Allocation of Overheads is a Bad Idea

The team here at RMC has been busy holding Ranching for Profit Schools in several locations. At these schools, a good part of classroom time is spent teaching and applying the Ranching for Profit Economic Model. This is our trademark way of doing an economic analysis of the ranching business, but the fundamentals apply to any business, whether ranching or not. The RFP Economic Model is built on the differentiation of overhead costs, direct costs, and gross product. Overhead costs are the costs that tend not to change as the units of production increase. For example, owner salary, depreciation on your pickup and tractor, land tax, insurance, etc.  If you are running 300 cows and go up to 350 your pickup deprecation won’t change and your ranch insurance policy won’t go up. In most cases 60-80% of the costs to your ranch are overheads.  

For some reason, many of us are tempted to allocate these overheads to the production unit. In my former role with extension I used to teach the economics this way. I’ve since seen the light and understand the dangers of allocating overheads. Allocation of overheads can lead to making the wrong decisions about which enterprises to expand, which to eliminate and where the focus should be for improving the business.

Let’s say we run 300 cows and have total ranch overheads of $200,000. If we allocate, we would say we have $666 of overhead costs per cow. If we have another $150 of direct costs per cow, then our total cow costs would be $816. If our gross product is $800 per cow, then we would assume we made a loss of $16 per cow. This might lead us to believe our cows are not profitable and we should find something else to do. If we look at it correctly, each cow produces a gross product of $800, with direct costs of $150, then each cow produces a gross margin of $650. This is the money left-over to pay overheads and for profit. Through benchmarking we would realize this is a strong gross margin and the focus should be to grow this enterprise, not eliminate it. Also through benchmarking, the numbers would point us to focusing on our overheads, not cow margins. The strategies to reduce overheads are totally different from the strategies to improve gross margin on the cow. 

There is an exception to this. If an overhead cost would entirely go away if we eliminated that division, then we can assign a bucket of overhead costs to that division. We call this bucket divisional overheads. An example would be the repairs and depreciation on the swather and baler for a farming division, hay enterprise on a ranch. Usually, the divisional overheads represent a fairly small fraction of the total overheads on a ranch. For RFP alumni we have videos and detailed explanations that go through this in depth as part of the newly released RFP Online. In RFP Online we go deeper than we do in the school, further explaining the definition of a division, how to set up your business in divisions and enterprises, and how to assign divisional overheads.

Don’t fall into the temptation to allocate overheads to the production unit. Doing so can lead you to make bad decisions. We’ve been teaching ranchers how to look at the economics of their business for over 35 years. Allocation of overheads is a bad idea. Don’t do it!