Can you explain this way of thinking about finances to me?

I’ve had run-ins with this twice now. I believe probably there’s some subtlety about accounting that I’m missing.

What happens is, one person will suggest we do something which will only cost money if it increases revenue. (Aside from very incidental normal cost-of-doing-business amounts.) (Think referral programs as an example.)

Then an administrator, with backing from the finance department, will say we can’t do it because we can’t pay the cost that would be incurred should that revenue-increasing event occur.

First guy points out this can’t be right, since the resulting cost is less than the revenue generated.

Admins/finance guys say something confusing and quick about how all costs have to be budgeted in advance otherwise we’re “eating into overhead.”

I don’t get it. Do you? Can you explain it to me?

That’s stupid. They should just say that they can’t pay the up-front costs, even if there might be a profit later.

The phrase “should that event occur” makes it sound as if the inability to pay is conditional on that event. But that’s insane, because, if the event occurs, the costs are more than made up by the profit.

Sounds to me like some jackass got his jargon tied in a knot. He should just have said, “We can’t afford this now, even though it might bring in a profit later.”

Not “We can’t afford this now, because it might bring in a profit later,” which is how it comes across as you quoted it.

Admins/finance guy is a moron. There are mysteries and subtleties to finance and finance law, but “greater than” shouldn’t be too hard a concept for him to understand.

But as described by the OP, the costs don’t occur unless the profit does, so even that wording isn’t right. I think you actually nailed it with your first couple words.

Is this a not-for-profit or other type organization whose overhead costs are monitored and reported on (ie Charity Navigator)?

That’s the only context in which I can see increasing overhead as a specific problem - the loss in contributions from being downgraded from A to B+ due to increased overhead could be greater than the gain expected.

Is it possible that the incremental cost, while less than the incremental revenue on its own, would still eat up all the contribution margin?

For example:

Frylock: Let’s start a referral program. We’ll pay 10% on net sales. For every $100 widget we sell from the referral program, our affiliate gets $10. If it doesn’t take off, there’s no cost to us!

Finance: Sorry, Frylock. The fully loaded (i.e. after overhead is allocated) cost is already $91. If we pay $10 on every affiliate sale you’ll be costing the company money on every sale!

I can’t speak for the finance people at your company – they could certainly be pulling stuff out of their collective asses – but I’ve seen people on message boards say things like “Why doesn’t Company X spend $1,000,000 on my great idea that would make $1,000,001? That’s $1 of FREE MONEY!”

Well, no. It doesn’t work that way. There are lots of things that a company could spend money on (and whether a referral payment comes before or after the new revenue, it’s still an expense), but they should be focusing on the best return on investment. At the companies I’ve worked at, they have a hurdle rate; if your investment doesn’t meet that rate of return, it’s not worth it.

In a big company, cost accounting is considered to be reality, no matter how far off real reality it really is. And the business cannot be more flexible than it’s budgeting system.

I think the hint to the underlying problem is in the OP’s comment "Admins/finance guys say something confusing and quick about how all costs have to be budgeted in advance otherwise we’re “eating into overhead.”

Their budgeting system is so inflexible they have to allocate all the funds for all the year’s estimated referral fees even before they’ve gotten a single referral.

Perhaps it something to do with accrued expenses which are not cash expenditures. Perhaps there is a dispcrepancy between when expenses are accrued and cash profits are realized that concerns them - I don’t really think that would be it thought. If you do not know the basics of accrual based accounting and do not understand how expenses are accounted for and realized you may have trouble understanding what they are looking at. What Hogarth said makes sense too. Either way I think they should be able to explain these things in understandable terms, so maybe part of the problem is they don’t have that ability.

Kind of sounds like the difference between accounting and economic profit.

I think this is it!

Another way to get a small scale profit but large scale loss is to be taking advantage of surplus on the small scale.

If you have empty space it can be used, but if the increase occurs then that will require costing the real estate space at commercial rates.

In business other paradoxes occur… where ‘economy of scale’ fails… In this state, a small business may pay more tax and have other costs (long service leave ) if it has over approx 20 employees.(the details of which are unimportant and I only give a general idea .)

It’s possible it could make financial sense.

Let’s say you’re a tow truck company. And somebody suggests, “Hey, let’s put in a bid for the city plowing contract. We don’t have to buy the snow plows unless we win the contract first. And if we do win the contract, it’s a guaranteed profit because the amount the contract is worth is more than the cost of the snow plows.”

