Hilton • Maher • Selto

10Managing and Allocating

Support-Service Costs

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

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The Service Cost Challenge

The GOAL of an organization is to achieve the objectives that prompted the creation

of the organization in the first place.

The GOAL of an organization is to achieve the objectives that prompted the creation

of the organization in the first place.

Commercial firms provide goods and services & earn at least a competitive

profit

Commercial firms provide goods and services & earn at least a competitive

profit

Nonprofit hospitalsprovide superior

healthcare & cover cost of operation

Nonprofit hospitalsprovide superior

healthcare & cover cost of operation

Cities provide essential services

to their citizens within budgetary

limits

Cities provide essential services

to their citizens within budgetary

limits

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The Service Cost Challenge

Achieving the goals of the organization requires the use of scarce resources and making

complex trade-offs among competing uses

Achieving the goals of the organization requires the use of scarce resources and making

complex trade-offs among competing uses

Requires:Reliable quantitative and

qualitative cost management information about relative costs and benefits of alternatives

Requires:Reliable quantitative and

qualitative cost management information about relative costs and benefits of alternatives

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Factors to be ConsideredFactors to be Considered

Internal Or Outsourced Support Services?

Knowledge Base

Knowledge Base

Complex or unique

organizations may have distinct

procedures and cultures

Complex or unique

organizations may have distinct

procedures and cultures

Reliable Service Providers

Reliable Service Providers

Sensitive Information

Sensitive Information

Some organizations

compete on the basis of their knowledge of technology or

complex market and political

situation

Some organizations

compete on the basis of their knowledge of technology or

complex market and political

situation

A less expensive, outsourced service is

not cost effective if the reliability and

quality of the service is low and adversely

affects the organizations to meet

its objectives

A less expensive, outsourced service is

not cost effective if the reliability and

quality of the service is low and adversely

affects the organizations to meet

its objectives

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Cost-based management

approaches to managing internal support-service

costs

Cost-based management

approaches to managing internal support-service

costs

Charge internalcustomers nothing

for support services and recover the

costs from general revenue

Charge internalcustomers nothing

for support services and recover the

costs from general revenue

Charge the cost of support services provided to using departments and

possibly recover the costs from these

internal customers

Charge the cost of support services provided to using departments and

possibly recover the costs from these

internal customers

Managing Internal Support-Service Costs

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Managing Internal Support-Service Costs

Cost allocations are, by nature, arbitrary and may not measure uses of resources

accurately

Cost allocations are, by nature, arbitrary and may not measure uses of resources

accurately

If internal customers are required to use internal

services, they may spend valuable time negotiating and

lobbying over fair prices which may be inefficient

If internal customers are required to use internal

services, they may spend valuable time negotiating and

lobbying over fair prices which may be inefficient

DISADVANTAGESDISADVANTAGES

Charge the cost of support services provided to using departments and

possibly recover the costs from these

internal customers

Charge the cost of support services provided to using departments and

possibly recover the costs from these

internal customers

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ProductionDepartments

ProductionDepartments

Support-serviceDepartments

Support-serviceDepartments

Provide services directly to customers

Provide services directly to customers

Provide services to each other

and to production

departments

Provide services to each other

and to production

departments

Distinquishing Between Support Services & Production Depts.

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Required reporting:

Tax regulations

External financial reporting

Required reporting:

Tax regulations

External financial reporting

Influencing Behavior:

Incentive to control

use of support services

Influencing Behavior:

Incentive to control

use of support services

Cost-based contracts:

Government

Foundation

Private industry

Cost-based contracts:

Government

Foundation

Private industry

Other Uses Of Cost Allocation

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1. Identify the costs to be allocated to internal customers

1. Identify the costs to be allocated to internal customers

Cost Allocation from Service Depts. To Internal Customers

2. Choose the appropriate allocation base(s) and rate(s)

2. Choose the appropriate allocation base(s) and rate(s)

3. Select and use a cost-allocation method

3. Select and use a cost-allocation method

4. Determine if the cost allocations achieve the desired results - if not,

begin the process again

4. Determine if the cost allocations achieve the desired results - if not,

begin the process again

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COST POOLSCOST POOLSBudgeted or actualspending amountsfor distinct sets of

resources

COST POOLSCOST POOLSBudgeted or actualspending amountsfor distinct sets of

resources

Why use multiple cost pools?Why use multiple cost pools?

