Describe Common Pitfalls And
Ways To Avoid Them In ABC
Principles of Cost Analysis and
Management
© Dale R. Geiger 2011
1
What Time is It?
•
•
•
•
•
•
2:00?
2:05?
2:03?
2:02:47?
2:02:46.35?
Remember: A broken clock is correct to 10
digits of precision twice a day
© Dale R. Geiger 2011
2
Terminal Learning Objective
• Task: Describe Common Pitfalls And Ways To Avoid
Them In ABC
• Condition: You are a cost advisor technician with
access to the GFEBS training database, PCAM course
handouts, readings, and spreadsheet tools and
awareness of Operational Environment
(OE)/Contemporary Operational Environment (COE)
variables and actors.
• Standard: with at least 80% accuracy:
• Describe limits to precision
• Describe affordability, credibility and relevance constraints
© Dale R. Geiger 2011
3
Choosing Level of Precision
• Goal:
• Managerially useful information for cost warrior
decision making
• Question:
• How much precision do cost warriors need?
managerially useful information
© Dale R. Geiger 2011
=
cost object
4
Things to Consider
• User needs
• Cost environment
• Cost style
• Organization
• Measurement issues
• Difficulty and cost
• Limits to precision
• Impact on behavior
© Dale R. Geiger 2011
5
User Defined Relevance
• Nearest 5 or 10 minutes
• Nearest minute or two
• Nearest 5 or 10 seconds
• Nearest nanosecond
• Good enough for most
decisions
• Needed to set your VCR
• Radio programming
• Synchronous data
transmission
© Dale R. Geiger 2011
6
Precision Costs
•
•
•
•
Nearest 5 or 10 minutes
Nearest minute or two
Nearest 5 or 10 seconds
Nanoseconds
•
•
•
•
$10
$200
$500
$100,000
© Dale R. Geiger 2011
7
Weakest Link Theory
• Cost can only be as precise as least precise
component
• Consider adding very precise numbers to very
imprecise numbers
• How precise can the total be?
© Dale R. Geiger 2011
8
Example: Cost of a Job
• Cost expression for a job:
Parts $ + Labor $ + Clerical OH $ + Supplies OH $
• Cost measurement for Job A:
Actual + Actual +
Parts
Labor
12% +
* $8K
$2995.27 + $2012.42 + $960.00 +
$2995.27/$16K
* $4K
$748.82
• Precision of cost measurement:
± $.01 ± $.01
± 10%* $960 ±
© Dale R. Geiger 2011
$10
9
Data vs. Information
• We can calculate $6446.51 for the job cost
• This data is poor information since:
• Total error is plus or minus $106.52
• While labor and parts are accurate to the penny,
clerical labor is accurate only to ± approx. $100
• Management decision making can be confused
and misled
$39,999
10
© Dale R. Geiger 2011
Dining Hall Case A
• Management is concerned that lunches are losing
money and wants to determine profit
• As part of the study non-food expenditures of $693K
must be distributed to cost objects:
• Breakfast
• Lunch
• Dinner
• This should determine whether the Hall suffers from
“Free Lunch Syndrome”
© Dale R. Geiger 2011
11
Data for Dining Hall Case
Management has identified the following
activities, along with their respective costs:
•
•
•
•
•
•
•
•
Cooling Food
Cleaning
Serving
Collecting Money
Preparing Food
Doing Paperwork
Washing Dishes
Prepare Veggies
$237
119
64
63
36
22
20
20
•
•
•
•
•
•
•
•
Prepare Salads
Plan Meals
Drive Trucks
Unload Trucks
Stock Shelves
Replenish Line
Maintain Equip.
