1. Describe Common Pitfalls And Ways To Avoid Them In ABC © Dale R. Geiger 20111

2. What Time is It? 2:00? 2:05? 2:03? 2:02:47? 2:02:46.35? Remember: A broken clock is correct to 10 digits of precision twice a day © Dale R. Geiger 20112

3. 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 © Dale R. Geiger 20113

4. Choosing Level of Precision Goal: Managerially useful information for cost warrior decision making Question: How much precision do cost warriors need? managerially useful information cost object = © Dale R. Geiger 20114

5. Things to Consider User needs Cost environment Cost style Organization Measurement issues Difficulty and cost Limits to precision Impact on behavior © Dale R. Geiger 20115

6. User Defined Relevance Nearest 5 or 10 minutes Nearest minute or two Nearest 5 or 10 seconds Nearest nanosecond Good enough for most decisions Needed to set your VCR Radio programming Synchronous data transmission © Dale R. Geiger 20116

7. Precision Costs Nearest 5 or 10 minutes Nearest minute or two Nearest 5 or 10 seconds Nanoseconds $10 $200 $500 $100,000 © Dale R. Geiger 20117

8. 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? © Dale R. Geiger 20118

9. Example: Cost of a Job Cost expression for a job: Parts $Labor $Clerical OH $ Supplies OH $ Parts $ + Labor $ + Clerical OH $ + Supplies OH $ Cost measurement for Job A: $2995.27 $2012.42 $960.00 $748.82 $2995.27 + $2012.42 + $960.00 + $748.82 Precision of cost measurement: ± $.01 ± $.01 ± 10%* $960 ± $10 ± $.01 ± $.01 ± 10%* $960 ± $10 Actual Parts + Actual Labor + 12% * $8K + $2995.27/$16K * $4K © Dale R. Geiger 20119

10. 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 Management decision making can be confused and misled $39,999 © Dale R. Geiger 2011 10

11. Dining Hall Case A Management is concerned that lunches are losing money and wants to determine profit As part of the study non-food expenditures of $693K must be distributed to cost objects: Breakfast Lunch Dinner This should determine whether the Hall suffers from “Free Lunch Syndrome” © Dale R. Geiger 201111

12. Data for Dining Hall Case Cooling Food $237 Cooling Food $237 Cleaning119 Cleaning119 Serving 64 Serving 64 Collecting Money 63 Collecting Money 63 Preparing Food 36 Preparing Food 36 Doing Paperwork 22 Doing Paperwork 22 Washing Dishes 20 Washing Dishes 20 Prepare Veggies 20 Prepare Veggies 20 Prepare Salads 20 Prepare Salads 20 Plan Meals 18 Plan Meals 18 Drive Trucks 18 Drive Trucks 18 Unload Trucks 14 Unload Trucks 14 Stock Shelves 14 Stock Shelves 14 Replenish Line 14 Replenish Line 14 Maintain Equip. 14 Maintain Equip. 14 Total $693 Total $693 Management has identified the following activities, along with their respective costs: © Dale R. Geiger 201112

13. 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 Activity:BreakfastLunchDinner Cooling Food30%10%60% © Dale R. Geiger 201113

14. Level of Detail Spreadsheet 208 69 416 © Dale R. Geiger 2011 14

15. 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? Does this give the information management needs? © Dale R. Geiger 201115

16. Dining Hall Case B Concerned about the accuracy of a single pool system management sends accounting to study cleaning cost distribution Reallocate adding the pool below. The worksheet will allocate all other costs by weighting the two bases Activity:BreakfastLunchDinner Cleaning35%20%45% © Dale R. Geiger 201116

17. Level of Detail Spreadsheet Unspecified dollars default to activity labeled “all other” Driver for “all other” calculated by weighting specified activities, drivers © Dale R. Geiger 201117

18. Two Pool, Two Driver Output 219 92 381 © Dale R. Geiger 2011 18

19. 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? © Dale R. Geiger 201119

20. 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 Activity:BreakfastLunchDinner Serving35%20%45% © Dale R. Geiger 201120

21. Three Pool, Three Driver Output © Dale R. Geiger 201121

22. Three Pool, Three Driver Output 223 99 371 © Dale R. Geiger 2011 22

23. How Many Activities Must Be Evaluated? $- $50 $100 $150 $200 $250 $300 $350 $400 $450 123456789101112131415 Number of Activities Evaluated Dinner ? ? ? Breakfast ? ? ? Lunch ? ? ? © Dale R. Geiger 201123

24. Diminishing Return to Accounting Effort $- $50 $100 $150 $200 $250 $300 $350 $400 $450 123456789101112131415 Number of Activities Evaluated Dinner Breakfast Lunch © Dale R. Geiger 201124

25. 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 © Dale R. Geiger 201125

26. Check on Learning How does the “Weakest Link” theory affect the level of precision possible in managerial costing? What does “false precision” mean? © Dale R. Geiger 201126

27. Cost of Detail Information is Not Free: Measuring Accumulating Storing Editing Manipulating Reporting Explaining © Dale R. Geiger 201127

28. Cost of Cost Methodology Gut feel, intuition or experience Back of the envelope calculation Estimates and analyses Managerial cost system Low $ High $ © Dale R. Geiger 201128

29. A Natural Tradeoff Exists Can go too far with level of detail Can have too little detail $ Cost of not having detail Cost of getting detail © Dale R. Geiger 201129

30. 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 © Dale R. Geiger 201130

31. Cost of Measurement Eventually Exceeds Benefit 1% of absolute value of error $180 per activity evaluated © Dale R. Geiger 2011 31

32. Cost of Precision in the Cost System Directly Related to: Number of Cost Objects Level of Precision Attempted Goal: Be on the target, but hitting the center may be too expensive © Dale R. Geiger 201132

