Calculate Cost of Service with
Multiple Cost Pools and Drivers
Intermediate Cost Analysis
and Management
1
Why did this cost measurement
method fail?
Chez Paris
Carol
Fillet and Lobster
Chicken Kiev
Top Sirloin
Caesar Salad
Coffee 2 @1.00
House Wine 4 @5.00
Champagne
Ice Cream
Chocolate Cheesecake
Sampler
Soup/Salad
Aperitif
Total
35.00
15.00
20.00
9.00
2.00
20.00
24.00
4.00
6.00
10.00
8.00
7 .00
Alice
$160.00
Thank You
Bob
Ted
2
Terminal Learning Objective
• Task: Calculate Cost of Service with Multiple Cost
Pools/Drivers
• Condition: You are training to become an ACE with access
to ICAM 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:
•
•
•
•
•
Identify 3 methods of distribution
Discuss relative merits of each
Describe need for homogeneity in pools/drivers
Describe need for correlation between pool and driver
Select suitable driver for cost pool
3
Review: Managerial Costing
raw accounting data
cost pool
managerial
costing
translation
method
of
distribution
managerially useful information
=
cost object
4
Review: Terminology
• Method of distribution:
• The mechanics of deriving
management information from
the cost pool
• Example:
• Determine unit cost by
adding all input costs and
dividing by number of units
method
of
distribution
5
Alternative Methods of Distribution
• Managers can obtain the needed view of cost
in several ways
• Guessing: gut feel of cost distribution
• Direct costing: detailed record keeping of all
incurred cost transactions by every cost object
• Allocation: distribution of cost pool in the same
proportion as a cost driver
6
Applications for Guessing
• Simple situations where:
• Cost of measurement error
is small
• Need for credibility is low
• Ability to hold someone
accountable is missing
• Cost of cost measurement
is high
guessing
and
gut feel
7
Detailed Record Keeping Applications
• Labor cost can be accounted
for by product through time
and attendance reporting
• Project costs can include
supplies and services
charged by job order
• Product material costs can be
determined through bill of
materials
detailed
record
keeping
8
Examples of Detailed Record Keeping
• Job order charges
• Bill of materials system
• Time and attendance reporting
9
Why Not Use Detailed Record Keeping
for All Cost?
• May not be practical
• Will be more expensive
• May not be necessary
• Probably less flexible
• May not be possible
• Joint costs and overhead
costs often consumed by more
than one cost object
method
of
distribution
10
An Extreme Example
• Consider the accountant at Detailed Transaction
Command
• Changes pencils every time he writes a transaction
for a different cost object
• Writes a materials ticket for each pencil issued to
each cost object
• Maintains meticulous time records
whenever he changes pencils
• Wonders what to do about
cost of
pencil sharpener?
11
Method of Distribution Comparison
cost of method
guessing
direct
allocation
accuracy flexibility
cheap
poor
good
very expensive
good
poor
reasonable
reasonable reasonable
12
Review: Allocation
• Allocation:
• A method of distribution that
distributes cost pool to cost
objects in the same
proportion as cost driver
• Example:
• Distributing the cost of
utilities to occupants in the
same proportion as space
occupied
allocation
based on
cost driver
13
Most Systems Combine Methods
cost pool
detailed
record
keeping
allocation
based on
cost driver
cost object
14
Combining Methods
Detailed Record Keeping
Materials
Allocation
Receptionist
Management
Labor
Accounting/
Payroll
Production
Control
15
Choosing a Method of Distribution
• Use guessing for simple decision making
• Keep detailed records when accounting cost is
low and high accuracy useful
• Allocate overhead, support, and indirect costs
when appropriate
• Consider management’s needs for precision
and timeliness
16
Discussion: Telephone Charges
• Should these be allocated or charged via
detailed, call-by-call records?
• Issues to consider
• What does management need?
• Is telephoning a core mission or support function?
• Are detailed records available?
17
Learning Check
• Which method of distribution is the least
expensive?
• Which method is the most accurate?
18
Facilities Case
• An Army Installation has four Companies that occupy five
buildings. Incurred costs of $100,000 include utilities, building
maintenance, and miscellaneous facilities related
expenditures. New policies require the Installation to charge
its costs back to Companies.
• Using the Allocation Worksheet and the following
information, prepare a cost allocation:
Company
A
Number of
Buildings
2
Company
B
1
Company
C
1
Company
D
1
19
Consider:
•
•
•
•
•
What are the cost objects?