Multiple cost pools facilitate managing the different types of support services and should allow more accurate cost allocations to internal

customers.

Multiple cost pools facilitate managing the different types of support services and should allow more accurate cost allocations to internal

customers.

1. Identify the Costs to be Allocated to Internal Customers

Planning and

Development

Planning and

Development

Information technologyInformation technology

FinanceFinance

Human Resources

Human Resources

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Support-Service Department•Finance•Human resources•Information Technology•Planning & development

Support-Service Department•Finance•Human resources•Information Technology•Planning & development

Cost-Allocation Base????

Cost-Allocation Base????

Traditional ApproachTraditional Approach

Without ABC, choose allocation bases that seem reasonable and justifiable to internal customers

Without ABC, choose allocation bases that seem reasonable and justifiable to internal customers

2. Choose the Appropriate Allocation Base(s) and Rate(s)

Look for Cause-and-Effect RelationshipsLook for Cause-and-Effect RelationshipsLook for Cause-and-Effect RelationshipsLook for Cause-and-Effect Relationships

Allocation bases may be ABC cost drivers, but without careful analysis it

is not possible to validate causal relationships

Allocation bases may be ABC cost drivers, but without careful analysis it

is not possible to validate causal relationships

Cost-Allocation BaseSize of budget before cost allocationsNumber of full-time equivalent employeesNumber of computers, including network serversNumber of project applications

Cost-Allocation BaseSize of budget before cost allocationsNumber of full-time equivalent employeesNumber of computers, including network serversNumber of project applications

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Steps in the ABC ApproachSteps in the ABC Approach

1. Measure each support-service department’s resourcespending by level (unit, batch, customer, facility).

1. Measure each support-service department’s resourcespending by level (unit, batch, customer, facility).

2. Choose the Appropriate Allocation Base(s) and Rate(s)

2. Identify and measure the activities demanded by internal customers that require support-service spending (e.g. hiring

and training new employees) to obtain cost-driver basis.

2. Identify and measure the activities demanded by internal customers that require support-service spending (e.g. hiring

and training new employees) to obtain cost-driver basis.

3. Divide support-service resource spending by appropriate cost-driver basis to derive cost-driver rates.

3. Divide support-service resource spending by appropriate cost-driver basis to derive cost-driver rates.

Look for Cause-and-Effect RelationshipsLook for Cause-and-Effect RelationshipsLook for Cause-and-Effect RelationshipsLook for Cause-and-Effect Relationships

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Direct Method

Direct Method

3. Select and Use a Cost-Allocation Base

Charges costs of support- service departments to internal

customers without making allocations among service

departments.

Charges costs of support- service departments to internal

customers without making allocations among service

departments.

Allocations go directly to production or direct-service

departments.This method ignores services

provided to other support service departments.

Allocations go directly to production or direct-service

departments.This method ignores services

provided to other support service departments.

ExampleExample

The City of Rock Creek The City of Rock Creek needs to allocate the costs of needs to allocate the costs of

three support services; three support services; Information Technology Information Technology

(IT), Building and Grounds (IT), Building and Grounds (BG) and Human Resources (BG) and Human Resources

(HR), to three Production (HR), to three Production (User) Departments.(User) Departments.

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Using the information below, allocate the costs to Using the information below, allocate the costs to the departments using the Direct Method.the departments using the Direct Method.

Using the information below, allocate the costs to Using the information below, allocate the costs to the departments using the Direct Method.the departments using the Direct Method.

Exh.10-6

3. Select and Use a Cost-Allocation Base

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When the allocation is complete, Support-Service Departments will have $0 allocated to them.

When the allocation is complete, Support-Service Departments will have $0 allocated to them.

Exh.10-6

Simply allocate each service department in turn to the various

production departments.

Simply allocate each service department in turn to the various

production departments.

3. Select and Use a Cost-Allocation Base

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When the allocation is complete, Support-Service Departments will have $0 allocated to them.

When the allocation is complete, Support-Service Departments will have $0 allocated to them.

Exh.10-6

We have assumed, in the direct method, We have assumed, in the direct method, that the service departments are NOT that the service departments are NOT

allocating to each other.allocating to each other.

We have assumed, in the direct method, We have assumed, in the direct method, that the service departments are NOT that the service departments are NOT

allocating to each other.allocating to each other.

3. Select and Use a Cost-Allocation Base

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When the allocation is complete, Support-Service Departments will have $0 allocated to them.

