1. Calculate Cost of Service with Multiple Cost Pools and Drivers
Intermediate Cost Analysis
and Management
3.4

2. Why did this cost measurement method fail?
Chez Paris
Fillet and Lobster
Chicken Kiev
Top Sirloin
Caesar Salad
Coffee
House Wine
Champagne
Ice Cream
Chocolate Cheesecake
Sampler
Soup/Salad
Aperitif
Total $160.00
Carol
Alice
Thank You
Bob
Ted

3. Terminal Learning Objective
Action: Calculate Cost of Service with Multiple Cost Pools/Drivers.
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:
Identify 3 methods of distribution
Discuss relative merits of each
Describe need for homogeneity in pools/drivers
Describe need for correlation between pool and driver
Select suitable driver for cost pool 

4. Review: Managerial Costing
cost pool
raw accounting data
managerial
costing
translation
method of
distribution =
cost object
managerially useful information

5. Review: Terminology Method of distribution: Example:
The mechanics of deriving management information from the cost pool
Example:
Determine unit cost by adding all input costs and dividing by number of units
method of
distribution

6. Alternative Methods of Distribution
Managers can obtain the needed view of cost in several ways
Guessing: gut feel of cost distribution
Direct costing: detailed record keeping of all incurred cost transactions by every cost object
Allocation: distribution of cost pool in the same proportion as a cost driver

7. Applications for Guessing
Simple situations where:
Cost of measurement error is small
Need for credibility is low
Ability to hold someone accountable is missing
Cost of cost measurement is high
guessing
and
gut feel

8. Detailed Record Keeping Applications
Labor cost can be accounted for by product through time and attendance reporting
Project costs can include supplies and services charged by job order
Product material costs can be determined through bill of materials
detailed
record
keeping

9. Examples of Detailed Record Keeping
Job order charges
Bill of materials system
Time and attendance reporting

10. Why Not Use Detailed Record Keeping for All Cost?
May not be practical
Will be more expensive
May not be necessary
Probably less flexible
May not be possible
Joint costs and overhead costs often consumed by more than one cost object
method of
distribution

11. An Extreme Example
Consider the accountant at Detailed Transaction Command
Changes pencils every time he writes a transaction for a different cost object
Writes a materials ticket for each pencil issued to each cost object
Maintains meticulous time records whenever he changes pencils
Wonders what to do about cost of pencil sharpener?

12. Method of Distribution Comparison
cost of method accuracy flexibility
guessing cheap poor good
direct very expensive good poor
allocation reasonable reasonable reasonable

13. Review: 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

14. Most Systems Combine Methods
cost pool
detailed
record
keeping
allocation
based on
cost driver
cost object

15. Combining Methods Detailed Record Keeping Allocation Receptionist
Materials
Management
Production Control
Labor
Accounting/
Payroll

16. Choosing a Method of Distribution
Use guessing for simple decision making
Keep detailed records when accounting cost is low and high accuracy useful
Allocate overhead, support, and indirect costs when appropriate
Consider management’s needs for precision and timeliness

17. Discussion: Telephone Charges
Should these be allocated or charged via detailed, call-by-call records?
Issues to consider
What does management need?
Is telephoning a core mission or support function?
Are detailed records available?

18. LSA #1 Check on Learning
Q1. Which method of distribution is the least expensive? A1. Q2. Which method is the most accurate? A2.
Q1. Which method of distribution is the least expensive?
A1. Guessing or gut-feel
Q2. Which method is the most accurate?
A2. Detailed record keeping

19. Facilities Case
An Army Installation has four Companies that occupy five buildings. Incurred costs of $100,000 include utilities, building maintenance, and miscellaneous facilities related expenditures. New policies require the Installation to charge its costs back to Companies.
Using the Allocation Worksheet and the following information, prepare a cost allocation:
Company
Company
Company
Company A B C D
Number of
Buildings 2 1 1 1

20. Consider: What are the cost objects? What is the cost driver?
What is the rate per building?
What is each company’s proportion?
What assumptions are made in using number of buildings as a cost driver?
Is this a good method of distribution?

