Identify Pitfalls in a Role Based Control Case Study Scenario Navy Research and Development Case © Dale R. Geiger 20111

Ever Wonder Why Overhead is Often Called Burden?

Terminal Learning Objective Task: Identify Pitfalls in a Role Based Control Case Study Scenario 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 Discuss role based control issues related to support functions Describe various allocation solutions for support functions Calculate step-down allocation © Dale R. Geiger 20113

SPAWAR Systems Center-Pacific Very high tech R&D funded by project basis Funding process required total cost by project for proper reimbursement Organized into research divisions with numerous centralized support functions Safety (as shown in last segment) Facilities (the focus of this case) and Many others

Proposed Change in Distribution of Facilities Cost Situation: meeting at Navy R&D lab Reviewing a distribution of San Diego facilities cost to operating divisions Existing method allocated based on labor Proposed method allocated based on square feet occupied Division Total Labor Basis ($M) Footage Basis ($M) Change ($M) (2.2) (.3) (.9) - Division Total Labor Basis ($M) Footage Basis ($M) Change ($M) (2.2) (.3) (.9) -

Chaos Resulted Division 30 wasnt represented as they were located in Pennsylvania Division 40 didnt say a word Divisions 50, 60, and 70 strongly objected to the methodology, purpose, and change The meeting deteriorated until the commander exercised his leadership role Division Total Labor Basis ($M) Footage Basis ($M) Change ($M) (2.2) (.3) (.9) - Division Total Labor Basis ($M) Footage Basis ($M) Change ($M) (2.2) (.3) (.9) -

Leadership Driven Management The Commander stated: Look, weve got to get our overhead down (Management need awareness) There are two ways to do this. One is to use the Soviet Method and Ill make all the decisions (Centralized management paradigm)

Leadership Driven Management The alternative is to use free market economics (Decentralized management paradigm) Activity based costing will tell you what things really cost (Actionable cost measurement capability) Ill look to you to make the right decisions. Which do you want?

NRaD Facilities Allocation Revisited Simple, direct allocation of facilities to line divisions on the basis of occupied space made sense to the CO Division 40 was growing rapidly (and was short space) while Division 50 was declining (and had a lot of space) Division Total Labor Basis ($M) Footage Basis ($M) Change ($M) (2.2) (.3) (.9) - Division Total Labor Basis ($M) Footage Basis ($M) Change ($M) (2.2) (.3) (.9) -

NRaD Facilities Allocation Revisited HOWEVER, the Commanding Officer had a major concern about the cost model: Motivated line departments to reduce but Did not put similar pressure on overhead The unintended consequence would be: Line functions vacating space Overhead functions moving in Advanced allocation issues had to be considered

A Generic Problem: Allocating Overhead to Overhead Functions Support functions support other support functions Payroll function serves accounting and administration Personnel department consumes facilities resources Accounting uses computing services How should this be handled?

Learning Check What was the Commanders Intent for the R&D lab? What problems can arise when support departments support other support departments? © Dale R. Geiger

Allocation Alternatives Direct, Simple Step Down Reciprocal

Allocation Alternatives Direct, Simple Step Down Reciprocal

Allocation Alternatives Direct, Simple Step Down Reciprocal

Direct, Simple Allocation Follows methods already covered in this course Allocates cost pools directly to cost objects Advantage: Advantage: easiest to use and explain Disadvantage Disadvantage: may provide free goods to support functions

Direct Simple Allocation Support X Support Y Support Z Core A Core B

Step Down Allocation Allocates first cost pool to other cost pools and cost objects Allocates second cost pool to other cost pools (less first pool) and cost objects Etc, Etc, Etc Advantage Advantage: prevents most free goods Disadvantage Disadvantage: increases the complexity and cost of cost system

Step Down Allocation Support X Support Y Support Z Core A Core B

Step Down Allocation First Step Support X Support Y Support Z Core A Core B

Step Down Allocation Second Step Support X Support Y Support Z Core A Core B

Step Down Allocation Third Step Support X Support Y Support Z Core A Core B

Reciprocal Allocation Recognizes consumption of all resources by all support functions Advantage Advantage: prevents free goods Disadvantages Disadvantages: Increases the complexity and cost of cost system (less affordable) Decreases the understanding of results (less credible) Provides excuses (less useful)

Reciprocal Allocation Support X Support Y Support Z Core A Core B

Reciprocal Allocation Create a system of n equations in n unknowns where: Matrix [D] represents fraction of services consumed Matrix [E] represents the vector of service costs Matrix [B] is the transpose of the reciprocal cost vector, Then:[E] = [B] [D] T T

