mistakes
In our work with companies across manufacturing, professional services, healthcare, and distribution, we see the same allocation errors repeated constantly. The first is using a single cost driver for all overhead. This ignores the fact that different types of overhead are driven by completely different activities — space costs are driven by physical footprint, procurement costs by number of purchase orders, IT support by number of users or incidents.
The second mistake is treating support departments as cost centres with no connection to outputs. When HR, Finance, or IT costs are dumped into a general overhead pool, their true consumption by different business units becomes invisible. The third is failing to separate capacity costs from activity costs — paying for idle capacity and then charging it to products as if it were productive use. The fourth is updating allocations only once a year, or less, while the business changes continuously.
What Activity-Based Costing Actually Fixes
Activity-Based Costing — and its more scalable successor, Time-Driven ABC — solves these problems by tracing overhead to the activities that actually cause it, then tracing those activities to the products, clients, or services that consume them. Instead of "spread rent across revenue," you ask: what does each department actually do, how long does each activity take, and which products or clients demand those activities?
The result is a radically more accurate picture of profitability. Companies that implement TDABC typically find that 20-30% of their product or client portfolio is destroying value — not because of bad pricing, but because of misallocated overhead that was masking the true cost-to-serve. Equally important, they discover which products and clients are genuinely profitable, often ones they had been undervaluing.
The Finance Team’s Role in Getting This Right
The shift from traditional overhead allocation to activity-based methods isn’t just a systems change — it’s a mindset change for the finance team. It requires finance to stop thinking of indirect costs as a burden to be distributed fairly and start thinking of them as economic resources consumed in specific ways by specific activities.
This means working closely with operations to understand what activities actually occur, what drives their consumption, and how to measure capacity. It means challenging assumptions that have been in place for years. It means accepting that a cleaner, simpler allocation method is not automatically a better one.
A Practical Starting Point
You don’t have to overhaul your entire costing system overnight. A useful first step is to identify your three largest overhead pools and ask: what is the single best driver for each? If you’re using the same driver for all three, there’s almost certainly a more accurate approach available. Map the activities within each pool, estimate the time or resource consumed per unit of activity, and see how the numbers change when you apply those drivers instead.
What you’ll find, in almost every case, is that your current margin picture shifts — sometimes dramatically. Some products become more profitable. Others reveal losses that weren’t visible before. That’s not bad news. That’s the information you need to make better decisions.
If you want to understand how your business currently handles overhead allocation — and whether your cost model is working for or against you — our free Profitability Health Check gives you a clear diagnosis across six key dimensions, including Cost Allocation.