Total
© Dale R. Geiger 2011
20
18
18
14
14
14
14
$693
12
Dining Hall Case
• Accounting spends a day and determines the
following distribution basis for food cooling
• Use the level of detail analysis worksheet to allocate
the cooling food cost on this basis
• Assume homogeneity and allocate all other cost on
this basis
Activity:
Cooling Food
Breakfast
30%
Lunch
10%
© Dale R. Geiger 2011
Dinner
60%
13
Level of Detail Spreadsheet
Allocation for
dining hall non food cost
cooling food
$450
416
$400
Activity B
$350
(in 000's )
$300
$250
Activity C
208
Activity D
$200
69
$150
Activity E
$100
All Other
$50
$0
breakfast
lunch
dinner
0
14
© Dale R. Geiger 2011
Questions to Consider
• Is this a good allocation method?
• Which other activities, if any, should be
analyzed?
• What cross subsidizations and incentives
might be created?
• Does this give the information management
needs?
© Dale R. Geiger 2011
15
Dining Hall Case B
• Concerned about the accuracy of a single pool
system management sends accounting to study
cleaning cost distribution
• Reallocate adding the pool below. The worksheet
will allocate all other costs by weighting the two
bases
Activity:
Cleaning
Breakfast
35%
Lunch
20%
© Dale R. Geiger 2011
Dinner
45%
16
Level of Detail Spreadsheet
• Unspecified dollars default to activity labeled “all other”
6.
6
Select Drivers for Each Activity
Activity
Driver
cooling driver
cooling foodcooling
driver
?
breakfast lunch
dinner
0 Total
1
0.3
0.1
0.6
0
1
2
0.35
0.2
0.45
0
1
(none)
Activity C (none)
8
0
0
0
0
0
(none)
Activity D (none)
8
0
0
0
0
0
(none)
Activity E (none)
8
0
0
0
0
0
32%
13%
55%
0%
100%
cleaning
All Other
cleaning driver
cleaning
driver
All Other
• Driver for “all other” calculated by weighting specified
activities, drivers
© Dale R. Geiger 2011
17
Two Pool, Two Driver Output
Allocation for
dining hall non food cost
cooling food
381
$400
$350
cleaning
219
Activity C
(in 000's)
$300
$250
92
$200
Activity D
$150
Activity E
$100
All Other
$50
$0
breakfast
lunch
dinner
0
18
© Dale R. Geiger 2011
Questions for Case B
• Is this a good allocation method?
• Which other activities, if any, should be
analyzed?
• What cross subsidizations and incentives
might be created?
• Does this give management the information it
needs?
© Dale R. Geiger 2011
19
Dining Hall Case C
• Believing that a greater level of accuracy can be
achieved, management asks accounting for serving’s
cost distribution
• Reallocate adding this activity. The worksheet will
allocate all other costs
Activity:
Serving
Breakfast
35%
Lunch
20%
© Dale R. Geiger 2011
Dinner
45%
20
Three Pool, Three Driver Output
7. Allocate Overhead to Cost Objects:
7
Activity
cooling food
cleaning
serving
Activity D
Activity E
All Other
Total
breakfast
$
71
$
42
$
22
$
$
$
88
$
223
lunch
$
$
$
$
$
$
$
24
24
13
39
99
© Dale R. Geiger 2011
dinner
$
142
$
54
$
29
$
$
$
146
$
371
?
$
$
$
$
$
$
$
-
0 Total
$
$
$
$
$
$
$
237
119
64
273
693
21
Three Pool, Three Driver Output
Allocation for
dining hall non food cost
cooling food
371
$400
$350
cleaning
223
serving
(in 000's)
$300
$250
Activity D
99
$200
$150
Activity E
$100
All Other
$50
$0
breakfast
lunch
dinner
0
22
© Dale R. Geiger 2011
How Many Activities Must Be
Evaluated?
$450
$400
?
Dinner
$350
?
?
$300
?
Breakfast
$250
?
?
$200
$150
?
Lunch
?
?
