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Describe Common Pitfalls in Activity Describe Common Pitfalls in Activity Based Costing and Ways to Avoid Based Costing and Ways to Avoid
ThemThem
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What Time is It?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
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Terminal Learning ObjectiveTerminal 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
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Choosing Level of PrecisionChoosing 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
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Things to ConsiderThings to Consider
• User needs• Cost environment• Cost style• Organization
• Measurement issues• Difficulty and cost• Limits to precision • Impact on behavior
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User Defined RelevanceUser 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
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Precision CostsPrecision Costs
• Nearest 5 or 10 minutes• Nearest minute or two• Nearest 5 or 10 seconds• Nanoseconds
• $10• $200• $500• $100,000
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Weakest Link TheoryWeakest 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?
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Example: Cost of a JobExample: Cost of a Job
• Cost expression for a job:Parts $Parts $ + Labor $Labor $ + Clerical OH $ Clerical OH $ + Supplies OH $Supplies OH $
• Cost measurement for Job A:
$2995.27 $2995.27 + $2012.42 $2012.42 + $960.00 $960.00 + $748.82$748.82
• Precision of cost measurement: ± $.01 ± $.01 ± $.01 ± $.01 ± 10%* $960 ± 10%* $960 ± $10± $10
Actual Actual Parts Parts
+ Actual Actual Labor Labor
+ 12% 12% * $8K * $8K
+ $2995.27/$16K $2995.27/$16K * $4K* $4K
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Data vs. InformationData 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$39,999
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Dining Hall Case ADining 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”
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Data for Dining Hall CaseData for Dining Hall Case
• Cooling FoodCooling Food $237 $237• CleaningCleaning 119119• Serving Serving 64 64• Collecting MoneyCollecting Money 63 63• Preparing FoodPreparing Food 36 36• Doing PaperworkDoing Paperwork 22 22• Washing DishesWashing Dishes 20 20• Prepare VeggiesPrepare Veggies 20 20
• Prepare SaladsPrepare Salads 20 20• Plan MealsPlan Meals 18 18• Drive TrucksDrive Trucks 18 18• Unload TrucksUnload Trucks 14 14• Stock ShelvesStock Shelves 14 14• Replenish Line Replenish Line 14 14• Maintain Equip.Maintain Equip. 14 14• TotalTotal $693 $693
Management has identified the following activities, along with their respective costs:
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Dining Hall Case Dining Hall Case (cont’d)(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: Breakfast Lunch DinnerCooling Food 30% 10% 60%
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Level of Detail SpreadsheetLevel of Detail Spreadsheet
$0
$100
$200
$300
$400
$500
(in 0
00's
)
breakfast lunch dinner 0
dining hall non food cost
cooling food
Activity B
Activity C
Activity D
Activity E
All Other
Allocation for
208
69
416
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Questions to ConsiderQuestions 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?
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Dining Hall Case BDining 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: Breakfast Lunch DinnerCleaning 35% 20% 45%
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Level of Detail SpreadsheetLevel of Detail Spreadsheet
• Unspecified dollars default to activity labeled “all other”
• Driver for “all other” calculated by weighting specified activities, drivers
6. Select Drivers for Each Activity ?
Activity breakfast lunch dinner 0 Total
cooling foodcooling driver 1 0.3 0.1 0.6 0 1
cleaning cleaning driver 2 0.35 0.2 0.45 0 1
Activity C (none) 8 0 0 0 0 0
Activity D (none) 8 0 0 0 0 0
Activity E (none) 8 0 0 0 0 0
All Other All Other 32% 13% 55% 0% 100%
Driver
(none)
(none)
(none)
cooling driver
cleaning driver
6
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Two Pool, Two Driver OutputTwo Pool, Two Driver Output
$0
$50
$100
$150
$200
$250
$300
$350
$400
(in
000
's)
breakfast lunch dinner 0
dining hall non food cost
cooling food
cleaning
Activity C
Activity D
Activity E
All Other
Allocation for
219
92
381
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Questions for Case BQuestions for Case B
• Is this a good allocation method?• Which other activities, if any, should be
analyzed?• What cross subsidizations and incentives
might be created?• Does this give management the information it
needs?
