The overhead allocation problem.
Spreading overhead across products and customers by a single, volume-based rate, the peanut-butter approach, makes everything look average. It over-costs the simple, high-volume lines and under-costs the complex, low-volume ones, so the numbers that guide pricing and mix decisions are quietly wrong even though the accounts balance. Here is why it happens and what to do instead.
One rate, spread evenly
Overhead is divided by a single driver, units, labour hours, sales, and smeared across everything. Simple and complex products get the same thin layer, so the complex ones look cheaper than they are and the simple ones look dearer.
Cost follows the work
Overhead is traced to the activities that consume it, then to the products and customers that use those activities. Cost lands where it is actually caused, so the picture reflects reality rather than an average.
Why an average lies
Averaging is comfortable because it feels fair and is easy to defend, but it assumes every product and customer consumes the operation in proportion to its volume or revenue. They do not. A low-volume product with fiddly setup, special handling and frequent small runs consumes far more activity per unit than a high-volume staple, yet a single rate gives them the same overhead load. The result is a systematic bias: complexity is subsidised, simplicity is penalised. Price on those numbers and you discount your best products, chase your worst, and never understand why margin keeps slipping.
ONE P&L, OPENED INTO THE LAYERS THAT GET MANAGED
Illustrative. Better allocation does not change total cost; it changes where the cost lands. Opening the P&L into managed layers is what turns an average back into a decision.
Allocation never changes the total. It only changes the truth about who earned the profit and who spent it.
That is why this is not an accounting nicety. The total overhead is fixed, but how it is attributed decides which products and customers look profitable, and therefore which ones you grow, price up, or walk away from. Get the allocation right and the same data set tells a different, truer story, one you can actually act on.
Common questions
- What is the overhead allocation problem?
- It is the distortion that happens when indirect cost is spread across products or customers by a single, volume-based rate. Because the rate ignores how differently each product or customer consumes the operation, it over-costs the simple, high-volume lines and under-costs the complex, low-volume ones. The accounts still balance, but the per-product and per-customer numbers are misleading.
- What is peanut-butter costing?
- It is a nickname for spreading overhead thinly and evenly across everything, like peanut butter on bread. It feels fair and is easy to run, but it hides the truth: complex, fiddly products and demanding customers get the same thin layer as simple ones, so they look cheaper to serve than they are.
- How does activity-based costing solve it?
- Instead of one rate, activity-based costing traces overhead to the activities that consume it, then to the products and customers that use those activities. Time-Driven Activity-Based Costing does this efficiently by costing the time each activity takes. Cost lands where it is actually caused, so the simple stops subsidising the complex.
- Does fixing allocation change total cost?
- No. The total overhead is the same; better allocation only changes how it is distributed across products and customers. But that redistribution is exactly what matters for pricing, mix and customer decisions, because it reveals which lines truly make money and which only appeared to.
Sources
Canonical works behind this method. Each opens in a new tab.
- PaperThe Hidden FactoryMiller, J. G. & Vollmann, T. E. (1985). Harvard Business Review 63(5).Argues transaction volume, not output volume, drives most overhead.
- PaperMeasure Costs Right: Make the Right DecisionsCooper, R. & Kaplan, R. S. (1988). Harvard Business Review 66(5).Seminal argument that averaged overhead distorts true product and customer cost.
- BookRelevance Lost: The Rise and Fall of Management AccountingJohnson, H. T. & Kaplan, R. S. (1987). Harvard Business School Press.Foundational critique of how conventional accounting lost decision relevance.
- PaperProfit Priorities from Activity-Based CostingCooper, R. & Kaplan, R. S. (1991). Harvard Business Review 69(3).Shows how ABC reveals unprofitable customers and products hidden by averaging.
- PaperActivity-Based Systems: Measuring the Costs of Resource UsageKaplan, R. S. & Cooper, R. (1992). Accounting Horizons 6(3).Distinguishes resource supplied from resource used, quantifying unused capacity.
Is an average hiding your real margins?
The Profit Check shows whether overhead allocation is distorting your product and customer profitability, in 12 to 15 minutes.
- Duration
- 12 to 15 minutes
- You receive
- Score, 7 dimensions, sector benchmark
- Price
- Free, no email needed
Proof
A distributor in New Zealand. €1.335M of cost-to-serve made visible, then halved, and 830 loss-making customers brought down to 295.
Read the case study →Who you would be talking to
Miguel Guimarães, Founding Partner
Cost and profitability practitioner for 25+ years. Lectured alongside Professor Robert S. Kaplan at the CFO conference in Amsterdam (2009).
Call +351 910 313 731