Simple Reciprocal Allocation Example: Two Activities and Two Cost Objects Payroll costs $700 and supports itself (1%), Receiving (2%), Code 30 (25%) and Code 40 (72%) Payroll reciprocal cost (PRC): Receiving costs $1000 and supports itself (1%), Payroll (1%), Code 30 (40%) and Code 40 (58%) Receiving reciprocal cost (RRC): This gives us two equations in two unknowns PRC = PRC +.01RRC RRC = PRC +.01RRC

Reciprocal Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost ,1111,700 © Dale R. Geiger

Reciprocal Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost ,1111,700 © Dale R. Geiger

Reciprocal Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost ,1111,700 © Dale R. Geiger

Reciprocal Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost ,1111,700 © Dale R. Geiger

Reciprocal Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost ,1111,700 © Dale R. Geiger

Reciprocal Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost ,1111,700 © Dale R. Geiger

Reciprocal Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost ,1111,700 © Dale R. Geiger

Reciprocal Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost ,1111,700 © Dale R. Geiger

Learning Check What is the primary advantage of the simple, direct method? What is the primary advantage of the reciprocal method? © Dale R. Geiger

Demonstration Problem (part 1) Payroll costs $700 and supports itself (1%), Receiving (2%), Code 30 (25%) and Code 40 (72%) Receiving costs $1000 and supports itself (1%), Payroll (1%), Code 30 (40%) and Code 40 (58%) Prepare a step-down distribution allocating payroll first and then receiving © Dale R. Geiger

Step Down Allocation Step one: define the hierarchy of support May be based on significance (largest first) Or on desired behaviors (eliminate free goods) In our case, we want to motivate wise consumption of payroll resources We will allocate payroll first Ignore payrolls allocation from itself and from receiving Allocate payroll to receiving and to codes 30 and 40 © Dale R. Geiger

Step Down Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost © Dale R. Geiger

Step Down Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost © Dale R. Geiger Step 2: Allocate first support activity to support and line functions

Step Down Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) -700 Final Cost © Dale R. Geiger

Step Down Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) -700 Final Cost © Dale R. Geiger Step 3: Allocate second support activity to line functions

Step Down Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost © Dale R. Geiger

Step Down Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost © Dale R. Geiger

Discussion on Step-Down Theoretically we would repeat the steps for each activity in the hierarchy What are the implications? What solutions might you suggest? © Dale R. Geiger

Suggested Step Down Hierarchy © Dale R. Geiger Most Important Support Activity X X Support Y Support Z Core A Core B

Suggested Step Down Hierarchy © Dale R. Geiger Most Important Support Activity X X Support Y Support Z Core A Core B

Suggested Step Down Hierarchy © Dale R. Geiger Most Important Support Activity X X Support Y Support Z Core A Core B

Demonstration Problem (part 2) Ignore the allocations from and between payroll and receiving Apply direct simple allocation Report Code 30 and Code 40 allocations cost Compare the results from the three methods © Dale R. Geiger

Direct, Simple Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost © Dale R. Geiger

Direct, Simple Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) -700 Final Cost © Dale R. Geiger

Direct, Simple Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost © Dale R. Geiger

Direct, Simple Allocation PayrollReceiving3040Total Cost Incurred Payroll Cost (add) Receiving Cost (add) Allocated (subtract) Final Cost © Dale R. Geiger

Compare the Three Methods PayrollReceiving3040Total Reciprocal Step-Down Simple © Dale R. Geiger What have you learned?

What is the first step in the step-down allocation process? What is the main advantage of the step-down method © Dale R. Geiger Learning Check

Recommendations – Pitfall Avoidance Keep it simple Allocate most support functions directly to cost objects Take exception rarely and thoughtfully Facilities Automated data processing Handle exceptions with step down method instead of reciprocal

Step Down Method Recommended to NraD Commanding Officer Facility overhead first allocated to all line and overhead functions Overhead functions included this cost in their budgets and subsequent direct, simple allocations Small impact on cost distribution Significant impact on behavior

NRaD Facilities Conclusion: Results Leaders of core functions chose role based control process over Soviet Method Both core and support functions quickly identified space no longer needed 35,000 square feet freed in first year with cost savings and cost avoidance evaluated at $2.3 million per year Monthly AAR still conducted 15 years later Why do you think this process has continued?