The impact of COVID-19 on measuring profitability
A fall in global demand has greatly altered the expected gross margin of an organisations performance units (i.e. business divisions) and consequently triggered a need to re-evaluate their cost allocation approach when measuring profitability across all products and services in the portfolio.
We anticipate that many global corporates will take measures to revise their cost allocation methods in the coming year. We observe however that more often than not these efforts are ineffective and can have the opposite effect to what was intended, making it harder to appraise performance.
In addition, as we look beyond the COVID-19 pandemic, improving cost allocation helps to ‘pull back the curtain’ on utilisation of shared services, helping to achieve savings and build a more agile service cost structure going forward.
Why are cost allocations so contentious?
Cost allocation is a topic that divides rather than unites opinion across large corporates. Support functions (IT, Finance, Risk & Compliance, HR etc.) are at risk of criticism from Business Units around the amount charged and their choice of allocation method.
This can be contentious because:
- Allocation methods are often subjective, based on a ‘best guess’ which can be challenged
- Business units are often limited in how they can influence large parts of their cost base (costs are semi-fixed or fixed) – this is frustrating for them
- There is a need to strike a balance between the accuracy of allocation calculation and the simplicity to help in understanding.
What has been the impact of COVID-19 on cost allocation?
Some corporates have thrived during the pandemic, but most have not. The drop in revenues and erosion of margins have led many businesses to embark on severe cost cutting measures. Corporates typically target prioritise business units, and move onto cost reduction activities on support functions later. This is because the support functions’ costs are not so easily scalable. This results in situations where the support functions become too big and are over supplying the business units.
We observe that frustration and disputes raised by business units around unfair cost allocation are a symptomatic pain point and an early indicator of oversized or inefficient support functions.
What will happen next?
When business units complain, support functions will look to undertake two potential courses of action:
- Re-evaluate and justify existing cost allocations. This can trigger a project around simplifying the existing allocations and/or providing the business units with greater detail behind allocations. These attempts only serve to frustrate the business and deliver a ‘least worse’ outcome, as percentage allocations are altered, resulting in winners and losers.
- Engage in tactical cost reduction projects. These deliver short-term savings but fail to address required structural changes. Costs then rise back up in subsequent periods and there is no sustained impact.
Cost transparency and cost reduction at the same time
When working with clients we consistently observe that cost allocations become more complex over time, often exacerbated by a long list of services not fully understood by the business units. A ‘spaghetti network’ of allocation rules and routines evolves, often without suitable central governance, and becomes unintelligible.
There are often no guiderails that actively prevent complexity. Simplification of allocations and rationalisation of services are a necessary foundation in order to convince all stakeholder groups that allocations are fair and transparent.
However, the simplification of allocation and cost transparency programmes should be executed alongside an integrated cost reduction strategy, as there will be significant interdependencies between the programmes. Forming a medium- to long-term cost reduction strategy will require the service functions and business units committing to engage with each other in order to understand the future demand for shared services.
How can Deloitte help?
We have worked with some of the world’s biggest and most complex organisations to design and implement cost allocation environments that achieve greater transparency and simplicity, and to assist support functions to transform their cost base and implement cost saving initiatives.
We understand how politically charged cost allocations can be and how important it is for business units to report performance. Furthermore, there are wider transfer pricing and tax considerations that need to be considered. Our solutions cover the end-to-end operating model and include identifying the right systems, establishing governance and controls, defining roles and responsibilities, and developing the reporting environments.
Our extensive experience with support functions mean we are ideally placed to assist with identifying cost reductions measures and we work with Functions Leaders to form comprehensive cost reduction strategies.
- ‘Reducing the size of the pie’ - transforming the cost base of IT, Finance, Risk and all other support functions
- Creating greater insight around the underlying drivers of cost and awareness around what can be influenced going forward
- Substantially reducing the management time and effort that cost allocation unnecessarily consumes
- Automating the allocation process and preventing further complexity