What is the cost driver?
What is the rate per building?
What is each company’s proportion?
What assumptions are made in using number
of buildings as a cost driver?
• Is this a good method of distribution?
20
Allocation Spreadsheet
Enter the cost pool
and cost objects
After entering driver data
the cost allocation
calculates automatically
21
What Difference Does
it Make?
• Some of the buildings are small?
• One of the building is the pentagon?
≠
22
Facilities Case B
• Not surprisingly, the Company Commanders were not pleased
to hear about the Facilities assessment. However, the
Company B brought up a valid point: Why should his
organization, which occupies a small building, receive the
same allocation as Company D, which occupies a substantially
larger building? Taking this into consideration, the Facilities
manager decided to re-allocate the $100,000 on the basis of
Square Footage occupied by each organization.
Company
A
Square
Footage
20000
Company
B
1000
Company
C
9000
Company
D
20000
23
Allocation Spreadsheet
Enter data for multiple drivers and
select drivers from pull-down lists
24
Consider:
•
•
•
•
•
•
What are the cost objects?
What is the cost driver?
What is the rate per square foot?
What is each company’s proportion?
Is this a better method of distribution?
Identify cross subsidizations and free goods
created by the Case A method
25
Facilities Case C
• At this point, the manager of Company D protested.
Yes, he did have a large building, but it was not air
conditioned. By his estimates, which were
reasonably accurate, forty percent of the facilities
expenditures were air conditioning related. These
expenses included the additional electricity,
maintenance and repair needed to keep the air
conditioning units running.
26
Facilities Case C
• Company D proposed dividing the Facilities Costs into two
separate cost pools: one for Air-Conditioning related costs,
and one for General Facilities costs. The General cost pool
would be allocated on the basis of square footage, just as
before. The Air Conditioning cost pool would be allocated on
the basis of air conditioned square footage.
Company
A
Company
B
Company
C
Company
D
Square
Footage
20000
1000
9000
20000
A/C Square
Footage
10000
1000
9000
0
27
Company D’s Method
Total Cost Pool $100K
Air Conditioning
Cost Pool
$40K
General
Cost Pool
$60K
A/C sq ft
Company Facility Cost
sq ft
28
Allocation Spreadsheet
Define activities and
assign cost to activities
Enter additional
cost driver data
29
Allocation Spreadsheet
Select drivers for
each activity
View the total allocation
for each Cost Object
30
Consider:
• What is the new rate per square foot?
• What is the rate per air conditioned square
foot?
• Identify any cross subsidizations and free
goods created by Case B’s method
• Is this a better method of distribution?
• Why might this method not reflect true cost?
31
Good Method Test
• Case A is a good method IF...
• All buildings are the same
• Case B is a good method IF...
• All square feet are the same
• Case C is a good method IF...
• All general square feet are the same AND
• All air conditioned square feet are the same
32
Don’t Forget Behavioral Impacts
• What undesired behavior is encouraged with
allocation by number of buildings
• Combining buildings one roof
• Expanding buildings when new building might
make more sense
• Rejecting assignment to small building
• In-fighting to occupy large air conditioned
buildings
33
Learning Check
• What happens to an object’s overhead
allocation as its proportion of cost driver
increases?
• If the unit of measure for the cost driver is
dollars, what will be the unit of measure for
the driver rate?
34
Assumptions
• Making assumptions is inescapable in
managerial costing
• There is simply too much to measure and too
many ways to measure it
• Reasonable assumptions simplify and facilitate
the measurement process
• Bad assumptions result in poor management
decision making
35
Homogeneity and Averaging
• Allocation methods implicitly assume
sameness or homogeneity
• Allocating the dinner check based on number
of eaters assumes that all eaters consume
resources equally
• Allocating facilities costs based on number of
buildings assumes that all buildings consume
facilities resources equally
36
Homogeneity and Averaging
• The homogeneity assumption allows the use
of average cost
• To simplify the allocation process
• To minimize the cost of measurement
• To avoid detailed record keeping for every cost
object
37
Cause and Effect Relationships
• A cause and effect relationship means:
• Increasing driver usage will cause more
consumption of resources
• Decreasing driver usage will cause less resource
consumption
• Allocating cost based on this driver will reflect the
underlying economics of cost consumption and
approximate true cost
38
Cause and Effect Relationships
• Give the cost manager another target for
managing cost
• Managing the driver usage will result in managing
cost
• Allow managers to make rational decisions
based on knowledge of true cost
• Instead of over-consuming goods and services
that appear to be free or low-cost
39
Common Examples of
Cause - Effect Cost Drivers
•
•
•
•
•
Square footage Heating costs
Number of employees Personnel costs
Mileage Motor pool costs
Computer hours  Computer costs
Others?