21. Allocation Spreadsheet
Enter the cost pool and cost objects
After entering driver data the cost allocation calculates automatically

22. What Difference Does it Make?
Some of the buildings are small?
One of the building is the pentagon? ≠

23. Facilities Case B
Not surprisingly, the Company Commanders were not pleased to hear about the Facilities assessment. However, the Company B brought up a valid point: Why should his organization, which occupies a small building, receive the same allocation as Company D, which occupies a substantially larger building? Taking this into consideration, the Facilities manager decided to re-allocate the $100,000 on the basis of Square Footage occupied by each organization.
Company A B C D
Square
Footage
20000
1000
9000

24. Allocation Spreadsheet
Enter data for multiple drivers and select drivers from pull-down lists

25. Consider: What are the cost objects? What is the cost driver?
What is the rate per square foot?
What is each company’s proportion?
Is this a better method of distribution?
Identify cross subsidizations and free goods created by the Case A method

26. Facilities Case C
At this point, the manager of Company D protested. Yes, he did have a large building, but it was not air conditioned. By his estimates, which were reasonably accurate, forty percent of the facilities expenditures were air conditioning related. These expenses included the additional electricity, maintenance and repair needed to keep the air conditioning units running.

27. Facilities Case C (Cont.)
Company D proposed dividing the Facilities Costs into two separate cost pools: one for Air-Conditioning related costs, and one for General Facilities costs. The General cost pool would be allocated on the basis of square footage, just as before. The Air Conditioning cost pool would be allocated on the basis of air conditioned square footage.
Company
Company
Company
Company A B C D
Square
Footage
20000
1000
9000
20000
A/C Square
10000
1000
9000
Footage

28. Company D’s Method Total Cost Pool $100K Air Conditioning General
A/C sq ft
sq ft
Company Facility Cost

29. Allocation Spreadsheet
Define activities and assign cost to activities
Enter additional cost driver data

30. Allocation Spreadsheet
Select drivers for each activity
View the total allocation for each Cost Object

31. Consider: What is the new rate per square foot?
What is the rate per air conditioned square foot?
Identify any cross subsidizations and free goods created by Case B’s method
Is this a better method of distribution?
Why might this method not reflect true cost?

32. Good Method Test Case A is a good method IF...
All buildings are the same
Case B is a good method IF...
All square feet are the same
Case C is a good method IF...
All general square feet are the same AND
All air conditioned square feet are the same

33. Don’t Forget Behavioral Impacts
What undesired behavior is encouraged with allocation by number of buildings
Combining buildings one roof
Expanding buildings when new building might make more sense
Rejecting assignment to small building
In-fighting to occupy large air conditioned buildings

34. LSA #2 Check on Learning
Q1. What happens to an object’s overhead allocation as its proportion of cost driver increases? A1. Q2. If the unit of measure for the cost driver is dollars, what will be the unit of measure for the driver rate? A2.
Q1. What happens to an object’s overhead allocation as its proportion of cost driver increases?
A1. It will increase
Q2. If the unit of measure for the cost driver is dollars, what will be the unit of measure for the driver rate?
A2. The unit of measure in the cost pool is dollars. If the unit of measure in the cost driver is also dollars, then the driver rate will be stated as a percentage.

35. Assumptions Making assumptions is inescapable in managerial costing
There is simply too much to measure and too many ways to measure it
Reasonable assumptions simplify and facilitate the measurement process
Bad assumptions result in poor management decision making

36. Homogeneity and Averaging
Allocation methods implicitly assume sameness or homogeneity
Allocating the dinner check based on number of eaters assumes that all eaters consume resources equally
Allocating facilities costs based on number of buildings assumes that all buildings consume facilities resources equally

37. Homogeneity and Averaging (Cont.)
The homogeneity assumption allows the use of average cost
To simplify the allocation process
To minimize the cost of measurement
To avoid detailed record keeping for every cost object

38. Cause and Effect Relationships
A cause and effect relationship means:
Increasing driver usage will cause more consumption of resources
Decreasing driver usage will cause less resource consumption
Allocating cost based on this driver will reflect the underlying economics of cost consumption and approximate true cost

39. Cause and Effect Relationships (Cont.)
Give the cost manager another target for managing cost
Managing the driver usage will result in managing cost
Allow managers to make rational decisions based on knowledge of true cost
Instead of over-consuming goods and services that appear to be free or low-cost

40. Common Examples of Cause - Effect Cost Drivers
Square footage Heating costs
Number of employees Personnel costs
Mileage Motor pool costs
Computer hours  Computer costs
Others?

