Hilton Maher Selto

10 Managing and Allocating Support-Service Costs McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

10-3 The Service Cost Challenge The GOAL of an organization is to achieve the objectives that prompted the creation of the organization in the first place. Commercial firms provide goods and services & earn at least a competitive profit Nonprofit hospitals provide superior healthcare & cover cost of operation Nonprofit hospitals provide superior healthcare & cover cost of operation Cities provide essential services to their citizens within budgetary limits Cities provide essential services to their citizens within budgetary limits

10-4 The Service Cost Challenge Achieving the goals of the organization requires the use of scarce resources and making complex trade-offs among competing uses Requires: Reliable quantitative and qualitative cost management information about relative costs and benefits of alternatives Requires: Reliable quantitative and qualitative cost management information about relative costs and benefits of alternatives

10-5 Factors to be Considered Internal Or Outsourced Support Services? Knowledge Base Complex or unique organizations may have distinct procedures and cultures Complex or unique organizations may have distinct procedures and cultures Reliable Service Providers Sensitive Information Some organizations compete on the basis of their knowledge of technology or complex market and political situation A less expensive, outsourced service is not cost effective if the reliability and quality of the service is low and adversely affects the organizations to meet its objectives

10-6 Cost-based management approaches to managing internal support-service costs Charge internal customers nothing for support services and recover the costs from general revenue Charge internal customers nothing for support services and recover the costs from general revenue Charge the cost of support services provided to using departments and possibly recover the costs from these internal customers Charge the cost of support services provided to using departments and possibly recover the costs from these internal customers Managing Internal Support- Service Costs

10-7 Managing Internal Support- Service Costs Cost allocations are, by nature, arbitrary and may not measure uses of resources accurately If internal customers are required to use internal services, they may spend valuable time negotiating and lobbying over fair prices which may be inefficient DISADVANTAGES Charge the cost of support services provided to using departments and possibly recover the costs from these internal customers Charge the cost of support services provided to using departments and possibly recover the costs from these internal customers

10-8 Production Departments Production Departments Support-service Departments Support-service Departments Provide services directly to customers Provide services to each other and to production departments Distinquishing Between Support Services & Production Depts.

10-9 Required reporting: Tax regulations External financial reporting Required reporting: Tax regulations External financial reporting Influencing Behavior: Incentive to control use of support services Influencing Behavior: Incentive to control use of support services Cost-based contracts: Government Foundation Private industry Cost-based contracts: Government Foundation Private industry Other Uses Of Cost Allocation

Identify the costs to be allocated to internal customers Cost Allocation from Service Depts. To Internal Customers 2. Choose the appropriate allocation base(s) and rate(s) 3. Select and use a cost-allocation method 4. Determine if the cost allocations achieve the desired results - if not, begin the process again

10-11 COST POOLS Budgeted or actual spending amounts for distinct sets of resources COST POOLS Budgeted or actual spending amounts for distinct sets of resources Why use multiple cost pools? Multiple cost pools facilitate managing the different types of support services and should allow more accurate cost allocations to internal customers. 1. Identify the Costs to be Allocated to Internal Customers Planning and Developmen t Information technology Finance Human Resources

10-12 Support-Service Department Finance Human resources Information Technology Planning & development Support-Service Department Finance Human resources Information Technology Planning & development Cost-Allocation Base ? Cost-Allocation Base ? Traditional Approach Without ABC, choose allocation bases that seem reasonable and justifiable to internal customers Without ABC, choose allocation bases that seem reasonable and justifiable to internal customers 2. Choose the Appropriate Allocation Base(s) and Rate(s) Look for Cause-and-Effect Relationships Allocation bases may be ABC cost drivers, but without careful analysis it is not possible to validate causal relationships Cost-Allocation Base Size of budget before cost allocations Number of full-time equivalent employees Number of computers, including network servers Number of project applications Cost-Allocation Base Size of budget before cost allocations Number of full-time equivalent employees Number of computers, including network servers Number of project applications

