The Death Spiral of Overhead

Overhead Cost Allocation

Overhead cost distortions, discussed in accompanying articles, sometimes combine with product proliferation in a slow, deadly spiral that takes decades to play out.

This usually happens to firms that start with a limited product line of relatively high volume products. The illustration and explanation below shows how this self-reinforcing process operates.

The most insidious aspect is time. With an initially successful firm, it may take decades before anyone recognizes that a problem exists. Each year, margins are a bit lower, but not enough to sound an alarm.

In addition, the normal ups and downs of the business cycle disguise the general trend. Some companies even grow as overall volume disguises thinning margins.

The problem is not with low volume products, per se. Many companies specialize in low volume and perform quite well. The real problem is mixing low and high volume combined with an over-simplified overhead allocation system.

While volume is "the usual suspect," other factors can also distort cost and drive a company into a similar death spiral. Activity Based Costing (ABC) is intended to prevent this. Focused Factories can also prevent such death spirals by ensuring that all products have similar cost characteristics.