One of the worst mistakes your clients can make is cutting or eliminating a product line it thinks is performing poorly but is actually doing well. This typically happens when your client is given the wrong financial information about performance or if costs are allocated across the company in a way that doesn’t make sense. If this second case happens and repeats itself multiple times, your client has entered the accounting death spiral. The death spiral refers to a wrong decision that leads to another wrong decision. Often, the wrong decision relates to how costs are spread across the company.
Imagine your client has five products. Products A, B, and C require high levels of overhead, while Products D and E do not. If your client allocates overhead evenly across the company, 20% of overhead costs are assigned to each product. Product E might incur minimal or insignificant overhead costs. Still, because it gets allocated more overhead than its fair share, its bottom line might look like it’s losing money. If its revenue isn’t as high as its total expenses, your client may decide to end Product E’s life.
By doing so, the overhead now has to be spread over the four remaining products. Similar to Product E, Product D doesn’t require a ton of overhead. However, it’s now receiving 25% of the total overhead costs, which might also make it look unprofitable. If your client decides to cut the cord and end Product D’s life, it has entered a death spiral as the increasing burden continually impacts the other product lines.
Death spirals are avoided by having the right information. Help your client address the methods it uses to allocate overhead costs as well as selling, general, and administrative costs. It also doesn’t hurt to do periodic tests for reasonableness to see if some product lines are getting too many expenses assigned to them, as it’s more efficient to avoid the death spiral rather than have your client work its way out of one.