Consider the following conversation between a self-styled cost allocation expert and Joe, the manager of a diner.
Expert: 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’s not going to cost! It’s going to be a profit. Sure, I had to pay $100 for a fancy rack to hold the bags, but the peanuts cost 24 cents a bag, and I sell ’em for 40 cents. Suppose I sell 50 bags a week to start. It’ll take 12 weeks to cover the cost of the rack. After that I have a clear profit of 16 cents a bag. The more I sell, the more I make.
Expert: 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?
Expert: 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 proportion of your expenditures for rent, heat, light, equipment depreciation, decorating, salaries for your waitresses, cook. . . .
Joe: The cook? What’s he got to do with the peanuts? He doesn’t even know I have them.
Expert: 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 that the peanut operation should pay exactly $2,278 per year toward these general overhead costs.
Joe: The peanuts? $2,278 a year for overhead? Nuts! The peanuts salesman said I’d make money—put ’em on the end of the counter, he said, and get 16 cents a bag profit.
Expert [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: Nothing. No stool there, just a dead spot at the end.
Expert: The modern cost picture permits no dead spots. Your counter contains 60 square feet, and your counter business grosses $60,000 a year. Consequently, the square foot of space occupied by the peanut rack is worth $1,000 per year. Since you have taken that area away from general counter use, you must charge the value of the space to the occupant.
Joe [eagerly]: Look! I have a better idea. Why don’t I just throw the nuts out—put them in a trash can?
Expert: Can you afford it?
Joe: Sure. All I have is about 50 bags of peanuts—cost about 12 bucks—so I lose $100 on the rack, but I’m out of this nutty business and no more grief.
Expert [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 $2,278 of annual overhead to the rest of your operation. Joe—be realistic—can you afford to do that?
Joe [completely crushed]: It’s unbelievable! Last week I was making money. Now I’m in trouble—just because I believe 50 bags of peanuts a week is easy.
Expert [with raised eyebrow]: That is the object of modern cost studies, Joe—to dispel those false illusions.
What should Joe do?