$100
$50
$-
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Number of Activities Evaluated
© Dale R. Geiger 2011
23
Diminishing Return to
Accounting Effort
$450
Dinner
$400
$350
Breakfast
$300
$250
$200
Lunch
$150
$100
$50
$-
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Number of Activities Evaluated
© Dale R. Geiger 2011
24
Summary on Precision
• Engineering tells us that:
• Number of significant digits can be no greater
than the least accurate component
• Common sense tell us that:
• No more than two digits make any real difference
in management decision making
• Lesson: Don’t spend managerial cost system
resources on false precision
© Dale R. Geiger 2011
25
Check on Learning
• How does the “Weakest Link” theory affect
the level of precision possible in managerial
costing?
• What does “false precision” mean?
© Dale R. Geiger 2011
26
Cost of Detail
• Information is Not Free:
•
•
•
•
•
•
•
Measuring
Accumulating
Storing
Editing
Manipulating
Reporting
Explaining
© Dale R. Geiger 2011
27
Cost of Cost Methodology
• Gut feel, intuition or
experience
• Back of the envelope
calculation
• Estimates and analyses
• Managerial cost system
© Dale R. Geiger 2011
Low $
High $
28
A Natural Tradeoff Exists
Cost of not having detail
Cost of getting detail
$
• Can go too far with level of detail
• Can have too little detail
© Dale R. Geiger 2011
29
Cost of Dining Hall
Cost System
• The marginal benefit of analyzing an activity
must justify analysis cost
• Use the cost of cost system worksheet to
determine the point of diminishing return if:
• It takes one person-day to perform a cost driver
analysis on an activity at a $180 cost
• The value of reducing error is 1% of error
© Dale R. Geiger 2011
30
Cost of Measurement Eventually
Exceeds Benefit
Cost of Cost System
$180 per
activity
evaluated
$3,000
$2,500
in 000's
$2,000
$1,500
Cumulative Error
Cost of System
$1,000
1% of
absolute
value of
error
$500
$1
2
3
4
5
6
7
8
9
10
11
Number of Activities Studied
© Dale R. Geiger 2011
12
13
14
15
31
Cost of Precision in
the Cost System
• Directly Related to:
• Number of Cost Objects
• Level of Precision Attempted
Goal: Be on the target, but
hitting the center may be too
expensive
© Dale R. Geiger 2011
32
Law of Diminishing Return
Tank Rounds Fired per Tank Destroyed
17
WWII
Gulf War
1.04
1.2
$ Cost Spent on Technology and Training
© Dale R. Geiger 2011
*Certain Victory
33
Important Considerations
• Willie Sutton Law of Managerial Costing
• Asked why he robbed banks he said:
• “Because that’s where the money is”
• Build managerial cost system structure around
the big ticket items:
• “Because that’s where the money is”
© Dale R. Geiger 2011
34
Where is the Money?
The Pareto Effect: The 80/20 Rule
50%
45%
40%
35%
30%
The Significant Few
25%
20%
15%
The Trivial Many
10%
5%
0%
© Dale R. Geiger 2011
35
Impact of Error
50%
45%
16%
20%
40%
35%
30%
25%
20%
15%
10%
5%
0%
Getting the significant few within 10% is as
Important as the total of the trivial many
© Dale R. Geiger 2011
36
Best Value in Measurement
• Measurement error in the significant few has
the biggest impact
• Measurement error in the trivial many makes
little difference
• A diminishing return to effort
• Better strategy: Spend system resources to
improve accuracy on significant few!
© Dale R. Geiger 2011
37
Sensitivity Analysis
• In the dining hall case study how much would
dinner cost increase if
• The driver for cooling food ($237K) is understated
10%?
• The driver for maintaining equipment ($14k) is
overstated 50%?
• In the dining hall case study how much does
total meal cost increase with these errors?
© Dale R. Geiger 2011
38
Check on Learning
• What are the costs of not enough detail in
cost information?
• What are the costs of more detailed cost
information?
• What is the Willie Sutton Law?