40
Learning Check
• What is the underlying assumption when
choosing a cost driver?
• A cause-effect relationship means that when
the driver usage is reduced, the
will also decrease.
41
Contracts Office Case
•
•
The contracts office at Fort Apache incurs annual
costs of $1 million. These costs are currently
distributed to companies A, B, and C on the basis
of their number of soldiers
How much is each company allocated?
Company
A
Number of
Soldiers
250
Company
B
300
Company
C
450
42
Contracts Case: Questions
•
•
•
•
•
What is the Cost Pool?
What is the Cost Object?
What is the Cost Driver?
What is the rate?
What is each Company’s proportion?
43
Contracts Case: Results
500
0
# of Soldiers
250
Company
A
Number of
Soldiers
250
300
450
Company
B
300
Company
C
450
44
Contracts Case:
Discussion Questions
• Is “number of soldiers” a good cost driver?
• Will decreasing soldiers decrease
consumption of contracts resources?
• What undesired behaviors might be
encouraged by this method of distribution?
45
Contracts Office: Case B
• Company C’s captain finds his allocation
unacceptable. He rejects being charged $450K when
he does not have any contracts and suggests using
number of contracts as the cost driver.
• How is cost allocated with this cost driver?
Company
A
Number of
Contracts
50
Company
B
50
Company
C
0
46
Contracts Case B: Questions
•
•
•
•
•
What is the Cost Pool?
What is the Cost Object?
What is the Cost Driver?
What is the rate?
What is each Company’s proportion?
47
Contracts Case B: Results
500
0
# of Soldiers
250
300
450
# of Contracts
500
500
0
Company
A
Number of
Contracts
50
Company
B
50
Company
C
0
48
Balloon Squeezing
•
•
•
•
Company A’s cost doubles
Company B’s cost increases 67%
Total cost remains unchanged
A change in distribution means:
• If one command’s allocation goes DOWN by $1000
Then...
• Someone else’s allocation has to go UP by $1000
• (Zero sum game requires support of top
management in order to succeed)
49
Contracts Case B: Discussion Questions
• Is “number of contracts” a good cost driver?
• Will decreasing number of contracts decrease
consumption of contracts resources?
• What undesired behaviors might be
encouraged by this method?
50
Contracts Office: Case C
• Company B labels these results wrong and points
out that its contracts are relatively simple and
that it always complies with contracts’ procedure
and lead time requests. The Company CO
suggests that a survey of contracts’ efforts be
used as the cost driver.
• How are costs allocated on this basis?
Company
A
Level of
Effort
60%
Company
B
40%
Company
C
0
51
Contracts Case C: Results
1000
0
# of Contracts
500
500
0
level of effort
600
400
0
• Who do you think is upset now?
52
Contracts Office: Case D
• Company A argues strongly that it cannot afford
$600k for contracts without compromising its
mission. The company CO, the most senior and
forceful of the company CO’s, demands that
“something fair, like the number of soldiers
wearing glasses” be used.
• How are costs allocated on this basis?
Company
A
Soldiers With
Glasses
15
Company
B
15
Company
C
15
53
Contracts Case: Results
Cost Consumption Method Results:
600
400
200
0
Co A
Co B
Co C
Cost Driver Distribution Profiles:
600
400
200
0
# soldiers
# contracts
effort
# glasses
54
Contracts: Discussion Questions
• Is “number of soldiers wearing glasses” a good
cost driver?
• (Never forget that we accountants are trained to
deal with nonsense)
• Which driver would you recommend
• If you are any of the company commanders?
• If you are the installation commander?
55
Driver Selection:
Issues to Consider
• Does the proposed driver correlate with
resource consumption?
• Less driver causes less resource
• More driver causes more resource
• Does the proposed driver motivate desirable
behavior?
• Cost conscious managers will work to reduce the
driver
• Does less driver benefit the organization?
