Three product lines, every one of them profitable on the income statement. One has been quietly losing $150,000 a year, and the way overhead allocation is calculated is the reason it stayed invisible.
Most owners treat overhead as a lump: rent, insurance, admin salaries, software, the accountant. It lands in one bucket labeled the cost of running the place and never gets connected to the work that actually has to pay for it. That is exactly the mistake that lets a losing line hide behind a profitable one until it is too late.
What Is Really Happening
Every business carries two kinds of cost. Direct costs trace to a specific job or unit, the parts, materials, and labor that go into what gets sold. Overhead is everything else, the fixed and semi-fixed cost of keeping the doors open whether the business ships one unit or a thousand. No invoice ever says overhead. It is the monthly lease, the office salaries, and the software that quietly adds per-seat fees every month.
The problem is not that overhead exists. It is that overhead has to be recovered in price, and most owners get the overhead allocation wrong. Every margin decision, which job to take, which line to grow, what to quote, depends on how overhead attaches to the work. Spread it across the business as a flat percentage, and one product line quietly subsidizes another. Tie it to a real driver, and the picture changes fast.
A Worked Example of Overhead Allocation
Consider a company with three product lines, using illustrative figures from a simple build. Together they generate $3.0 million in revenue and $1,150,000 in gross profit, against $900,000 of overhead. That leaves a respectable $250,000, about 8 percent net.
Allocate that $900,000 as a flat 30 percent of revenue, the most common shortcut in overhead allocation, and each line lands at a passable margin. Line A generates $1.2 million in revenue, carries $360,000 in overhead, and nets $140,000 in profit, an 11.7 percent margin. Line B generates $1.0 million in revenue, carries $300,000 in overhead, and nets $50,000 in profit, a 5.0 percent margin. Line C generates $800,000 in revenue, carries $240,000 in overhead, and nets $60,000 in profit, a 7.5 percent margin. Nothing alarms anyone. Line A is clearly the star, B and C look fine.
Now allocate that same $900,000 by direct labor hours instead, since Line C is not simple high-volume work, it is custom, low-volume work that eats setup and handling time. Line A uses 2,000 hours at $75 per hour, carrying $150,000 in overhead and netting $350,000 in profit, a 29.2 percent margin. Line B uses 4,000 hours, carrying $300,000 in overhead and netting the same $50,000 in profit, a 5.0 percent margin. Line C uses 6,000 hours, carrying $450,000 in overhead, and turns into a $150,000 loss, an 18.8 percent loss.
The line that looked fine at 7.5 percent was actually losing $150,000 a year, subsidized entirely by Line A. The price on Line C never recovered the hours it consumed, because the overhead allocation never charged it for them. Choosing a lazy allocation method means making growth and pricing decisions off a profit number that is not real.
What the Owner Should Test
A few questions reveal whether overhead allocation is telling the truth. What driver actually consumes overhead, labor hours, machine hours, number of jobs, or floor space? The line that eats the driver should carry the cost, since revenue is a driver of almost nothing.
Does any line or customer flip from profit to loss under a real allocation? Running the numbers both ways, flat percentage and true driver, reveals whether a flip exists, and a flip is the one decision worth real attention that month.
Is overhead growing faster than gross profit? Tracking overhead as a percentage of revenue over twelve months shows whether it is drifting upward while margin stays flat, a sign that overhead is quietly doing damage on its own.
Is the overhead structural or discretionary? A building lease is a commitment. Subscriptions, travel, and unused software are choices. Reductions need to come from the discretionary bucket, or the business ends up starving its own operation.
Which overhead actually supports revenue? Cutting the cost that produces nothing should always come before touching the cost that keeps customers and production moving.
The Takeaway
Overhead is not a blob to shrug at. It is a price the work has to carry, and attaching it with a flat percentage instead of the real driver means keeping the wrong lines, pricing the good ones too high, and paying for the loss in cash a year later. Recalculating overhead allocation once is often enough to reveal which “profitable” line never actually was.
Book a call with Business CFO for Hire to find out whether your overhead allocation is hiding a losing product line behind a profitable one.
