Slides identify common errors in ABC planning

Dining Hall Case• 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

Describe Common Pitfalls And Ways To Avoid Them In

ABC

Principles of Cost Analysis and Management

What Time is It?

Terminal Learning Objective

• Task: Describe Common Pitfalls And Ways To Avoid Them In ABC

• Condition: You are a cost advisor technician with access to the GFEBS training

database, PCAM 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

• Managerially useful information for cost warrior decision making

managerially useful information cost object

=

User Defined Relevance

• Good enough for most decisions

• Synchronous data transmission

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 $ + Clerical OH $ + Supplies OH $

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

$39,999

Dining Hall Case A

• As part of the study non-food expenditures of $693K must be distributed to cost objects:

Data for Dining Hall Case

Dining Hall Case

• 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

208

69

416

Questions to Consider

• Is this a good allocation method?

• Which other activities, if any, should be analyzed?

• What cross subsidizations and incentives might be created?

Dining Hall Case B

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

6 Select Drivers for Each Activity ?

cooling driver cleaning driver

6

Two Pool, Two Driver Output

dining hall non food cost

cooling food cleaning Activity C Activity D Activity E All Other

Allocation for

Questions for Case B

• Is this a good allocation method?

• Which other activities, if any, should be analyzed?

• What cross subsidizations and incentives might be created?

• Does this give management the information it needs?

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

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

dining hall non food cost

cooling food cleaning serving Activity D Activity E All Other

Allocation for

How Many Activities Must Be Evaluated?

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

Cost of Cost Methodology

• Gut feel, intuition or experience

• Back of the envelope calculation

Low $

High $

A Natural Tradeoff Exists

• Can go too far with level of 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 Exceeds Benefit

1% of absolute

$180 per activity evaluated

Cost of Cost System

Cost of Precision in

the Cost System

• Directly Related to:

• 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

Gulf War Tank Rounds Fired per Tank Destroyed

1.04

Important Considerations

• Willie Sutton Law of Managerial Costing

• Build managerial cost system structure around the big ticket items:

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!

Sensitivity Analysis

• In the dining hall case study how much would dinner cost increase if

• The driver for cooling food ($237K) is understated 10%?

• The driver for maintaining equipment ($14k) is overstated 50%?

• In the dining hall case study how much does total meal cost increase with these errors?

Check on Learning

• What are the costs of not enough detail in cost information?

• What are the costs of more detailed cost information?

• What is the Willie Sutton Law?

Managerial Costing: A Two Edged Sword

• Economically Rational Decision Making

• Poor Costing Yields

Managing the Cost Driver

• Activity Cost Reduction

activity

allocation based on cost driver

Danger: Right Behavior, Wrong Outcome

• Managerial costing systems motivate managers to reduce cost drivers

• 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

Plant Wide, Labor Based ABC System Used to Work

45 labor 45 labor

5 support 5 support

Reality left plant right plant

50 50

ABC Process Pool = 10

Driver = labor Proportion 50/50

Allocation 5/5

Cost System Report left plant right plant

50 50

ABC System Fails to Evolve With Automation

Driver = labor Proportion 90/10

Allocation 45/5

Outsourcing With Bad Cost Information

• Case facts:

• Navy evaluation of ship refurbishment

• Navy shipyards vs private shipyards

• Navy uses single pool based on labor

• Costs are identical in both shipyards

Navy Cost Reporting is Flawed by Labor Driver

• Real Costs Non Nuclear Nuclear

Bid Comparison: What Work Did the Navy Privatize?

Non Nuclear Nuclear Non Nuclear Nuclear

labor

over-head

Remember Free Goods

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

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

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

• It may be desirable in the long run to provide a capability or encourage a change that would be discouraged by true cost

• Example: True cost may discourage investment in vital technologies that are in the best interests of the organization

Computer Ops Mini Case

• $1,000,000 fixed cost of operation

• Basis of allocation: Hours used

Hours 600 650 750

• Due to weather and business reasons C’s usage declines next period

• The hours of use allocation base shifts cost to A and B

Hours 600 650 750 Allocation $353K $382K $265KChange $ 53K $ 57K -$110K

Computer Ops Mini Case

• 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

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

• A and B’s reduce usage shifts cost to C

• C cannot afford a computer this expensive and stops using

• Cost per hour jumps to $1600 per hour from the original $500 per hour once the largest user stops using the system

• There is no way A and B can afford this monster

• They stop using the system

• Clerk in A logs on accidentally for 30 seconds

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

• The true cost of resources consumed will help motivate rational, desired behaviors

• It is not in the organization’s best interest to reduce certain activities such as safety and technology

• Averaging by its nature both under costs and over costs

• Always consider the behavioral motivations

Check on Learning

• How does incorrect cost information affect outsourcing decisions?

Practical Exercise