1. Calculate Cost Of A Service/Job With Multiple Cost Pools/Drivers © Dale R. Geiger 20111

2. Why did this cost measurement method fail? Thank You 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 Chez Paris Bob Carol Ted Alice © Dale R. Geiger 20112

3. Terminal Learning Objective Task: Calculate Cost Of A Service/Job With Multiple Cost Pools/Drivers Condition: You are a cost advisor technician with access to all regulations/course handouts, and awareness of Operational Environment (OE)/Contemporary Operational Environment (COE) variables and actors. Standard: with at least 80% accuracy: Distinguish drivers as transactional, duration, or intensity Describe need for homogeneity in pools/drivers Describe need for correlation between pool and driver Select suitable driver for cost pool © Dale R. Geiger 20113

4. 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 © Dale R. Geiger 20114

5. 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 © Dale R. Geiger 20115

6. Homogeneity and Averaging 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 © Dale R. Geiger 20116

7. Types of Cost Drivers Cost Drivers may be: Unit-based: Assumes a correlation between consumption of a unit of driver and consumption of cost pool Assumes all units of the driver are homogeneous Examples: purchase orders, headcount, etc. © Dale R. Geiger 20117

8. Types of Cost Drivers Cost Drivers may be: Duration-based: Assumes a correlation between time spent on an activity and consumption of cost pool Will be stated in units of time (hours, minutes, etc.) Example: Machine hours or labor hours © Dale R. Geiger 20118

9. Types of Cost Drivers Cost Drivers may be: Intensity-based: Assumes a correlation between the level of effort expended and consumption of cost pool Usually stated as a percentage or proportion Example: Support services assign cost to projects based on effort expended on each project © Dale R. Geiger 20119

10. 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 © Dale R. Geiger 201110

11. Cause and Effect Relationships 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 © Dale R. Geiger 201111

12. 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? © Dale R. Geiger 201112

13. Check on Learning What is the underlying assumption when choosing a cost driver? A cause-effect relationship means that when the driver usage is reduced, the will also decrease. © Dale R. Geiger 201113

14. 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 A B C Number of Soldiers250300450 © Dale R. Geiger 201114

15. 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? © Dale R. Geiger 201115

16. Contracts Case: Results Company A B C Number of Soldiers250300450 © Dale R. Geiger 201116

17. 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? © Dale R. Geiger 201117

18. 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 A B C Number of Contracts50 0 © Dale R. Geiger 201118

19. 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? © Dale R. Geiger 201119

20. Contracts Case B: Results Company A B C Number of Contracts50 0 © Dale R. Geiger 201120

21. 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) © Dale R. Geiger 201121

22. 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? © Dale R. Geiger 201122

23. 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 A B C Level of Effort60%40%0 © Dale R. Geiger 2011 23

24. Contracts Case C: Results Who do you think is upset now? © Dale R. Geiger 201124

25. 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 A B C Soldiers With Glasses15 © Dale R. Geiger 2011 25

26. Contracts Case: Results Cost Consumption Method Results: Cost Driver Distribution Profiles: © Dale R. Geiger 201126

27. 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? © Dale R. Geiger 201127

28. 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? © Dale R. Geiger 201128

29. 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 © Dale R. Geiger 201129

30. Check on Learning What does “balloon squeezing” mean? What should be considered when choosing a cost driver? © Dale R. Geiger 201130

31. 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 © Dale R. Geiger 201131

32. 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 © Dale R. Geiger 201132

33. 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 © Dale R. Geiger 201133

34. 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 © Dale R. Geiger 201134

35. 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 © Dale R. Geiger 201135

36. Level of Effort Example 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 Effort Makers { © Dale R. Geiger 201136

37. 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 © Dale R. Geiger 201137

38. Random Error Random error tends to offset This error is probably not significant Both LOE estimates capture the major effects up down © Dale R. Geiger 201138

39. 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 © Dale R. Geiger 201139

40. Example: Returns Driver in IRS Audit Office 0 10 20 30 40 # of returns corporate complex other simple individual individual © Dale R. Geiger 201140

41. IRS Quality Control Level of Effort Analysis QRS-1 QRS-2 TRAINING DISCLOSURE TOTAL PERCENT FOR BASIS PERCENT FOR BASIS 11 12 2 2 27 100 5.0 2.0 0.8 0.0 7.8 28.8 5.0 5.5 0.8 0.0 11.3 41.8 0 0 0 0 0 0 0.0 4.0 0.4 0.0 4.4 16.3 1.0 0.5 0.0 2.0 3.5 12.9 people complex corporate other simple other individual individual districts individual individual districts © Dale R. Geiger 201141

42. Precisely Wrong vs. Roughly Right 0 10 20 30 40 # of returns level of effort corporate complex other simple other individual individual districts © Dale R. Geiger 201142

43. Check on Learning Why is level of effort sometimes a better driver than unit-based or duration-based drivers? What is the primary criticism of the level of effort driver? © Dale R. Geiger 201143

44. Cost of a Job Let’s re-visit our job cost problem Mechanical service department incurs the following costs for the month of September: Mechanic labor $20K Parts 16K Clerical labor 8K Shop supplies 4K Is the overhead cost pool homogeneous? Total Overhead = $12K © Dale R. Geiger 201144

45. Cost of a Job During the month four jobs are started and completed What is the total cost of each job if all overhead is allocated using parts dollars? Job:ABCDTotal Parts $K3211016 Labor $K2351020 Overhead (Parts $K) 3/16*12 = 2.25 2/16*12 = 1.5 1/16*12 =.75 10/16*12 = 7.5 12 Total $K 7.256.56.7527.548 © Dale R. Geiger 201145

46. Cost Driver Analysis Which drivers are unit-based? Which are duration based? Are units of cost driver homogeneous? Is there a cause and effect relationship between the cost pool and the drivers? Job:ABCDTotal Parts $K3211016 Labor $K2351020 Labor Hr1508050520800 © Dale R. Geiger 201146

47. Cost Driver Analysis Shop supplies are closely correlated to parts dollars -but- Discussion indicates that clerical efforts were expended in the following manner Job:ABCDTotal Clerical Efforts 12%8%30%50%100% © Dale R. Geiger 201147

48. Cost of a Job Use the allocation spreadsheet to allocate the overhead to each job What is the cost pool? What are the cost objects? What are the activities? What are the drivers for each activity? © Dale R. Geiger 201148

49. Allocation Spreadsheet Enter activities and cost driver data as shown © Dale R. Geiger 2011 49

50. Allocation Spreadsheet Select cost drivers and view the new allocation © Dale R. Geiger 2011 50

51. Cost of a Job How do costs shift? Job:ABCDTotal Parts $K3211016 Labor $K2351020 Overhead (two pool) 1.71 1.14 2.65 6.50 12.00 Old Total 7.256.56.7527.548 New Total Change © Dale R. Geiger 201151

52. How might this shift affect management decisions? Job:ABCDTotal Parts $K3211016 Labor $K2351020 Overhead (two pool) 1.71 1.14 2.65 6.50 12.00 Old Total 7.256.56.7527.548 New Total 6.716.148.6526.548 Change -.54-.36+1.90 © Dale R. Geiger 201152 Check on Learning

53. Practical Exercise © Dale R. Geiger 201153