41. LSA #3 Check on Learning
Q1. What is the underlying assumption when choosing a cost driver? A1. Q2. A cause-effect relationship means that when the driver usage is reduced, the will also decrease. A2.
Q1. What is the underlying assumption when choosing a cost driver?
A1. That all units of the cost driver consume the cost pool resources (more or less) equally.
Q2. A cause-effect relationship means that when the driver usage is reduced, the will also decrease.
A2. Cost Pool.

42. Contracts Office Case
The contracts office at Fort Apache incurs annual costs of $1 million. These costs are currently distributed to companies A, B, and C on the basis of their number of soldiers
How much is each company allocated?
Company
Company
Company A B C
Number of
Soldiers
250
300
450

43. Contracts Case: Questions
What is the Cost Pool?
What is the Cost Object?
What is the Cost Driver?
What is the rate?
What is each Company’s proportion?

44. Contracts Case: Results
Company
Company
Company A B C
Number of
Soldiers
250
300
450

45. Contracts Case: Discussion Questions
Is “number of soldiers” a good cost driver?
Will decreasing soldiers decrease consumption of contracts resources?
What undesired behaviors might be encouraged by this method of distribution?

46. Contracts Office: Case B
Company C’s captain finds his allocation unacceptable. He rejects being charged $450K when he does not have any contracts and suggests using number of contracts as the cost driver.
How is cost allocated with this cost driver?
Company
Company
Company A B C
Number of
Contracts 50 50

47. Contracts Case B: Questions
What is the Cost Pool?
What is the Cost Object?
What is the Cost Driver?
What is the rate?
What is each Company’s proportion?

48. Contracts Case B: Results
Company
Company
Company A B C
Number of
Contracts 50 50

49. Balloon Squeezing Company A’s cost doubles
Company B’s cost increases 67%
Total cost remains unchanged
A change in distribution means:
If one command’s allocation goes DOWN by $1000 Then...
Someone else’s allocation has to go UP by $1000
(Zero sum game requires support of top management in order to succeed)

50. Contracts Case B: Discussion Questions
Is “number of contracts” a good cost driver?
Will decreasing number of contracts decrease consumption of contracts resources?
What undesired behaviors might be encouraged by this method?

51. Contracts Office: Case C
Company B labels these results wrong and points out that its contracts are relatively simple and that it always complies with contracts’ procedure and lead time requests. The Company CO suggests that a survey of contracts’ efforts be used as the cost driver.
How are costs allocated on this basis?
Company
Company
Company A B C
Level of
Effort
60%
40%

52. Contracts Case C: Results
Who do you think is upset now?

53. Contracts Office: Case D
Company A argues strongly that it cannot afford $600k for contracts without compromising its mission. The company CO, the most senior and forceful of the company CO’s, demands that “something fair, like the number of soldiers wearing glasses” be used.
How are costs allocated on this basis?
Company
Company
Company A B C
Soldiers With
Glasses 15 15 15

54. Contracts Case: Results
Cost Consumption Method Results:
Cost Driver Distribution Profiles:

55. Contracts: Discussion Questions
Is “number of soldiers wearing glasses” a good cost driver?
(Never forget that we accountants are trained to deal with nonsense)
Which driver would you recommend
If you are any of the company commanders?
If you are the installation commander?

56. Driver Selection: Issues to Consider
Does the proposed driver correlate with resource consumption?
Less driver causes less resource
More driver causes more resource
Does the proposed driver motivate desirable behavior?
Cost conscious managers will work to reduce the driver
Does less driver benefit the organization?

