Costing Averages Distortion: Why Your Margin Report Misleads

Costing Averages Distortion: what leaders should fix next.

STABILIZE THE BUSINESS

Mustafa M A

11/1/20266 min read

a person stacking coins on top of a table

Introductory

On Khalid’s monthly report, chilled dairy earns a 12% margin and rice, oil and sugar earn 4%. Both numbers are wrong, and they are wrong in opposite directions.

Khalid owns a food distribution business in Riyadh (an illustrative case, not a real client). His report is not careless. It follows a rule most companies use: share the warehouse and delivery costs across products as a percentage of sales. That one rule is the source of costing averages distortion, and it quietly steers sales, pricing and range decisions the wrong way.

The short answer

What is happening: Shared costs are spread by sales value, so products that use more handling, space and trips look cheaper than they are.

Why it matters: The products that look most profitable get the most sales effort, while the ones that really pay the bills get priced too high and lose tenders.

What to do first: Re-split your three largest shared cost pools by what actually drives them, and compare the new ranking with the old one.

The Myth: A Percentage of Sales Is a Fair Way to Share Costs

The belief sounds reasonable. Every product helps pay the rent, the warehouse staff and the trucks. Bigger products pay more, smaller ones pay less. It is simple, everyone can check it, and the accounting system does it automatically.

Accounting writers even have a name for it: peanut-butter costing, because the overhead is spread evenly like a thin layer across everything. The name is a warning, not a recommendation. Spreading costs evenly makes costly products look cheaper and cheap ones look costlier than they really are.

Why Smart People Keep Believing It

There are three good reasons.

• It is easy. One rate, one calculation, no arguments about drivers.

• It feels fair. Nobody’s product is singled out.

• It works when products are alike. If every product used the warehouse and trucks in the same way, sharing by sales would be close enough.

The trouble is the last condition. In most businesses, products are not alike. They are different in exactly the ways that drive cost.

Where the Myth Breaks: Khalid’s Two Product Groups

Khalid sells SAR 80 million a year. His warehouse, cold store, delivery and admin costs come to SAR 8 million, so his system charges every product 10% of its sales.

He has two product groups:

• Ambient staples (rice, oil, sugar): SAR 50 million of sales, a 14% gross margin (the profit left after paying suppliers). They move on full pallets and need no cooling.

• Chilled dairy: SAR 30 million of sales, a 22% gross margin. It needs the cold store and refrigerated trucks, and it is picked case by case for small orders.

Under the 10% rule, the report looks like this:

• Ambient: gross margin SAR 7.0 million, less overhead SAR 5.0 million, leaves SAR 2.0 million (4% of sales).

• Dairy: gross margin SAR 6.6 million, less overhead SAR 3.0 million, leaves SAR 3.6 million (12% of sales).

Now share the same SAR 8 million by what drives it. The cold store and refrigerated fleet (SAR 3.5 million) serve only dairy. Case picking (SAR 2.0 million) is mostly dairy. Pallet handling (SAR 1.5 million) is mostly ambient. Only general admin (SAR 1.0 million) is still shared by sales.

The picture flips:

• Ambient: overhead falls from SAR 5.0 million to about SAR 2.3 million. Profit rises to about SAR 4.7 million, roughly 9% of sales.

• Dairy: overhead rises from SAR 3.0 million to about SAR 5.7 million. Profit falls to about SAR 0.9 million, roughly 3% of sales.

Nothing in the business changed. The same SAR 8 million was simply shared honestly. About SAR 2.7 million of cost had been sitting on the wrong products.

What Costing Averages Distortion Does to Decisions

A wrong cost is not just a reporting problem. It moves money.

• Sales effort goes to the wrong place. If commissions follow reported margin, the sales team pushes dairy, the product that uses the most expensive capacity.

• Prices go wrong in both directions. Ambient tenders are priced to cover overhead they do not use, so Khalid loses bids he should win. Dairy is priced too low for what it costs to serve.