© Dale R. Geiger 2011
39
Managerial Costing: A Two Edged
Sword
• Good Costing Yields
• Desired Behavior
• Economically Rational Decision Making
• Poor Costing Yields
• Undesired Behavior
• Over Consumption of Under Costed Goods
• Under Consumption of Over Costed Goods
© Dale R. Geiger 2011
40
Managing the Cost Driver
• ABC Systems Give Cost
Warriors Two Targets
activity
• Activity Cost Reduction
• Cost Driver Reduction
• Example:
• Reduced Square Footage
• Should Lead to Reduced
Utilities, Maintenance, etc.
allocation
based on
cost driver
cost object
© Dale R. Geiger 2011
41
Danger: Right Behavior, Wrong
Outcome
• Managerial costing systems motivate
managers to reduce cost drivers
• A system with the wrong design can
• Reduce consumption of the wrong thing
• Inadvertently increase consumption of costly
resources that now appear to be free goods
© Dale R. Geiger 2011
42
Example: Wrong Emphasis
• Industry commonly allocates many overheads
on the basis of direct labor
• Labor appears much more expensive than it
really is resulting in
•
•
•
•
Over spending on industrial engineering
Over automating
Excessive off shore development
Wrong outsourcing decisions
© Dale R. Geiger 2011
43
Plant Wide, Labor Based ABC System
Used to Work
ABC Process
Pool = 10
45 labor
45 labor
5 support
5 support
Driver = labor
Proportion 50/50
Allocation 5/5
Reality
left plant right plant
50
50
© Dale R. Geiger 2011
Cost System Report
left plant right plant
50
50
44
ABC System Fails to Evolve With
Automation
5 labor
ABC Process
Pool = 50
45 support
Driver = labor
Proportion 90/10
45 labor
5 support
Allocation 45/5
Reality
left plant right plant
50
50
© Dale R. Geiger 2011
Cost System Report
left plant right plant
90
10
45
Outsourcing With Bad Cost
Information
• Case facts:
•
•
•
•
Navy evaluation of ship refurbishment
Nuclear and non-nuclear
Navy shipyards vs. private shipyards
Navy uses single pool based on labor
• Assumptions
• Costs are identical in both shipyards
• Overhead for nuclear exceeds non-nuclear
© Dale R. Geiger 2011
46
Navy Cost Reporting is Flawed by
Labor Driver
• Real Costs
Non Nuclear
• Labor
• Overhead
Nuclear
40
40
40
80
• Reported Costs
• Activity Pool
120 =
• Driver Proportion
• Overhead Distribution
40
50%
60
© Dale R. Geiger 2011
+
80
50%
60
47
Bid Comparison: What Work Did the
Navy Privatize?
120
overhead
100
80
60
40
labor
20
0
Non Nuclear Nuclear
Non Nuclear Nuclear
Private Yards
Navy Yards
© Dale R. Geiger 2011
48
Follow-up Questions
• How much profit could private shipyard non
nuclear bids have added and still won the
competition?
• What’s the maximum amount of cost the navy
could have saved after closing non nuclear
shipyards?
