Is That Project Really in the Red? When "Proration" Kills Excellent Businesses

When a company hits hard times, a conversation like this starts somewhere.

"This project is in the red. We either need to cut staff or cut outsourcing—one or the other."

If you look at the profit and loss statement, it is indeed in the red. So, you cut. You reduce. But wait a moment.Is that deficit really attributable to that project? Today, I will talk about the pitfall of "proration," where many companies end up killing excellent businesses with their own hands.

Searching for "Management Accounting" online leads to a trap

When you think, "I want to see the profitability of each project," and search for "management accounting," it usually says: "Allocate company-wide expenses (head office rent, administrative department salaries, interest, etc.) to each project based on sales ratios or similar." This is called proration (allocation).

This itself is not wrong. Allocating all company-wide costs to each business without omission to grasp the overall picture is a correct task from a financial perspective.

However—if you judge whether to cut a project by looking at these "fully prorated figures," you will make a major mistake. Online articles usually only teach you "how to prorate." They don't teach you "in what situations you should use those figures." That is where the trap lies.

True management accounting changes its appearance based on "timing"

The most important thing about management accounting is actually this.The expenses that should be included change depending on "why you are looking at the numbers."

• When you want to get an overview of the entire company(normal times). → Prorate and include all expenses. This is useful for looking at the long term to see if "this project is contributing to the company in the end, even after bearing head office costs."This usage is correct.

• When you want to decide whether to continue or cut a project(emergency times). → Remove the proration.This is because indirect costs (rent, administrative departments, interest) do not disappear even if you cut the project. This is the point.

This is the crucial part. The figures for the same project change their appearance depending on "what you want to know." It is not that "proration is always correct," nor is it that "proration is always wrong."It is fine during normal times, but absolutely forbidden during emergencies. The tougher things get, the more you must not let your judgment be killed by prorated deficits.

Why should you not prorate during emergencies? Because it has the exact same structure as the "sunk costs" I wrote about previously regarding depreciation. You must not mix costs that won't disappear even if cut into your judgment. The only things that disappear when you cut a project are that project's direct costs. Rent, head office personnel expenses, and interest all remain. The remaining projects will just have to bear them more heavily.

Make decisions based on "contribution margin"

So, what do you use to decide whether to cut or continue? It is **contribution margin (and contribution margin ratio)**.

　Contribution Margin = Sales - Direct Costs of the Project

Look at this figure "before" subtracting indirect costs. This is "how much that project is contributing to the entire company." As a guideline, if the contribution margin ratio (contribution margin ÷ sales) is20%, it is excellent. Even at 10%, it is sustainable. Look at this ratio to decide whether to "expand it, improve the ratio, or if it's still no good, cut it."

There is one caution here.Profit margin and profit amount are separate issues. For example, if you spend money on advertising, sales might grow and the profit "amount" might increase. However, because direct costs like advertising expenses increase, the profit "margin" will decrease. Moreover, the effect of advertising cannot be understood without a long-term view. Therefore, "whether to look at the ratio or the amount," "whether to look at the short term or the long term"—this is where a manager's skill is tested, and where they struggle the most. Numbers cannot be explained by a single yardstick.

Point the arrow in the other direction—if it's 'in the red due to head office expenses,' suspect the head office.

And now, I will say what I most want to say in this article.

A certain project is earning properly with a contribution margin of 20%. Yet, when head office expenses (rent, administrative departments, executive compensation, interest) are allocated, it becomes a loss. At this point, many companies think: 'This project isn't covering head office expenses. Therefore, it's no good. Let's cut it.'

But the arrow might be pointing the wrong way.

The front line is producing a respectable contribution margin of 20%. What ate into that and turned it into a loss was expenses that the front line did not decide—the front line does not decide the number of administrative staff, the head office rent, whether to take out loans, executive compensation, or fees for professional services. If that is the case, shouldn't the question be directed not at the front line, but at the cost structure of the head office (management) that created those indirect costs?

For example, suppose a company with monthly sales of about 50 million yen has head office rent (including company housing, etc.) exceeding 2 million yen per month. Several percent of sales is rent. Is that an expense decided by the front line? Or is it an expense decided by management? It is not uncommon for the true identity of what made a front-line project look 'in the red' to actually be management-side costs.

It is easy to blame the front line for being 'in the red after allocation.' But if a margin is being produced and it's still in the red, the first thing to suspect is the head office's scale of operations. I previously wrote in a piece about employees that 'employees not moving is a design flaw on the management side for not creating the mechanism.' This is the accounting version of that. Before easily shifting the responsibility for a loss to the front line, management must look at their own cost structure in the mirror.

Summary: 3 things to take away today

1. Do not cut projects based on allocated figures. In management accounting, the expenses included change depending on 'what you are looking at it for.' Use allocation for an overview, but not for decision-making. Do not mix indirect costs (sunk costs) that won't disappear even if you cut the project into your decision-making.

2. Make decisions based on contribution margin (direct costs only). A 20% contribution margin is excellent, 10% is okay. Furthermore, if you view the project as an 'investment' and look at the number of years to recover it in cash, you are less likely to be deceived by apparent losses.

3. If a margin is being produced but it's in the red due to allocation—suspect the head office's cost structure, not the front line. It is not uncommon for the true identity of a loss to be the management's own scale of operations.

Allocation is a tool. It is useful for getting an overview of the whole, but if you bring it out when deciding the life or death of a business, you might end up killing an excellent business with your own hands. 'What are you looking at these numbers for?' Not getting that wrong is what keeps a company going for a long time.

Is that project really in the red? Before you cut it, please take another look at it using only direct costs. You are the one who decides.

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This article is an explanation of general concepts and is not intended as individual accounting or management advice. For specific decisions, please be sure to consult an expert such as your tax accountant.