10-13 Steps in the ABC Approach 1. Measure each support-service department’s resource spending by level (unit, batch, customer, facility). 1. Measure each support-service department’s resource spending by level (unit, batch, customer, facility). 2. Choose the Appropriate Allocation Base(s) and Rate(s) 2. Identify and measure the activities demanded by internal customers that require support-service spending (e.g. hiring and training new employees) to obtain cost-driver basis. 3. Divide support-service resource spending by appropriate cost-driver basis to derive cost-driver rates. Look for Cause-and-Effect Relationships

10-14 Direct Method Direct Method 3. Select and Use a Cost- Allocation Base Charges costs of support- service departments to internal customers without making allocations among service departments. Allocations go directly to production or direct-service departments. This method ignores services provided to other support service departments. Allocations go directly to production or direct-service departments. This method ignores services provided to other support service departments. Example The City of Rock Creek needs to allocate the costs of three support services; Information Technology (IT), Building and Grounds (BG) and Human Resources (HR), to three Production (User) Departments.

10-15 Using the information below, allocate the costs to the departments using the Direct Method. Exh Select and Use a Cost- Allocation Base

10-16 When the allocation is complete, Support-Service Departments will have $0 allocated to them. Exh Simply allocate each service department in turn to the various production departments. 3. Select and Use a Cost- Allocation Base

10-17 When the allocation is complete, Support-Service Departments will have $0 allocated to them. Exh We have assumed, in the direct method, that the service departments are NOT allocating to each other. 3. Select and Use a Cost- Allocation Base

10-18 When the allocation is complete, Support-Service Departments will have $0 allocated to them. Exh Select and Use a Cost- Allocation Base

Select and Use a Cost- Allocation Base Step Method Step Method Recognizes that some support- service departments provide services to other support services as well as production and direct service departments Allocations begin with the service department with the largest proportion of its total allocation base in other service departments Example The City of Rock Creek needs to allocate the costs of three support services among the other support services AND to three Production (User) Departments.

10-20 Using the information below, allocate the costs to the departments using the Step Method. Exh Select and Use a Cost- Allocation Base

10-21 In this case, HR has 25% of its costs going to other service departments. So, start allocating with HR. When the allocation is complete, Support-Service Departments will have $0 allocated to them. Exh Select and Use a Cost- Allocation Base

10-22 B&G now has $86,500 in costs that must be allocated. When the allocation is complete, Support-Service Departments will have $0 allocated to them. Exh Select and Use a Cost- Allocation Base

10-23 When the allocation is complete, Support-Service Departments will have $0 allocated to them. B&G and HR have been fully allocated. Finish the task by allocating the $47,535 in IT. Exh Select and Use a Cost- Allocation Base

10-24 When the allocation is complete, Support-Service Departments will have $0 allocated to them. Exh Select and Use a Cost- Allocation Base

10-25 Cost Allocation Accuracy The Direct Method does not consider interactions among service departments The Reciprocal Method is more thorough in considering interactions among service departments ABC cost-driver bases should reflect cause- and-effect relationship between resource spending and use Most Accurate Combination Most Accurate Combination Step 4: Determine if the Cost Allocations Achieve Desired Results The Step Method considers some interactions among service departments The Step Method considers some interactions among service departments

10-26 COST ALLOCATION EFFECTS If support-service departments provide significant services to each other, the amounts of costs allocated to direct-service, production, and marketing departments probably differ under each method. If support-service departments provide significant services to each other, the amounts of costs allocated to direct-service, production, and marketing departments probably differ under each method. Significant differences can effect: Significant differences can effect: Contracts Decision- making Decision- making Performance evaluations Performance evaluations Step 4: Determine if the Cost Allocations Achieve Desired Results

10-27 COST ALLOCATION COSTS AND BENEFITS Complex cost-allocation systems are difficult and costly to DESIGN Complex cost-allocation systems are difficult and costly to DESIGN Complex cost-allocation systems are difficult and costly to MAINTAIN Complex cost-allocation systems are difficult and costly to MAINTAIN Cost-allocation systems may require revision in a continual process of improvement, which is costly but can be justified if decisions and organizational performance also continue to improve. Step 4: Determine if the Cost Allocations Achieve Desired Results

10-28 END OF CHAPTER 10