© Dale R. Geiger 2011
49
Remember Free Goods
• Perceived Cost Drives Real Consumption
• Free Goods Have Infinite Demand
• Underlying Goal: Manage Cost
Cost
• “True” cost motivates better cost
management by introducing
rational economic choice in
ongoing management
decisions
Quantity Demanded
© Dale R. Geiger 2011
50
Over Consumption Pitfalls:
Summary
• Successful managerial cost systems motivate
behavior for better or worse
• Flaws in the system can inadvertently
motivate behavior in wrong direction
• Having total cost precise and being right “on
average” can lead to ruin
• Be reasonably right . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . .Not precisely wrong
© Dale R. Geiger 2011
51
Sometimes Behavior is More
Important than Truth
• Typically we want to cut cost by
• Determining and allocating true cost
• Encouraging cost reduction behavior
• Occasionally we don’t want true cost
• If reduction of activity cost is undesired
• If reduction of the driver is undesired
• When emphasis of some other behavior is
needed
© Dale R. Geiger 2011
52
Consider Some Drivers We May Not
Want Reduced
• Imagine the potential for undesirable behavior
if the ABC system allocated
• Safety program costs based on number of times
safety equipment issued
• Patent legal staff based on patents issued
• Hazardous materials overhead based on materials
turned in for disposal
• Maintenance based on preventative maintenance
costs
© Dale R. Geiger 2011
53
Sometimes We Don’t Want the
Activity Cost Reduced
• Sometimes a higher level view recognizes that
just cutting cost is not the goal
• Perhaps an investment is being made for the
future
• It may be desirable in the long run to provide a
capability or encourage a change that would be
discouraged by true cost
• Example: True cost may discourage investment in
vital technologies that are in the best interests of
the organization
© Dale R. Geiger 2011
54
Computer Ops Mini Case
• $1,000,000 fixed cost of operation
• 2000 hours of services rendered
• Basis of allocation: Hours used
Users
A
Hours
600
Allocation $300K
B
650
$325K
© Dale R. Geiger 2011
C
750
$375K
55
Computer Ops Mini Case
• Due to weather and business reasons C’s
usage declines next period
• The hours of use allocation base shifts cost to
A and B
Users
A
B
C
Hours
600
650
750
Allocation $353K
$382K
$265K
Change
$ 53K
$ 57K
-$110K
© Dale R. Geiger 2011
56
Computer Ops Mini Case
• A and B see cost increase while their usage did
not
• They direct their people to cut usage:
• To adjust to higher cost per hour
• To guard against future rate increase
• To make up for budget hit
© Dale R. Geiger 2011
57
Computer Ops Mini Case
• A and B significantly reduce use for the next
period while C’s usage returns to normal
• A and B’s reduce usage shifts cost to C
Users
A
Hours
300
Allocation $218K
Change -$134K
B
325
$237K
-$145K
© Dale R. Geiger 2011
C
750
$545K
$279K
58
Computer Ops Mini Case
• C cannot afford a computer this expensive and
stops using
• Cost per hour jumps to $1600 per hour from the
original $500 per hour once the largest user stops
using the system
Users
Hours
Allocation
Change
A
B
300
325
$480K $520K
$262K $283K
C
0
0
-$545K
© Dale R. Geiger 2011
59
Computer Ops Mini Case
• There is no way A and B can afford this monster
• They stop using the system
• Clerk in A logs on accidentally for 30 seconds
Users
A
B
C
Hours
.008
0
0
Allocation $1000K
0
0
Change $520K -$520K
0
0
© Dale R. Geiger 2011
60
A Death Spiral
1600
1400
1200
1000
800
600
400
200
0
Case A
Case B
Case C
Case D
Cost Per Hour or Use
© Dale R. Geiger 2011
61
A Solution From the National Institutes
of Health
• Operate genetic resources unit
• Provides rare frozen embryos for potential
research uses worldwide
• Infrequently needed, but would never be used
if users charged for use
• Solution: Individual research institutes
negotiate an allocation based on the relative
value of availability
© Dale R. Geiger 2011
62
Summary: Pitfalls
• Under costed cost objects are over consumed
• The true cost of resources consumed will help
motivate rational, desired behaviors
• Over costed cost objects are under consumed
• It is not in the organization’s best interest to reduce
certain activities such as safety and technology
• Coster beware:
• Averaging by its nature both under costs and over
costs
• Always consider the behavioral motivations
© Dale R. Geiger 2011
63
Check on Learning
• How does incorrect cost information affect
outsourcing decisions?
• How might motivating reduced consumption
be bad for an organization?
© Dale R. Geiger 2011
64
Practical Exercise
© Dale R. Geiger 2011
65