Since variable costs are unique to a product, the issue with product profitability is how to allocate the fixed costs of the operations and facilities through which the product passes.
Today: Fixed costs are handled by allocation. Quoting from Accounting Tools:
“The very term “allocation” implies that there is no overly precise method available for charging a cost to a cost object such as a product, so the allocating entity is using an approximate method for doing so. Thus, you may continue to refine the basis upon which you allocate costs, using such allocation bases as square footage, headcount, cost of assets employed…”
According to Accounting Tools, the solution is volume-based allocation. Quoting:
“A volume-based allocation is an allocation of factory overhead costs based on a unit of activity, rather than a cost. Examples of such allocation bases are the amount of square footage used, the number of labor hours used, the number of machine hours used, and the number of units produced.” The problem with a volume-based allocation is that it can’t be used for planning because the future’s activity levels aren’t known.
OIS’s Solution:
OIS handles the volume-based allocation problem with a concept called landed product cost. This concept is enabled by the structure of the OIS model which is node/link where the nodes model the income statement’s facilities, operations within facilities and products within operations. This nested relationship of product, process and facility cost functions is illustrated in the figure below. For more details of OIS’s structure and data, see OIS Details.
As described in OIS Advantages, OIS’s solution includes a new most profitable product forecast; i.e., the plan for “the number of units” to be produced. So, the landed product cost is simply the variable product costs plus the process (i.e., operations, activity, flow) and facility fixed costs divided by the unit volume of the new forecast’s products’ volumes.
Product profitability is then simply the products’ revenues minus the product’s forecasted costs. Finally, customer profitability is simply the sum of the products’ profit that aggregated customers are forecasted to receive.