When the allocation is complete, Support-Service Departments will have $0 allocated to them.

Exh.10-6

3. Select and Use a Cost-Allocation Base

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3. Select and Use a Cost-Allocation Base

Step Method

Step Method

Recognizes that some support-service departments provide

services to other support services as well as production and direct service departments

Recognizes that some support-service departments provide

services to other support services as well as production and direct service departments

Allocations begin with the service department with the largest proportion of its total

allocation base in other service departments

Allocations begin with the service department with the largest proportion of its total

allocation base in other service departments

ExampleExample

The City of Rock Creek The City of Rock Creek needs to allocate the costs of needs to allocate the costs of

three support services three support services among the other support among the other support

services services ANDAND to three to three Production (User) Production (User)

Departments.Departments.

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Using the information below, allocate the costs to Using the information below, allocate the costs to the departments using the Step Method.the departments using the Step Method.

Using the information below, allocate the costs to Using the information below, allocate the costs to the departments using the Step Method.the departments using the Step Method.

Exh.10-7

3. Select and Use a Cost-Allocation Base

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In this case, HR has 25% of its costs going to other service

departments. So, start allocating with HR.

In this case, HR has 25% of its costs going to other service

departments. So, start allocating with HR.

When the allocation is complete, Support-Service Departments will have $0 allocated to them.

When the allocation is complete, Support-Service Departments will have $0 allocated to them.

Exh.10-7

3. Select and Use a Cost-Allocation Base

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B&G now has $86,500 in costs that must be allocated.

B&G now has $86,500 in costs that must be allocated.

When the allocation is complete, Support-Service Departments will have $0 allocated to them.

When the allocation is complete, Support-Service Departments will have $0 allocated to them.

Exh.10-7

3. Select and Use a Cost-Allocation Base

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When the allocation is complete, Support-Service Departments will have $0 allocated to them.

When the allocation is complete, Support-Service Departments will have $0 allocated to them.

B&G and HR have been fully allocated. Finish the task by allocating the $47,535 in IT.

B&G and HR have been fully allocated. Finish the task by allocating the $47,535 in IT.

Exh.10-7

3. Select and Use a Cost-Allocation Base

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When the allocation is complete, Support-Service Departments will have $0 allocated to them.

When the allocation is complete, Support-Service Departments will have $0 allocated to them.

Exh.10-7

3. Select and Use a Cost-Allocation Base

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Cost Allocation AccuracyCost Allocation Accuracy

The Direct Method does not consider interactions among service departments

The Direct Method does not consider interactions among service departments

The Reciprocal Method is more thorough in considering interactions among service

departments

The Reciprocal Method is more thorough in considering interactions among service

departments

ABC cost-driver bases should reflect cause-and-effect relationship between resource

spending and use

ABC cost-driver bases should reflect cause-and-effect relationship between resource

spending and use

Most Accurate

Combination

Most Accurate

Combination

Step 4: Determine if the Cost Allocations Achieve Desired Results

The Step Method considers some interactionsamong service departments

The Step Method considers some interactionsamong service departments

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COST ALLOCATION EFFECTSCOST ALLOCATION EFFECTS

If support-service departments provide significant services to eachother, the amounts of costs allocated to direct-service, production,

and marketing departments probably differ under each method.

If support-service departments provide significant services to eachother, the amounts of costs allocated to direct-service, production,

and marketing departments probably differ under each method.

Significantdifferences can effect:

Significantdifferences can effect:

ContractsContracts

Decision-making

Decision-making

Performanceevaluations

Performanceevaluations

Step 4: Determine if the Cost Allocations Achieve Desired Results

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COST ALLOCATION COSTS AND BENEFITSCOST ALLOCATION COSTS AND BENEFITS

Complex cost-allocationsystems are difficult

and costly to DESIGN

Complex cost-allocationsystems are difficult

and costly to DESIGN

Complex cost-allocationsystems are difficult

and costly to MAINTAIN

Complex cost-allocationsystems are difficult

and costly to MAINTAIN

Cost-allocation systems may require revision in a continual process of improvement, which is costly but

can be justified if decisions and organizational performance also continue to improve.

Cost-allocation systems may require revision in a continual process of improvement, which is costly but

can be justified if decisions and organizational performance also continue to improve.

Step 4: Determine if the Cost Allocations Achieve Desired Results

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END OF CHAPTER

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