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© Dale R. Geiger 2011 1
Calculate Cost Of A Service/Job With Multiple Cost Pools/Drivers
Principles of Cost Analysis and Management
© Dale R. Geiger 2011 2
Why did this cost measurement method fail?
Thank You
Fillet and Lobster 35.00Chicken Kiev 15.00Top Sirloin 20.00Caesar Salad 9.00Coffee 2 @1.00 2.00House Wine 4 @5.00 20.00Champagne 24.00Ice Cream 4.00Chocolate Cheesecake 6.00Sampler 10.00Soup/Salad 8.00Aperitif 7 .00
Total $160.00
Chez Paris
Bob
Carol
Ted
Alice
© Dale R. Geiger 2011 3
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 4
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 5
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 6
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 7
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 8
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 9
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
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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 11
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
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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 13
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 14
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?
CompanyA
CompanyB
CompanyC
Number ofSoldiers 250 300 450
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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?
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Contracts Case: Results
0
500
# of Soldiers 250 300 450
CompanyA
CompanyB
CompanyC
Number ofSoldiers 250 300 450
© Dale R. Geiger 2011 17
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 18
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?
CompanyA
CompanyB
CompanyC
Number ofContracts 50 50 0
© Dale R. Geiger 2011 19
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 20
Contracts Case B: Results
0
500
# of Soldiers 250 300 450
# of Contracts 500 500 0
CompanyA
CompanyB
CompanyC
Number ofContracts 50 50 0
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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 22
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?
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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?
CompanyA
CompanyB
CompanyC
Level ofEffort 60% 40% 0
© Dale R. Geiger 2011
© Dale R. Geiger 2011 24
Contracts Case C: Results
• Who do you think is upset now?
0
1000
# of Contracts 500 500 0
level of effort 600 400 0
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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?
CompanyA
CompanyB
CompanyC
Soldiers WithGlasses 15 15 15
© Dale R. Geiger 2011
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Contracts Case: Results
0
200
400
600
Co A Co B Co C
0
200
400
600
# soldiers # contracts effort # glasses
Cost Consumption Method Results:
Cost Driver Distribution Profiles:
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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 28
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 29
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
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Check on Learning
• What does “balloon squeezing” mean?• What should be considered when choosing a
cost driver?
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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:
• Produces a customized driver of reasonable accuracy
allocationbased on cost driver
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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
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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
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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
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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
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Level of Effort ExampleA B C Total
Ted 10% 50% 40% 100%Bob 30% 40% 30% 100%Sue 50% 50% 0% 100%Linda 25% 25% 50% 100%Average 29% 41% 30% 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
EffortMakers {
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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
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Random ErrorA B C Total
Ted 10% 40% 50% 100%Bob 25% 50% 25% 100%Sue 40% 60% 0% 100%Linda 30% 30% 40% 100%Average 26% 45% 29% 100%Old Average 29% 41% 30% 100%Error -3% 4% -1% 0%
• Random error tends to offset• This error is probably not significant• Both LOE estimates capture the major effects
up
down
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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
• Produces significantly more error
A B C TotalTed 10% 40% 50% 100%Bob 20% 30% 50% 100%Sue 50% 40% 10% 100%Linda 20% 20% 60% 100%Average 25% 33% 43% 100%Old Average 29% 41% 30% 100%Error -4% -9% 13% 0%
up
down
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Example: Returns Driver in IRS Audit Office
0
10
20
30
40 # of returns
corporate complex other simple individual individual
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IRS Quality ControlLevel of Effort Analysis
QRS-1
QRS-2
TRAINING
DISCLOSURE
TOTAL
PERCENT FOR BASIS
11
12
2
2
27
100
5.0
2.0
0.8
0.0
7.8
28.8
5.0
5.5
0.8
0.0
11.3
41.8
0
0
0
0
0
0
0.0
4.0
0.4
0.0
4.4
16.3
1.0
0.5
0.0
2.0
3.5
12.9
people complex corporate other simple other individual individual districts
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Precisely Wrong vs.Roughly Right
0
10
20
30
40# of returns
level of effort
corporate complex other simple other individual individual districts
© Dale R. Geiger 2011 43
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 44
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 $20K • Parts 16K• Clerical labor 8K• Shop supplies 4K
• Is the overhead cost pool homogeneous?
Total Overhead = $12K
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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 TotalParts $K 3 2 1 10 16Labor $K 2 3 5 10 20Overhead(Parts $K)
3/16*12= 2.25
2/16*12= 1.5
1/16*12= .75
10/16*12= 7.5 12
Total $K 7.25 6.5 6.75 27.5 48
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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 TotalParts $K 3 2 1 10 16Labor $K 2 3 5 10 20Labor Hr 150 80 50 520 800
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Cost Driver Analysis
• Shop supplies are closely correlated to parts dollars
-but-• Discussion indicates that clerical efforts were
expended in the following manner
Job: A B C D TotalClerical Efforts
12% 8% 30% 50% 100%
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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?
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Cost of a Job
• How do costs shift?
Job: A B C D TotalParts $K 3 2 1 10 16Labor $K 2 3 5 10 20Overhead (two pool) 1.71 1.14 2.65 6.50 12.00 Old Total 7.25 6.5 6.75 27.5 48New Total
Change
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• How might this shift affect management decisions?
Job: A B C D TotalParts $K 3 2 1 10 16Labor $K 2 3 5 10 20Overhead (two pool) 1.71 1.14 2.65 6.50 12.00 Old Total 7.25 6.5 6.75 27.5 48New Total 6.71 6.14 8.65 26.5 48Change -.54 -.36 +1.9 -1 0
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