Calculate Cost Of A Service/Job With Multiple Cost Pools/Drivers © Dale R. Geiger 20111.

© Dale R. Geiger 2011 1

Calculate Cost Of A Service/Job With Multiple Cost Pools/Drivers

Principles of Cost Analysis and Management


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


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


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


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


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


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.



• 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



• 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


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


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


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?


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.


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


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?


Contracts Case: Results

0

500

# of Soldiers 250 300 450

CompanyA

CompanyB

CompanyC

Number ofSoldiers 250 300 450


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?


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


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?


Contracts Case B: Results

0

500

# of Soldiers 250 300 450

# of Contracts 500 500 0

CompanyA

CompanyB

CompanyC

Number ofContracts 50 50 0


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)


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?

23

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


Contracts Case C: Results

• Who do you think is upset now?

0

1000

# of Contracts 500 500 0

level of effort 600 400 0

25

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



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:


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?


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?


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


Check on Learning

• What does “balloon squeezing” mean?• What should be considered when choosing a

cost driver?


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


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


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


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


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


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 {


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


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


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


Example: Returns Driver in IRS Audit Office

0

10

20

30

40 # of returns

corporate complex other simple individual individual


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


Precisely Wrong vs.Roughly Right

0

10

20

30

40# of returns

level of effort

corporate complex other simple other individual individual districts


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?


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


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


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


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%


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?

49

Allocation Spreadsheet

Enter activities and cost driver data as shown


50

Allocation Spreadsheet

Select cost drivers and view the new allocation



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


• 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

Check on Learning


Practical Exercise

Calculate Cost Of A Service/Job With Multiple Cost Pools/Drivers © Dale R. Geiger 20111.

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