56
Contracts Case: Lessons
• Using cost driver to allocate is easy
• Choosing the right cost driver may be hard
• Cannot ignore behavioral implications
• So count on them
• Design system to motivate desired behavior
• True economic cost usually motivates the right
cost management behavior
57
Learning Check
• What does “balloon squeezing” mean?
• What should be considered when choosing a
cost driver?
58
Why Level of Effort Analysis?
• Many costs are not easily
correlated with cost objects
• Less true in manufacturing
• Very true in service
• Level of effort analysis
technique easily:
allocation
based on
cost driver
• Produces a customized driver of
reasonable accuracy
59
Overhead: Likely Candidate for Level of
Effort (LOE)
• Overhead Areas Often Use LOE Since:
• Work Usually Specialized and Not Consumed
Uniformly by Line Organizations
• Like the Contracts Office
• Lack of Consumption Homogeneity May Mean
that Common Drivers are Poor
• i.e. Square Feet, Direct Labor Hours, Mileage, etc.,
Do not Adequately Correlate to Cost Object
Consumption of Overhead Resources
60
Developing LOE as a Driver
• Interview Activity Manager
• Concentrate on People’s “Efforts” Supporting
Cost Objects
• Find out What Proportion of Each Person’s
Time would be “Invoiced” to Each Cost Object
if Activity was a Business and Cost Object was
a Customer
61
Precision and LOE
• Activity Manager Will Only be Able to Make
Rough Estimates
• Estimates Get Better Over Time
• Random Estimate Errors Tend to Offset
• Systematic Error Can Induce Bias
• Saliency Can Induce Bias
62
Beneficial By-Products
• Staff/overhead organizations often
misunderstand their role
• It’s easy for staff to think they are line
• Often helpful to organization when staff
functions are forced to think of their line
customers as paying the bills
• Publicizing LOE creates a forum for cost and
support issues
63
Level of Effort Example
{
Effort
Makers
A
Ted
10%
Bob
30%
Sue
50%
Linda
25%
Average 29%
B
50%
40%
50%
25%
41%
C
40%
30%
0%
50%
30%
Total
100%
100%
100%
100%
100%
• Staff manager has good idea of where people
work and who they support
• The bottom line represents a “proportional”
method allocation basis for the staff function
64
Don’t Forget Homogeneity Assumption
• Implicit assumptions:
• Effort costs the same for each person
• Other costs proportional to people
• If Ted is a lawyer and others are paralegals,
the level of effort is biased
• Use weighting factor, or
• Make two separate activities if bias is significant
65
Random Error
A
Ted
10%
Bob
25%
Sue
40%
Linda
30%
Average
26%
Old Average 29%
Error
-3%
B
40%
50%
60%
30%
45%
41%
4%
C
50%
25%
0%
40%
29%
30%
-1%
Total
100%
100%
100%
100%
100%
100%
0%
up
down
• Random error tends to offset
• This error is probably not significant
• Both LOE estimates capture the major effects
66
Criticism of Level of Effort
• Bias is possible due to “saliency”
• Recent problems are fresh in mind
• Suppose C had a big problem last month
A
Ted
10%
Bob
20%
Sue
50%
Linda
20%
Average
25%
Old Average 29%
Error
-4%
B
40%
30%
40%
20%
33%
41%
-9%
C
50%
50%
10%
60%
43%
30%
13%
Total
100%
100%
100%
100%
100%
100%
0%
up
down
• Produces significantly more error
67
Example: Returns Driver in IRS Audit
Office
40
# of returns
30
20
10
0
corporate complex
individual
other
simple
individual
68
IRS Quality Control
Level of Effort Analysis
people
complex corporate
individual
other
simple
other
individual districts
QRS-1
11
5.0
5.0
0
0.0
1.0
QRS-2
12
2.0
5.5
0
4.0
0.5
TRAINING
2
0.8
0.8
0
0.4
0.0
DISCLOSURE
2
0.0
0.0
0
0.0
2.0
27
7.8
11.3
0
4.4
3.5
PERCENT FOR BASIS 100
28.8
41.8
0
16.3
12.9
TOTAL
69
Precisely Wrong vs.
Roughly Right
# of returns
40
level of effort
30
20
10
0
corporate
complex
individual
other
simple
individual
other
districts
70
Learning Check
• Why is level of effort sometimes a better
driver than a unit-based driver?
• What is the primary criticism of the level of
effort driver?
71
Practical Exercise
72