Slides 4 1 describe common pitfalls in activity based costin

Dining Hall Case cont’d• Accounting spends a day and determines the following distribution basis for food cooling • Use the level of detail analysis worksheet to allocate the cooling f

Describe Common Pitfalls in Activity Based Costing and Ways to Avoid

Them

What Time is It?

• Remember: A broken clock is correct to 10

digits of precision twice a day

Terminal Learning Objective

• Task: Describe Common Pitfalls in Activity Based

Costing and Ways to Avoid Them

• 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:

• Describe limits to precision

• Describe affordability, credibility and relevance

constraints

Choosing Level of Precision

• Goal:

• Managerially useful information for cost warrior decision making

• Question:

• How much precision do cost warriors need?

managerially useful information = cost object

User Defined Relevance

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?

Example: Cost of a Job

• Cost expression for a job:

Parts $ + Labor $ Labor $ + Clerical OH $ Clerical OH $ + Supplies OH $ Supplies OH $

• Cost measurement for Job A:

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

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”

Data for Dining Hall Case

Management has identified the following

activities, along with their respective costs:

Dining Hall Case (cont’d)

• 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

Level of Detail Spreadsheet

breakfast lunch dinner 0

dining hall non food cost

Questions to Consider

• Is this a good allocation method?

• Which other activities, if any, should be

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

Level of Detail Spreadsheet

• Unspecified dollars default to activity labeled “all other”

• Driver for “all other” calculated by weighting specified activities, drivers

Activity breakfast lunch dinner 0 Total

cooling foodcooling driver 1 0.3 0.1 0.6 0 1 cleaning cleaning driver 2 0.35 0.2 0.45 0 1 Activity C (none) 8 0 0 0 0 0 Activity D (none) 8 0 0 0 0 0 Activity E (none) 8 0 0 0 0 0 All Other All Other 32% 13% 55% 0% 100%

Driver

(none) (none) (none)

cooling driver cleaning driver

6

Two Pool, Two Driver Output

breakfast lunch dinner 0

dining hall non food cost

cooling food cleaning Activity C Activity D Activity E All Other

Allocation for

219

92

381

Questions for Case B

• Is this a good allocation method?

• Which other activities, if any, should be

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

Three Pool, Three Driver Output

Activity breakfast lunch dinner 0 Total cooling food $ 71 $ 24 $ 142 $ - $ 237 cleaning $ 42 $ 24 $ 54 $ - $ 119 serving $ 22 $ 13 $ 29 $ - $ 64 Activity D $ - $ - $ - $ - $ - Activity E $ - $ - $ - $ - $ - All Other $ 88 $ 39 $ 146 $ - $ 273

Total $ 223 $ 99 $ 371 $ - $ 693

7

Three Pool, Three Driver Output

breakfast lunch dinner 0

dining hall non food cost

cooling food cleaning serving Activity D Activity E All Other

Allocation for

223

99

371

How Many Activities Must Be

Lunch

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

Learning Check

• How does the “Weakest Link” theory affect

the level of precision possible in managerial costing?

• What does “false precision” mean?

Cost of Cost Methodology

• Gut feel, intuition or

experience

• Back of the envelope

calculation

• Estimates and analyses

• Managerial cost system

Low $

High $

A Natural Tradeoff Exists

• Can go too far with level of detail

• Can have too little detail

$

Cost of not having detail Cost of getting detail

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

Cost of Measurement Eventually

1% of absolute value of error

$180 per activity evaluated

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

Goal: Be on the target, but hitting the center may be too

expensive

Law of Diminishing Return

17 WWII

1.2

Gulf War Tank Rounds Fired per Tank Destroyed

$ Cost Spent on Technology and Training

1.04

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”

Where is the Money?

The Pareto Effect: The 80/20 Rule

The Significant Few

The Trivial Many

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!

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

Managing the Cost Driver

• ABC Systems Give Cost

Warriors Two Targets

• Activity Cost Reduction

• Cost Driver Reduction

• Example:

• Reduced Square Footage

• Should Lead to Reduced

Utilities, Maintenance, etc

activity

allocation based on cost driver

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

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

Plant Wide, Labor Based ABC System

Driver = labor Proportion 50/50 Allocation 5/5

Cost System Report left plant right plant

50 50

ABC System Fails to Evolve With

Driver = labor Proportion 90/10 Allocation 45/5

Cost System Report left plant right plant

90 10

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

Navy Cost Reporting is Flawed by

Bid Comparison: What Work Did the

Navy Privatize?

Non Nuclear Nuclear Non Nuclear Nuclear

Private Yards Navy Yards labor

over-head

Remember Free Goods

• Perceived Cost Drives Real Consumption

• Free Goods Have Infinite Demand

• Underlying Goal: Manage Cost

• “True” cost motivates better cost

management by introducing rational economic choice in

ongoing management

decisions

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

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

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

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

• Maybe it is desirable in the long run to provide

a capability or encourage a change that would

be discouraged by true cost

Computer Ops Mini Case

• $1,000,000 fixed cost of operation

• 2000 hours of services rendered

• Basis of allocation: Hours used

Hours 600 650 750

Computer Ops Mini Case B

• Due to weather and business reasons C’s

usage declines next period

• Allocation ? ? ?

• Change ? ? ?

Computer Ops Mini Case C

• 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

Computer Ops Mini Case C

• A and B significantly reduce use for the next period while C’s usage returns to normal

Hours 300 325 750

Allocation ? ? ? Change ? ? ?

Computer Ops Mini Case D

• C cannot afford a computer this expensive and stops using

Allocation ? ? ? Change ? ? ?

Computer Ops Mini Case D

• Cost per hour jumps to $1600 per hour from the original $500 per hour once the largest

user stops using the system

Change $262K $283K -$545K

Computer Ops Mini Case E

• There is no way A and B can afford this

monster

• They stop using but a clerk in A logs on

accidentally for 30 seconds

Computer Ops Mini Case E

• There is no way A and B can afford this

monster

• They stop using but a clerk in A logs on

accidentally for 30 seconds

Change $520K -$520K 0

Case A Case B Case C Case D

Cost Per Hour or Use

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

Summary: Pitfalls

• Under costed cost objects are over consumed

• Over costed cost objects are under consumed

• Coster beware:

• Averaging by its nature both under costs and over costs

Learning Check

• How does incorrect cost information affect

outsourcing decisions?

• How might motivating reduced consumption

be bad for an organization?

Practical Exercise