1. Describe Common Pitfalls in Activity Based Costing and Ways to Avoid Them 1

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 2

3. Terminal Learning Objective Task: Describe Common Pitfalls in Activity Based Costing and Ways to Avoid Them 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: Describe limits to precision Describe affordability, credibility and relevance constraints 3

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 = 4

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

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 6

7. Precision Costs Nearest 5 or 10 minutes Nearest minute or two Nearest 5 or 10 seconds Nanoseconds $10 $200 $500 $100,000 7

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? 8

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 9

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 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” 11

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: 12

13. Dining Hall Case (cont’d) 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% 13

14. Level of Detail Spreadsheet 208 69 416 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? 15

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% 16

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

18. Two Pool, Two Driver Output 219 92 381 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? 19

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% 20

21. Three Pool, Three Driver Output 21

22. Three Pool, Three Driver Output 223 99 371 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 ? ? ? 23

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

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 25

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

27. Cost of Detail Information is Not Free: Measuring Accumulating Storing Editing Manipulating Reporting Explaining 27

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

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 29

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 30

31. Cost of Measurement Eventually Exceeds Benefit 1% of absolute value of error $180 per activity evaluated 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 32

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 33

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” 34

35. Where is the Money? The Pareto Effect: The 80/20 Rule The Significant Few The Trivial Many 35

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% 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! 37

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? 38

39. Learning Check 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? 39

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 40

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 41

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 42

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 43

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 44

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 45

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 46

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 47

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

49. Followup 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? 49

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 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 51

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 52

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 53

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 Maybe it is desirable in the long run to provide a capability or encourage a change that would be discouraged by true cost 54

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

56. Computer Ops Mini Case B Due to weather and business reasons C’s usage declines next period UsersABC Hours 600 650 450 Allocation ? ? ? Change ? ? ? 56

57. Computer Ops Mini Case C 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 57

58. Computer Ops Mini Case C A and B significantly reduce use for the next period while C’s usage returns to normal UsersABC Hours 300 325 750 Allocation ? ? ? Change ? ? ? 58

59. Computer Ops Mini Case D C cannot afford a computer this expensive and stops using UsersABC Hours 300 325 0 Allocation ? ? ? Change ? ? ? 59

60. Computer Ops Mini Case D 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 60

61. Computer Ops Mini Case E There is no way A and B can afford this monster They stop using but a clerk in A logs on accidentally for 30 seconds UsersABC Hours.008 0 0 Allocation $1000K0 0 Change $520K -$520K 0 61

62. Computer Ops Mini Case E There is no way A and B can afford this monster They stop using but a clerk in A logs on accidentally for 30 seconds UsersABC Hours.008 0 0 Allocation $1000K0 0 Change $520K -$520K 0 62

63. A Death Spiral 0 200 400 600 800 1000 1200 1400 1600 Case ACase BCase CCase D Cost Per Hour or Use 63

64. 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 64

65. Summary: Pitfalls Under costed cost objects are over consumed Over costed cost objects are under consumed Coster beware: Averaging by its nature both under costs and over costs 65

66. Learning Check How does incorrect cost information affect outsourcing decisions? How might motivating reduced consumption be bad for an organization? 66

67. Practical Exercise 67