Someone Has to Pay for the Legal Department and Nobody Volunteers
Corporate overhead is real spending that no single business unit chose to incur. How it gets allocated determines which units look profitable and which look like they should be shut.
The Cost That Belongs to Everyone
A company has a legal department, a finance function, an IT organisation, a chief executive and a building. None of these belongs to a single product line. All of them cost money. To report profit by business unit, that spending has to be pushed down somehow, and the mechanism is overhead allocation.
The word allocation is doing a lot of work. There is no fact of the matter about how much of the general counsel salary belongs to the industrial division. The allocation is a convention, chosen by the finance team, and different conventions produce materially different answers.
The Common Bases
Allocations run on a driver, some measurable quantity assumed to track how much of the shared resource a unit consumes.
| Driver | Argument for it | Failure mode |
|---|---|---|
| Revenue | Simple, always available | Punishes high revenue low margin units |
| Headcount | Tracks HR and IT reasonably | Unrelated to legal or treasury effort |
| Operating profit | Charges those who can pay | Penalises success directly |
| Direct cost | Scales with unit size | Rewards outsourcing to shrink the base |
Revenue is the most widely used because it is the least arguable to measure. It is also the one most likely to mislead. A distribution business with thin margins and large revenue absorbs a large overhead charge while consuming very little head office attention.
Allocating overhead on revenue quietly taxes volume, and volume businesses are exactly the ones whose margins cannot absorb it.
The Death Spiral
The most damaging thing a bad allocation does is trigger a sequence that looks like disciplined portfolio management and is actually self harm.
A unit receives a large overhead charge. After the charge it reports a loss. Management concludes the unit destroys value and closes it. The overhead it was carrying does not disappear, because the legal department and the head office building still exist. That cost is now redistributed to the remaining units, one of which now reports a loss. The process repeats.
This is a real pattern with a name in management accounting, and it happens because the allocation was treated as a cost that would go away with the unit. Almost none of it does.
Allocated Cost Versus Avoidable Cost
The distinction that prevents the spiral is between allocated and avoidable cost. Avoidable cost is spending that genuinely stops if the unit stops. Allocated cost is spending that continues regardless and has merely been assigned.
For any keep or close decision, only avoidable cost is relevant. A unit generating 10 million of contribution above its avoidable costs is worth keeping even if an allocation shows it losing money, because closing it makes the company 10 million worse off.
The reported figure and the decision figure are different numbers, and a finance team that cannot produce both will make bad calls with confidence.
Activity Based Costing and Why It Is Rare
The rigorous answer is activity based costing, which traces overhead through the specific activities that consume it. Rather than spreading legal costs on revenue, it counts contracts reviewed, disputes handled and filings made, then charges units by usage.
It gives far better answers. It is also expensive to build and maintain, requires people to track their time against activities, and generates its own arguments about activity definitions. Many companies implement it, discover the maintenance burden, and quietly revert to a revenue driver.
A workable middle path is to allocate only the overhead that has a defensible driver and to leave the genuinely common costs, the chief executive and the board, in an unallocated corporate line that no unit is charged for and no unit argues about.
What Good Practice Looks Like
Three habits separate a useful system from a political one. Report divisional results both before and after allocation, so managers can see what they control. Use avoidable cost, not allocated cost, for any structural decision. And hold the allocation method stable across years, because changing the driver reshuffles apparent profitability without anything real having changed.
The Bottom Line
Overhead allocation looks like an accounting formality and functions as a strategic input. The method chosen determines which units appear profitable, which get investment and which get closed. The single most useful discipline is to keep allocated cost out of decisions that only avoidable cost should drive, because the alternative is closing a business that was contributing and finding the costs still there afterwards.