Distribute Single Cost Pool to Users Principles of Cost Analysis and Management

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Terminal Learning Objective Action: Allocate Single Cost Pool to Users Condition: FM Leaders in a classroom environment working as a member of a small group, using doctrinal and administrative publications, self-study exercises, personal experiences, practical exercises, handouts, and discussion Standard: With at least 80% accuracy (70% for international Learners) you must: Explain how poor cost information encourages undesired behaviors Calculate driver rate and proportion

A Broad Definition of Managerial Costing raw accounting data managerial costing translation managerially useful information

Why Is This Translation Needed? Accounting Systems usually measure input or source costs Labor, overhead, materials Salaries, benefits, supplies, contracts Managers want measurements based on output or consumption Product, service, project Consuming organization, customer

Managerial Costing Terms cost pool raw accounting data managerial costing translation method of distribution = cost object managerially useful information

Terminology Cost pool - An aggregation of incurred costs (as measured by the accounting system) which must be distributed or assigned to cost objects. Examples: - Salary and benefits, supplies, travel, etc. in an airfield operations center - Utility bills for a garrison Method of distribution - the mechanics of deriving management information from the cost pool. The source costs in the cost pool will be assigned or distributed to cost objects, those views of cost that are useful to management. Example: - Determine unit cost by adding all input costs and dividing by number of units. Cost Object - A view of cost needed by management - 120mm tube product cost - Morale, welfare, recreation cost - Armor school cost

What is Allocation? Allocation: Example: A method of distribution that distributes cost pool to cost objects in the same proportion as cost driver Example: Distributing the cost of utilities to occupants in the same proportion as space occupied allocation based on cost driver

The Mechanics of Allocation Allocation is a basic technique of activity based costing (ABC) Becoming an expert is required but easy Allocation mechanics excel spreadsheet makes it even easier allocation based on cost driver

Two Allocation Methods Rate Method: Uses a computed rate per driver unit Proportion Method: Computes a proportional share of the total cost based on driver usage Both Methods Yield same results Represent the same underlying algebra

Reconciling the Two Methods Rate Method Total Cost Pool Total Number of Driver Units * Number of Driver Units Used Equals Proportion Method Number of Driver Units Used Total Number of Driver Units * Total Cost Pool Equals Number of Driver Units Used * Total Cost Pool Total Number of Driver Units

Reconciling the Two Methods Rate Method Total Cost Pool Total Number of Driver Units * Number of Driver Units Used Equals Proportion Method Number of Driver Units Used Total Number of Driver Units * Total Cost Pool Equals Number of Driver Units Used * Total Cost Pool Total Number of Driver Units

Split the Dinner Check Total $160.00 Carol Alice Thank You Bob Ted Chez Paris Fillet and Lobster 35.00 Chicken Kiev 15.00 Top Sirloin 20.00 Caesar Salad 9.00 Coffee 2 @1.00 2.00 House Wine 4 @5.00 20.00 Champagne 24.00 Ice Cream 4.00 Chocolate Cheesecake 6.00 Sampler 10.00 Soup/Salad 8.00 Aperitif 7 .00 Total $160.00 Carol Alice Thank You Bob Ted

Identifying Key Information What is the cost pool? - The dinner check of $160 What are the cost objects? Bob, Carol, Ted and Alice What is the cost driver? What is the cost pool? - The dinner check of $160 The dinner check of $160 What are the cost objects? - Bob, Carol, Ted, and Alice Bob, Carol, Ted and Alice What is the cost driver? - Number of persons (or eaters)

Allocation Mechanics.xls

Allocation by Rate Method First, calculate the driver rate: Total cost pool Total driver units Cost pool = $160 Total driver units = 4 eaters Rate = $40/eater Cost pool = $160 Total driver units = 4 eaters Rate = $40/eater

Allocation by Rate Method (Cont.) Second, multiply by driver units used by each cost object: Bob = 1 eater * $40/eater = $40 Carol = 1 eater * $40/eater = $40 Ted = 1 eater * $40/eater = $40 Alice = 1 eater * $40/eater = $40 What if Bob and Carol are a couple and Bob is paying for them both? Bob = 1 eater * $40/eater = $40 Carol = 1 eater * $40/eater = $40 Ted = 1 eater * $40/eater = $40 Alice = 1 eater * $40/eater = $40 What if Bob and Carol are a couple and Bob is paying for them both?

