Calculate Cost Of A Service/Job
With Multiple Cost Pools/Drivers
Principles of Cost Analysis and
Management
© Dale R. Geiger 2011
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
© Dale R. Geiger 2011
Ted
2
Terminal Learning Objective
• Task: Calculate Cost Of A Service/Job With Multiple
Cost Pools/Drivers
• Condition: You are a cost advisor technician with
access to all regulations/course handouts, and
awareness of Operational Environment
(OE)/Contemporary Operational Environment (COE)
variables and actors.
• Standard: with at least 80% accuracy:
•
•
•
•
Distinguish drivers as transactional, duration, or intensity
Describe need for homogeneity in pools/drivers
Describe need for correlation between pool and driver
Select suitable driver for cost pool
© Dale R. Geiger 2011
3
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
© Dale R. Geiger 2011
4
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
© Dale R. Geiger 2011
5
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
© Dale R. Geiger 2011
6
Types of Cost Drivers
• Cost Drivers may be:
• Unit-based:
• Assumes a correlation between consumption of a unit
of driver and consumption of cost pool
• Assumes all units of the driver are homogeneous
• Examples: purchase orders, headcount, etc.
© Dale R. Geiger 2011
7
Types of Cost Drivers
• Cost Drivers may be:
• Duration-based:
• Assumes a correlation between time spent on an
activity and consumption of cost pool
• Will be stated in units of time (hours, minutes, etc.)
• Example: Machine hours or labor hours
© Dale R. Geiger 2011
8
Types of Cost Drivers
• Cost Drivers may be:
• Intensity-based:
• Assumes a correlation between the level of effort
expended and consumption of cost pool
• Usually stated as a percentage or proportion
• Example: Support services assign cost to projects
based on effort expended on each project
© Dale R. Geiger 2011
9
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
© Dale R. Geiger 2011
10
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
© Dale R. Geiger 2011
11
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?
© Dale R. Geiger 2011
12
Check on Learning
• 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.
© Dale R. Geiger 2011
13
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
Company
B
250
© Dale R. Geiger 2011
300
Company
C
450
14
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?
© Dale R. Geiger 2011
15
Contracts Case: Results
500
0
# of Soldiers
250
300
Company
A
Number of
Soldiers
450
Company
B
250
© Dale R. Geiger 2011
300
Company
C
450
16
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?
© Dale R. Geiger 2011
17
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
Company
B
50
© Dale R. Geiger 2011
50
Company
C
0
18
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?
© Dale R. Geiger 2011
19
Contracts Case B: Results
500
0
# of Soldiers
250
300
450
# of Contracts
500
500
0
Company
A
Number of
Contracts
Company
B
50
© Dale R. Geiger 2011
50
Company
C
0
20
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)
© Dale R. Geiger 2011
21
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?
© Dale R. Geiger 2011
22
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
Company
B
60%
40%
Company
C
0
23
© Dale R. Geiger 2011
Contracts Case C: Results
1000
0
# of Contracts
500
500
0
level of effort
600
400
0
• Who do you think is upset now?
© Dale R. Geiger 2011
24
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
Company
B
15
15
Company
C
15
25
© Dale R. Geiger 2011
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
© Dale R. Geiger 2011
# glasses
26
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?
© Dale R. Geiger 2011
27
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?
© Dale R. Geiger 2011
28
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
© Dale R. Geiger 2011
29
Check on Learning
• What does “balloon squeezing” mean?
• What should be considered when choosing a
cost driver?
© Dale R. Geiger 2011
30
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
© Dale R. Geiger 2011
31
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
© Dale R. Geiger 2011
32
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
© Dale R. Geiger 2011
33
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
© Dale R. Geiger 2011
34
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
© Dale R. Geiger 2011
35
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
© Dale R. Geiger 2011
36
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
© Dale R. Geiger 2011
37
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
© Dale R. Geiger 2011
38
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
© Dale R. Geiger 2011
39
Example: Returns Driver in IRS Audit
Office
40
# of returns
30
20
10
0
corporate complex
individual
other
simple
individual
© Dale R. Geiger 2011
40
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
© Dale R. Geiger 2011
41
Precisely Wrong vs.
Roughly Right
# of returns
40
level of effort
30
20
10
0
corporate
complex
individual
other
© Dale R. Geiger 2011
simple
individual
other
districts
42
Check on Learning
• Why is level of effort sometimes a better
driver than unit-based or duration-based
drivers?
• What is the primary criticism of the level of
effort driver?
© Dale R. Geiger 2011
43
Cost of a Job
• Let’s re-visit our job cost problem
• Mechanical service department incurs the
following costs for the month of September:
•
•
•
•
Mechanic labor
Parts
Clerical labor
Shop supplies
$20K
16K
8K
4K
Total Overhead = $12K
• Is the overhead cost pool homogeneous?
© Dale R. Geiger 2011
44
Cost of a Job
• During the month four jobs are started and
completed
• What is the total cost of each job if all
overhead is allocated using parts dollars?
Job:
A
B
C
D
Total
Parts $K
3
2
1
10
16
Labor $K
2
3
5
10
20
Overhead
(Parts $K)
3/16*12
= 2.25
2/16*12
1/16*12
= 1.5
= .75
10/16*12
= 7.5
12
7.25
6.5
6.75
27.5
48
Total $K
© Dale R. Geiger 2011
45
Cost Driver Analysis
•
•
•
•
Which drivers are unit-based?
Which are duration based?
Are units of cost driver homogeneous?
Is there a cause and effect relationship
between the cost pool and the drivers?
Job:
A
B
C
D
Total
Parts $K
3
2
1
10
16
Labor $K
2
3
5
10
20
Labor Hr
150
80
50
520
800
© Dale R. Geiger 2011
46
Cost Driver Analysis
• Shop supplies are closely correlated to parts
dollars
-but• Discussion indicates that clerical efforts were
expended in the following manner
Job:
Clerical
Efforts
A
B
12%
C
8%
D
30%
© Dale R. Geiger 2011
Total
50%
100%
47
Cost of a Job
• Use the allocation spreadsheet to allocate the
overhead to each job
• What is the cost pool?
• What are the cost objects?
• What are the activities?
• What are the drivers for each activity?
© Dale R. Geiger 2011
48
Allocation Spreadsheet
Enter activities and cost
driver data as shown
49
© Dale R. Geiger 2011
Allocation Spreadsheet
Select cost drivers and
view the new allocation
50
© Dale R. Geiger 2011
Cost of a Job
• How do costs shift?
Job:
A
B
C
D
Total
Parts $K
3
2
1
10
16
Labor $K
2
3
5
10
20
6.50
27.5
12.00
48
Overhead
(two pool)
Old Total
1.71
7.25
1.14
6.5
2.65
6.75
New Total
Change
© Dale R. Geiger 2011
51
Check on Learning
• How might this shift affect management
decisions?
Job:
A
B
C
D
Total
Parts $K
3
2
1
10
16
Labor $K
2
3
5
10
20
2.65
6.75
6.50
27.5
12.00
48
Overhead
(two pool)
Old Total
1.71
7.25
1.14
6.5
New Total
6.71
6.14
8.65
26.5
48
Change
-.54
-.36
+1.9
-1
0
© Dale R. Geiger 2011
52
Practical Exercise
© Dale R. Geiger 2011
53