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Dining Hall Case CDining Hall Case C
• Believing that a greater level of accuracy can be achieved, management asks accounting for serving’s cost distribution
• Reallocate adding this activity. The worksheet will allocate all other costs
Activity: Breakfast Lunch DinnerServing 35% 20% 45%
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Three Pool, Three Driver OutputThree Pool, Three Driver Output
7. Allocate Overhead to Cost Objects: ?
Activity breakfast lunch dinner 0 Totalcooling food 71$ 24$ 142$ -$ 237$ cleaning 42$ 24$ 54$ -$ 119$ serving 22$ 13$ 29$ -$ 64$ Activity D -$ -$ -$ -$ -$ Activity E -$ -$ -$ -$ -$ All Other 88$ 39$ 146$ -$ 273$ Total 223$ 99$ 371$ -$ 693$
7
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Three Pool, Three Driver OutputThree Pool, Three Driver Output
$0
$50
$100
$150
$200
$250
$300
$350
$400
(in
000
's)
breakfast lunch dinner 0
dining hall non food cost
cooling food
cleaning
serving
Activity D
Activity E
All Other
Allocation for
223
99
371
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How Many Activities Must Be How Many Activities Must Be Evaluated?Evaluated?
$-
$50
$100
$150
$200
$250
$300
$350
$400
$450
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15Number of Activities Evaluated
Dinner ? ? ?
Breakfast ? ? ?
Lunch ? ? ?
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Diminishing Return to Diminishing Return to Accounting EffortAccounting Effort
$-
$50
$100
$150
$200
$250
$300
$350
$400
$450
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15Number of Activities Evaluated
Dinner
Breakfast
Lunch
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Summary on PrecisionSummary 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
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Learning CheckLearning Check
• How does the “Weakest Link” theory affect the level of precision possible in managerial costing?
• What does “false precision” mean?
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Cost of DetailCost of Detail
• Information is Not Free:• Measuring• Accumulating• Storing• Editing• Manipulating• Reporting• Explaining
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Cost of Cost Methodology Cost of Cost Methodology
• Gut feel, intuition or experience
• Back of the envelope calculation
• Estimates and analyses• Managerial cost system
Low $
High $
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A Natural Tradeoff ExistsA 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
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Cost of Dining Hall Cost of Dining Hall Cost SystemCost 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
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Cost of Measurement Eventually Cost of Measurement Eventually Exceeds BenefitExceeds Benefit
Cost of Cost System
$-
$500
$1,000
$1,500
$2,000
$2,500
$3,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Number of Activities Studied
in 0
00's
Cumulative Error
Cost of System
1% of absolutevalue of
error
$180 peractivity
evaluated
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Cost of Precision in Cost of Precision in the Cost Systemthe 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
Goal: Be on the target, but hitting the center may be too
expensive
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Law of Diminishing ReturnLaw of Diminishing Return
17WWII
1.2
Gulf War
Tank Rounds Fired per Tank Destroyed
$ Cost Spent on Technology and Training
1.04
*Certain Victory33
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Important ConsiderationsImportant 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”
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Where is the Money?Where is the Money?The Pareto Effect: The 80/20 RuleThe Pareto Effect: The 80/20 Rule
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
The Significant Few
The Trivial Many
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Impact of ErrorImpact 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%
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Best Value in Measurement 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!
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Sensitivity AnalysisSensitivity 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?
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Learning CheckLearning 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?