33. Law of Diminishing Return 17 WWII 1.2 Gulf War Tank Rounds Fired per Tank Destroyed $ Cost Spent on Technology and Training 1.04 *Certain Victory © Dale R. Geiger 201133

34. Important Considerations Willie Sutton Law of Managerial Costing Asked why he robbed banks he said: “Because that’s where the money is” Build managerial cost system structure around the big ticket items: “Because that’s where the money is” © Dale R. Geiger 201134

35. Where is the Money? The Pareto Effect: The 80/20 Rule The Significant Few The Trivial Many © Dale R. Geiger 201135

36. Impact of Error Getting the significant few within 10% is as Important as the total of the trivial many 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 16% 20% © Dale R. Geiger 2011 36

37. 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! © Dale R. Geiger 201137

38. 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? © Dale R. Geiger 201138

39. 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? © Dale R. Geiger 201139

40. Managerial Costing: A Two Edged Sword Good Costing Yields Desired Behavior Economically Rational Decision Making Poor Costing Yields Undesired Behavior Over Consumption of Under Costed Goods Under Consumption of Over Costed Goods © Dale R. Geiger 201140

41. Managing the Cost Driver ABC Systems Give Cost Warriors Two Targets Activity Cost Reduction Cost Driver Reduction Example: Reduced Square Footage Should Lead to Reduced Utilities, Maintenance, etc. activity allocation based on cost driver © Dale R. Geiger 201141

42. Danger: Right Behavior, Wrong Outcome Managerial costing systems motivate managers to reduce cost drivers A system with the wrong design can Reduce consumption of the wrong thing Inadvertently increase consumption of costly resources that now appear to be free goods © Dale R. Geiger 201142

43. 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 Over automating Excessive off shore development Wrong outsourcing decisions © Dale R. Geiger 201143

44. Plant Wide, Labor Based ABC System Used to Work 45 labor 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 © Dale R. Geiger 201144

45. ABC System Fails to Evolve With Automation 45 labor 5 labor 5 support 45 support Reality left plant right plant 50 50 ABC Process Pool = 50 Driver = labor Proportion 90/10 Allocation 45/5 Cost System Report left plant right plant 90 10 © Dale R. Geiger 201145

46. Outsourcing With Bad Cost Information Case facts: Navy evaluation of ship refurbishment Nuclear and non-nuclear Navy shipyards vs. private shipyards Navy uses single pool based on labor Assumptions Costs are identical in both shipyards Overhead for nuclear exceeds non-nuclear © Dale R. Geiger 201146

47. Navy Cost Reporting is Flawed by Labor Driver Real Costs Non Nuclear Nuclear Labor 4040 Overhead4080 Reported Costs Activity Pool 120 =40 + 80 Driver Proportion 50% 50% Overhead Distribution6060 © Dale R. Geiger 201147

48. Bid Comparison: What Work Did the Navy Privatize? Non Nuclear Nuclear Private Yards Navy Yards labor over- head © Dale R. Geiger 201148

49. Follow-up Questions How much profit could private shipyard non nuclear bids have added and still won the competition? What’s the maximum amount of cost the navy could have saved after closing non nuclear shipyards? © Dale R. Geiger 201149

50. Cost Quantity Demanded Remember Free Goods Perceived Cost Drives Real Consumption Free Goods Have Infinite Demand Underlying Goal: Manage Cost “True” cost motivates better cost management by introducing rational economic choice in ongoing management decisions © Dale R. Geiger 2011 50

51. 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 © Dale R. Geiger 201151

52. 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 When emphasis of some other behavior is needed © Dale R. Geiger 201152

53. 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 Maintenance based on preventative maintenance costs © Dale R. Geiger 201153

54. 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 © Dale R. Geiger 201154

55. Computer Ops Mini Case $1,000,000 fixed cost of operation 2000 hours of services rendered Basis of allocation: Hours used Users A BC Hours 600 650 750 Allocation $300K $325K $375K © Dale R. Geiger 201155

56. Due to weather and business reasons C’s usage declines next period The hours of use allocation base shifts cost to A and B Users A BC Hours 600 650 750 Allocation $353K $382K $265K Change $ 53K$ 57K -$110K © Dale R. Geiger 201156 Computer Ops Mini Case

57. 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 © Dale R. Geiger 201157 Computer Ops Mini Case

58. 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 Users A BC Hours 300 325 750 Allocation $218K $237K $545K Change -$134K-$145K $279K © Dale R. Geiger 201158 Computer Ops Mini Case

59. 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 UsersABC Hours 300 325 0 Allocation $480K $520K 0 Change $262K $283K -$545K © Dale R. Geiger 201159 Computer Ops Mini Case

60. 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 Users ABC Hours.008 0 0 Allocation $1000K0 0 Change $520K -$520K 0 0 © Dale R. Geiger 201160 Computer Ops Mini Case

61. A Death Spiral 0 200 400 600 800 1000 1200 1400 1600 Case ACase BCase CCase D Cost Per Hour or Use © Dale R. Geiger 201161

62. 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 © Dale R. Geiger 201162

63. Summary: Pitfalls Under costed cost objects are over consumed The true cost of resources consumed will help motivate rational, desired behaviors Over costed cost objects are under consumed It is not in the organization’s best interest to reduce certain activities such as safety and technology Coster beware: Averaging by its nature both under costs and over costs Always consider the behavioral motivations © Dale R. Geiger 201163

64. Check on Learning How does incorrect cost information affect outsourcing decisions? How might motivating reduced consumption be bad for an organization? © Dale R. Geiger 201164

65. Practical Exercise © Dale R. Geiger 201165