• Investment follows the illusion. A second cold store looks like an investment in the “best” product line.

Management may make every one of these decisions carefully, with good data and good intentions. The decisions are still wrong, because the cost under them is an average.

What the Evidence Does and Does Not Prove

A new cost split is a hypothesis, not a verdict. Before acting, test three things.

First, check the drivers with the people who run the work. Ask the warehouse manager how many case picks and pallet moves each group really needs. Ask the fleet manager how many refrigerated trips serve dairy. If operations disagrees with the split, the split is wrong, not operations.

Second, separate costs that would leave from costs that would stay. If Khalid dropped dairy tomorrow, the cold store lease might run for another four years. A cost can belong to a product without being saved by dropping it. That is why the right response is usually to reprice, re-route or change minimum order sizes, not to exit.

Third, look for value the cost model cannot see. Some customers may buy rice from Khalid only because he also brings their dairy. If so, dairy’s thin margin may be the price of keeping profitable ambient volume.

So the new numbers do not prove dairy should go. They prove the old numbers cannot be used to decide.

Research suggests this gap is common. Activity-based costing means sharing costs by the activities that cause them. Harvard’s Robert Kaplan and Steven Anderson argued that its early versions failed in many firms because they were too slow to build and maintain. Their simpler method needs only two estimates per resource: what one minute of capacity costs, and how many minutes each order or product uses. In Saudi Arabia, a 2020 study of 200 manufacturing units found that higher indirect costs and product complexity did not predict which firms adopted activity-based costing. The need and the method do not always meet.

The Reality: Cost Follows Behaviour, Not Sales

The better principle is simple to say. A product costs what it consumes: the space it occupies, the picks it needs, the trips it takes and the time it uses. Sales value tells you how much the customer pays. It tells you very little about how much it costs to serve.

Here is the 3Ms view: an average is a cost that nobody owns. Until a cost has a driver and an owner, no one will manage it.

You do not need a full costing project to start. Three steps are enough:

1. Pick the three largest shared cost pools. In distribution these are usually warehousing, delivery and order handling.

2. Give each one a driver people can count. Pallet positions, case picks, delivery trips, orders.

3. Re-rank products or customers and put the old and new rankings side by side. The biggest moves are where the averages were hiding the most.

Where This Sits in the 3Ms Business Operating System

The signal enters as a disagreement: finance ranks a product as a star while operations calls it the hardest to serve. Cost-to-serve analysis diagnoses the gap by moving shared costs onto real drivers. The decision follows in pricing, minimum order sizes, delivery routes and sales incentives. The CFO owns the driver model, the commercial director owns the price and range decisions, and operations confirms the driver counts. The new product and customer margins then enter the monthly management review, and the drivers are checked again whenever the mix changes.

If you want to see where averages are hiding cost in your business, the 3Ms Cost-to-Serve capability starts with exactly this re-ranking. For a related lens, see our earlier piece on When Overhead Costs Mislead Management Decisions (https://www.3msbusiness.com/when-overhead-costs-mislead-management-decisions).

The Question to Ask This Month

Suppose you re-split your three largest shared costs tomorrow. Which product would lose its place at the top of your margin report, and who in your company would be most surprised?

External Sources Used

1. AccountingTools, “Peanut-butter costing”: https://www.accountingtools.com/articles/peanut-butter-costing

2. Kaplan, R. S. (2005), “Rethinking Activity-Based Costing”, HBS Working Knowledge (Kaplan and Anderson, HBR 2004): https://www.library.hbs.edu/working-knowledge/rethinking-activity-based-costing

3. Aljabr, A. (2020), “The influences on Activity-Based Costing adoption as an optimal costing system design: Evidence from Saudi Arabia” (200 Saudi manufacturing units): https://doaj.org/article/0a460a52981840709c192f2e0bb3d7f1

4. Background (not cited in the body): BDO, “Improving Profitability Through Cost-to-Serve”: https://www.bdo.com/improving-profitability-through-cost-to-serve