I did not write this conversation and I have no idea who did. If someone recognises it as belonging to him, please let me know so that I can give full credit. If you read the conversation, keep in mind practices in your company. The story applies not only to ABC costing but to any sort of costing that allocates as described below. Standard costing, full absorption costing etc. all suffer from the problem behind the story. This link is to the source of my peanuts picture!
In discussing the costs incident to various types of operations, the analogy was drawn of the restaurant, which adds a rack of peanuts to the counter, intending to pick up a little additional profit in the usual course of business. However, the accuracy of the analogy is evident when one considers the actual problem faced by the Restaurateur
(Joe)as revealed by his Accountant-Efficiency Expert
(Eff. Ex.)
EFF. EX. Joe, you said you put in these peanuts because some people ask for them, but do you realize what this rack of peanuts is costing you?
JOE It ain't gonna cost. 'Sgonna be a profit. Sure, I pay $25 for a fancy rack to bags, but the peanuts cost 6 cents and I sell 'em for 10 cents. I sell 50 bags a week to start. It'll take 12-weeks to cover the cost of the rack. After that, I gotta clear profit of 4 cents a bag. The more I sell, the more I make.
EFF. EX. That is an antiquated and completely unrealistic approach, Joe. Fortunately, modern accounting procedures permit a more accurate picture which reveals the complexities involved.
JOE Huh?
EFF. EX. To be precise, those peanuts must be integrated into your entire operation and be allocated their appropriate share of business overhead. They must share a proportionate part of your expenditures for rent, heat, light, equipment depreciation, decorating, salaries for your waitresses, cook,...
JOE The cook? he gotta do wit' ? He don' even know I got'em!
EFF. EX. Look, Joe, the cook is in the kitchen, the kitchen prepares the food, the food is what brings people in here, and the people ask to buy peanuts. That's why you must charge a portion of the cook's wages, as well as a part of your own salary to peanut sales. This sheet contains a carefully calculated cost analysis which indicates the peanut operation should pay exactly $1,278 per year toward these general overhead costs.
JOE The peanuts? $1,278 a year for overhead? The nuts?
EFF. EX. It's really a little more than that. You also spend money each week to have the windows washed, to have the place swept out in the mornings, and to keep soap in the washroom. That raises the total to $1,313 per year.
JOE (Thoughtfully)But the peanut salesman said I'd make money -- put'em on the end of the counter, he said -- and get 4 cents a bag profit.
EFF. EX. (With a sniff)He's not an accountant. Do you actually know what the portion of the counter occupied by the peanut rack is worth to you?
JOE Ain't worth nothing - no stool there - just a dead spot at the end.
EFF. EX. The modern cost picture permits no dead spots. Your counter contains 60 square feet and your counter business grosses $15,000 a year. Consequently, the square foot of space occupied by the present rack is worth $250 a year. Since you have taken that area away from general counter use, you must the value of the space to the occupant.
JOE You mean I gotta add $250 a year more to the peanuts?
EFF. EX. Right. That raises their share of the general operating costs to a grand total of $1,563 per year. Now then, if you sell 50 bags of peanuts per week, these allocated costs will amount to 60 cents per bag.
JOE What?
EFF. EX. Obviously, to that must be added your purchase price of 6 cents per bag, which brings the total to 66 cents. So, you see, by selling peanuts at 10 cents per bag, you are losing 56 cents on every sale.
JOE Something's crazy.
EFF. EX. Not at all. Here are the figures. They prove your peanut operation cannot stand on its own feet.
JOE (Brightening)Suppose I sell peanuts - thousand bags a week 'stead a fifty?
EFF. EX. (Tolerantly)Joe, you don't understand the problem. If the volume of peanut sales increases, your operating costs will go up. You'll have to handle more bags, with more time, more depreciation, more everything. The basic principle of accounting is firm on that subject: "The Bigger the Operation, the More General Overhead Costs that Must be Allocated." No, increasing the volume of sales won't help.
JOE Okay, you're so smart, you tell me what I gotta do.
EFF. EX. (Condescendingly)Well -- you could first reduce the operating expenses.
JOE How?
EFF. EX. Move to a building with cheaper rent. Cut salaries. Wash the windows bi-weekly. Have the floor swept only on Thursday. Remove the soap from the washrooms. Decrease the square foot value of your counter. For example, if you can cut your expenses 50%, that will reduce the amount allocated to peanuts from $1,563 down to $781.50 per year, reducing the cost to 35 cents per bag.
JOE (Slowly) That's better.
EFF. EX. Much, much better. However, even then you would lose 26 cents per bag if you charge only 10 cents. Therefore, you must also raise your selling price. If you want a net profit of 4 cents per bag, you would have to charge 40 cents.
JOE (Flabbergasted) You mean after I cut operating costs 50%, I still gotta charge 40 cents for a 10-cent bag of peanuts? Nobody's that nuts about nuts. Who'd buy 'em?
EFF. EX. That's a secondary consideration. The point is at 40 cents, you'd be selling at a price based upon a true and proper evaluation of your then reduced costs.
JOE (Eagerly) Look! I got a better idea. Why don't I just throw the nuts 'em in a trash can?
EFF. EX. Can you afford it?
JOE Sure. All I got is about 50 bags of peanuts -- cost about three bucks -- so I lose $25 on the rack, but I'm outa this nutsy business and no more grief.
EFF. EX. (Shaking head) Joe, it isn't quite that simple. You are in the peanut business! The minute you throw those peanuts out, you are adding $1,563 of annual overhead to the rest of your operation. Joe, be realistic -- can you afford to do that?
JOE (Completely crushed) unbelievable! Last week, I was gonna make money. Now, I'm in a trouble -- because I think peanuts on a counter is a gonna bring me some extra profit -- because I believe 50 bags of peanuts a week is easy.
EFF. EX. (With raised eyebrow)That is the object of modern cost studies, Joe, to dispel false illusions