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Managerial Costing: A Two Edged Managerial Costing: A Two Edged SwordSword
• 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
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Managing the Cost DriverManaging the Cost Driver
• ABC Systems Give CostWarriors Two Targets• Activity Cost Reduction• Cost Driver Reduction
• Example:• Reduced Square Footage• Should Lead to Reduced
Utilities, Maintenance, etc
activity
allocationbased on
cost driver
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Danger: Right Behavior, Wrong Danger: Right Behavior, Wrong OutcomeOutcome
• 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
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Example: Wrong EmphasisExample: 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
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Plant Wide, Labor Based ABC System Plant Wide, Labor Based ABC System Used to WorkUsed to Work
45 labor 45 labor
5 support 5 support
Realityleft plant right plant 50 50
ABC ProcessPool = 10
Driver = laborProportion 50/50
Allocation 5/5
Cost System Reportleft plant right plant 50 50
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ABC System Fails to Evolve With ABC System Fails to Evolve With AutomationAutomation
45 labor
5 labor
5 support
45 support
Realityleft plant right plant 50 50
ABC ProcessPool = 50
Driver = laborProportion 90/10
Allocation 45/5
Cost System Reportleft plant right plant 90 10
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Outsourcing With Bad Cost Outsourcing With Bad Cost InformationInformation
• 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
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Navy Cost Reporting is Flawed by Navy Cost Reporting is Flawed by Labor DriverLabor Driver
• Real Costs Non Nuclear Nuclear• Labor 40 40• Overhead 40 80
• Reported Costs• Activity Pool 120 = 40 + 80• Driver Proportion 50% 50%• Overhead Distribution 60 60
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Bid Comparison: What Work Did the Bid Comparison: What Work Did the Navy Privatize?Navy Privatize?
0
20
40
60
80
100
120
Non Nuclear Nuclear Non Nuclear NuclearPrivate Yards Navy Yards
labor
over-head
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Followup QuestionsFollowup 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?
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Cost
Quantity Demanded
Remember Free GoodsRemember 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
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Over Consumption Pitfalls:Over Consumption Pitfalls:SummarySummary
• 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
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Sometimes Behavior is More Sometimes Behavior is More Important than TruthImportant 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
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Consider Some Drivers We May Not Consider Some Drivers We May Not Want ReducedWant 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
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Sometimes We Don’t Want the Sometimes We Don’t Want the Activity Cost ReducedActivity 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
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Computer Ops Mini CaseComputer Ops Mini Case
• $1,000,000 fixed cost of operation• 2000 hours of services rendered• Basis of allocation: Hours used
Users A B C Hours 600 650 750 Allocation $300K $325K $375K
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Computer Ops Mini Case BComputer Ops Mini Case B
• Due to weather and business reasons C’s usage declines next period
• Users A B C • Hours 600 650 450 • Allocation ? ? ? • Change ? ? ?
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Computer Ops Mini Case CComputer 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
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Computer Ops Mini Case CComputer Ops Mini Case C
• A and B significantly reduce use for the next period while C’s usage returns to normal
Users A B C Hours 300 325 750 Allocation ? ? ? Change ? ? ?
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Computer Ops Mini Case DComputer Ops Mini Case D
• C cannot afford a computer this expensive and stops using
Users A B C Hours 300 325 0 Allocation ? ? ? Change ? ? ?
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Computer Ops Mini Case DComputer 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
Users A B C Hours 300 325 0 Allocation $480K $520K 0Change $262K $283K -$545K
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Computer Ops Mini Case EComputer 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
Users A B C Hours .008 0 0 Allocation $1000K 0 0Change $520K -$520K 0
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Computer Ops Mini Case EComputer 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
Users A B C Hours .008 0 0 Allocation $1000K 0 0Change $520K -$520K 0
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A Death SpiralA Death Spiral
0
200
400
600
800
1000
1200
1400
1600
Case A Case B Case C Case D
Cost Per Hour or Use
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A Solution From the National Institutes A Solution From the National Institutes of Healthof 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
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Summary: PitfallsSummary: 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
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Learning CheckLearning Check
• How does incorrect cost information affect outsourcing decisions?
• How might motivating reduced consumption be bad for an organization?
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Practical ExercisePractical Exercise
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