57. Contracts Case: Lessons
Using cost driver to allocate is easy
Choosing the right cost driver may be hard
Cannot ignore behavioral implications
So count on them
Design system to motivate desired behavior
True economic cost usually motivates the right cost management behavior

58. LSA #4 Check on Learning
Q1. What does “balloon squeezing” mean? A1. Q2. What should be considered when choosing a cost driver? A2.
Q1. What does “balloon squeezing” mean?
A1. It means that when one cost object’s allocation goes down, another cost object’s allocation must go up. The total cost pool does not change, only the distribution
Q2. What should be considered when choosing a cost driver?
A2. Homogeneity and cause-effect relationships are important, but even more important are the behavioral implications of a cost driver. Cost drivers represent a target for managers to decrease in order to reduce cost. Is reduction of that cost driver in the best interest of the organization?

59. Why Level of Effort Analysis?
Many costs are not easily correlated with cost objects
Less true in manufacturing
Very true in service
Level of effort analysis technique easily:
Produces a customized driver of reasonable accuracy
allocation
based on
cost driver

60. Overhead: Likely Candidate for Level of Effort (LOE)
Overhead Areas Often Use LOE Since:
Work Usually Specialized and Not Consumed Uniformly by Line Organizations
Like the Contracts Office
Lack of Consumption Homogeneity May Mean that Common Drivers are Poor
i.e. Square Feet, Direct Labor Hours, Mileage, etc., Do not Adequately Correlate to Cost Object Consumption of Overhead Resources

61. Developing LOE as a Driver
Interview Activity Manager
Concentrate on People’s “Efforts” Supporting Cost Objects
Find out What Proportion of Each Person’s Time would be “Invoiced” to Each Cost Object if Activity was a Business and Cost Object was a Customer

62. Precision and LOE
Activity Manager Will Only be Able to Make Rough Estimates
Estimates Get Better Over Time
Random Estimate Errors Tend to Offset
Systematic Error Can Induce Bias
Saliency Can Induce Bias

63. Beneficial By-Products
Staff/overhead organizations often misunderstand their role
It’s easy for staff to think they are line
Often helpful to organization when staff functions are forced to think of their line customers as paying the bills
Publicizing LOE creates a forum for cost and support issues

64. Level of Effort Example{
Effort
Makers
Staff manager has good idea of where people work and who they support
The bottom line represents a “proportional” method allocation basis for the staff function

65. Don’t Forget Homogeneity Assumption
Implicit assumptions:
Effort costs the same for each person
Other costs proportional to people
If Ted is a lawyer and others are paralegals, the level of effort is biased
Use weighting factor, or
Make two separate activities if bias is significant

66. Random Error up down Random error tends to offset
This error is probably not significant
Both LOE estimates capture the major effects

67. Criticism of Level of Effort
Bias is possible due to “saliency”
Recent problems are fresh in mind
Suppose C had a big problem last month
Produces significantly more error up
down

68. Example: Returns Driver in IRS Audit Office
# of returns 40 30 20 10
corporate complex other simple
individual individual

69. IRS Quality Control Level of Effort Analysis
people complex corporate other simple other
individual individual districts
QRS-1 11
5.0
5.0
0.0
1.0
QRS-2 12
2.0
5.5
4.0
0.5
TRAINING 2
0.8
0.8
0.4
0.0
DISCLOSURE 2
0.0
0.0
0.0
2.0
TOTAL 27
7.8
11.3
4.4
3.5
PERCENT FOR BASIS
100
28.8
41.8
16.3
12.9

70. Precisely Wrong vs. Roughly Right
# of returns 40
level of effort 30 20 10
corporate complex other simple other
individual individual districts

71. LSA #5 Check on Learning
Q1. Why is level of effort sometimes a better driver than a unit-based driver? A1. Q2. What is the primary criticism of the level of effort driver? A2.
Q1. Why is level of effort sometimes a better driver than a unit-based driver?
A1. It can provide a better reflection of true cost when unit-based drivers fail due to lack of homogeneity.
Q2. What is the primary criticism of the level of effort driver?
A2. Saliency can cause significant error in the estimates. Normal ‘random’ error should not be a problem, as the errors should offset.

72. Conduct Practical Exercise

73. TLO Summary
Action: Calculate Cost of Service with Multiple Cost Pools/Drivers.
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:
Identify 3 methods of distribution
Discuss relative merits of each
Describe need for homogeneity in pools/drivers
Describe need for correlation between pool and driver
Select suitable driver for cost pool