It is a guaranteed profit. But the city doesn’t pay in advance. And your accountant points out you don’t have the money now to buy the snow plows. So you can’t afford the short term costs of the contract even though you know you’d make a profit from it in the long run.

Would that mean that an estimated amount to be paid out would, due to company or other rules, have to be encumbered (set aside in an account, not to be touched unless the event for which it was encumbered occurs) for the balance of the fiscal year? That would make the money unavailable for other purposes until the end of the project or the changing of the fiscal year releases it.

Imagine you work for a preternaturally simple company - it’s just you and one other guy.

Your job is to meet with clients where through your sheer intellect you provide $100 / hour of value to them. For every $100 revenue you bring in, the company compensates you $75. That’s all you get though. If you’re not producing revenue, the company doesn’t pay you.

On the other hand, the company pays your partner a relatively fixed salary. He doesn’t generate any revenue himself and his pay certainly doesn’t vary directly with your workload.

So from a literal cash flow point of view, every unit of $100 revenue costs $75 and the remaining $25 goes into a pot and whatever is needed is used to pay your partner. Whatever is left after that is the actual profit.

There isn’t a single unassailably correct way to allocate his cost on a unit basis in advance, but finance people still want to. Your partner might calculate that if you divide his total cost last year by the number of hours you worked, it comes out to $20 / hour.

That $20 isn’t literally tied to the unit of work in any direct cash-based way, and it will almost certainly be slightly different in the future. On the other hand, it’s 20% of the company’s revenue so your partner is right to want to account for it some way. So he says, “Let’s just add $20 / hour to our costs, to allocate overhead. Now our unit cost is $95/hour”.

So if you proposed paying $10 / hour to anyone who referred you, you’re now paying $105 for every $100 you earn. You get $100 in cash, pay yourself $75, pay your referee $10, and have $15 left over. Unfortunately the best estimate your partner has come up with says he needs $20 just to pay himself.

Let’s assume this is it.

Overhead is not necessarily fixed. If your program takes off and you double your sales, you will need more account reps, more tooling, larger warehouse space, etc. What you thought of as nicely profitable may not be so. Using fully loaded cost is the most conservative way to look at these opportunities. If the rosiest view of your program’s success doesn’t look good using conservative finance, it’s an iffy proposition. It may still be useful, but it needs a deeper look.

I don’t know about this specific example, but I certainly know some where accountants create negative value.

My daughter worked for a small (she was employee #8) publisher that worked out of a rented house in Brooklyn. They published scientific lab manuals in looseleaf form that were upgraded quarterly and made a tidy profit. The owner sold out to a major publisher. When the lease expired, the moved the whole operation into their Manhattan building. I guess everybody moved over a bit to make room. So the costs of this imprint went down. But suddenly the imprint went from being profitable to losing money. Because the accountants attributed the cost of rented space in Manhattan to them and rental space in Manhattan is much more expensive than in Brooklyn. Fortunately, they didn’t close them down, although she no longer works there.

A second example. I knew a man who worked as an engineer for Hitachi in Japan. In an effort to avoid every engineer having to buy copies of every important book, they set up a library. It would have saved a lot of money, except… the accountants insisted that every division of the company do its own accounting and show a profit. Including the library. So they had to charge everyone who came into the library and looked at a book. Predictably, the engineers needed authorization from their managers to do this and managers being managers, they were worried about their own bottom lines (from accounting, of course) and were reluctant to do so. So the library wasn’t much used. They had to raise their rates to the point that it became cheaper for each department to have its own copies of books they used.

How is this an accountant’s fault? Why wouldn’t you blame the manager who actually moved their operation to a much more expensive office space instead of an accountant who accurately accounted for that cost increase?

Accountants worry about transfer pricing for precisely the reason you described. If they let the library buy a bunch of books and didn’t “charge” individual departments for them, nobody would know how much each department was spending on books. It obviously didn’t save a lot of money, since in actuality the departments decided they could just buy their own books cheaper. Once again this sounds like a case of an accountant accurately reporting reality and getting blamed for what was a bad idea by whoever started the library.

Who cares how much each department is spending on books? The point is to stop department level spending on books, not track it.

Using hindsight, I would setup the library as a cost center with it’s own spending budget, and allocate the costs to the departments as overhead or keep it at the top. Departments get to request books, or get their own book spending budget overseen by the library, and the books stay in the library for all to use, at no incremental cost to the user.

It makes you wonder how this company handled its janitorial needs.