Allocation by Rate Method (Cont.)

Allocation by Proportion Method First, calculate each cost object’s proportion: Driver units used Total driver units Bob = 1 eater/4 eaters = 25% Carol = 1 eater/4 eaters = 25% Ted = 1 eater/4 eaters = 25% Alice = 1 eater/4 eaters = 25% Bob = 1 eater/4 eaters = 25% Carol = 1 eater/4 eaters = 25% Ted = 1 eater/4 eaters = 25% Alice = 1 eater/4 eaters = 25%

Allocation by Proportion Method (Cont.) Second, multiply each cost object’s proportion by total cost pool Bob = 25% * $160 = $40 Carol = 25% * $160 = $40 Ted = 25% * $160 = $40 Alice = 25% * $160 = $40 What if Bob and Carol are a couple and Bob is paying for them both? Bob = 25% * $160 = $40 Carol = 25% * $160 = $40 Ted = 25% * $160 = $40 Alice = 25% * $160 = $40 What if Bob and Carol are a couple and Bob is paying for them both?

Allocation by Proportion Method (Cont.)

The Results

LSA #1 Check on Learning Q1. What is the rate per hour when the cost pool totals $30,000 and the total hours are 500? A1. Q2. One of the cost objects uses 50 hours or resources from the cost pool described above. What is its proportion? A2. Show Slide #23: LSA#1 Check on Learning Facilitator’s Note: Ask the following Questions; (Facilitate discussion on answers given) Q1.What is the rate per hour when the cost pool totals $30,000 and the total hours are 500? A1. $30,000/500 hours = $60/hour Q2. One of the cost objects uses 50 hours or resources from the cost pool described above. What is its proportion? A2. 50 hours/500 hours = 10%

LSA #1 Summary During this block, we discussed the rate and proportion methods. Each method results in the same manner when applied. We also defined key cost terminology and their importance in determining which allocation method to use.

Cross Subsidization Consumption Cost allocation Is This Fair? Consumption Cost allocation Consumption Cost allocation

Incremental Effects What Happens if Bob Spends $10 More? 90 80 70 60 Original 50 40 Incremental Change 30 20 10 Bob Consumes Bob Pays

Incremental Effects What Happens if Bob Spends $10 Less? 80 70 60 Decreased Amount 50 Bob’s Actual Consumption And Payment 40 30 20 10 Bob Consumes Bob Pays

Allocation: a Zero-Sum Game The Total is Constant Changing allocation basis simply redistributes cost Increased Allocation for One Cost Object Decreases the allocation for other cost objects Sometimes called “Balloon Squeezing” or “Peanut Butter Effect”

Measurement Effects Motivation Managerial costing inevitably impacts behavior Design of managerial costing systems must recognize and anticipate this effect Consider in this example What incentives exist to spend more? What incentives exist to spend less? What would you do if you went to dinner with them tonight?

LSA #2 Check on Learning Q1. Why did allocation based on number of eaters fail to reflect resource consumption? A1. Q2. What are the effects of incorrect allocation? A2. Show Slide #30: LSA#2 Check on Learning Facilitator’s Note: Ask the following Questions; (Facilitate discussion on answers given) Q1. Why did allocation based on number of eaters fail to reflect resource consumption? A1. Allocation based on number of eaters failed to reflect resource consumption because the cost driver “number of eaters” does not reflect consumption. - This problem, while illustrating the mechanics of allocation, does not reflect true consumption. Q2. What are the effects of incorrect allocation? A2. Unfair cross-subsidizations, the creation of almost free incremental goods, dysfunctional behavioral motivation Q3. What might be a better method of allocation in the dinner check case? A3. Detailed record keeping may be best in this problem --i.e. separate checks Q3. What might be a better method of allocation in the dinner check case? A3.

LSA #2 Summary When we chose which allocation method to use, we are able to identify and cross subsidization between cost objects. This could potentially create undesired behaviors due to the incremental effects of the measurement.

TLO Summary Action: Allocate Single Cost Pool to Users Condition: FM Leaders in a classroom environment working as a member of a small group, using doctrinal and administrative publications, self-study exercises, personal experiences, practical exercises, handouts, and discussion Standard: With at least 80% accuracy (70% for international Learners) you must: Explain how poor cost information encourages undesired behaviors Calculate driver rate and proportion

Practical Exercises