Why ABC? ABC s of Activity-Based Costing. The Theory of Costing for Performance Measures. A Contingency Framework Perspective Leslie K.

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1 ABC s of Activity-Based Costing The Theory of Costing for Performance Measures Dr. Leslie K. Breitner Daniel J. Evans School of Public Affairs University of Washington 14 October 2005 PLEASE DO NOT COPY OR USE ANY PARTS OF THIS PRESENTATION WITHOUT PERMISSION. Why ABC? What does it cost? [This is a slippery question!] Why do I want to know? What s the relationship to performance management/measurement? Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 2 A Contingency Framework Perspective Leslie K. Breitner Contingent Factors: Environment Technology Political climate Authorizers Stakeholders Media Vision / Mission Strategy Organizational Structure Goals PERFORMANCE Structure: Responsibility Centers Management Control System Processes: Programming Budgeting Measurement Reporting 1

2 Managing for Results: Growing Interest and A Model REPORT AND EVALUATE RESULTS STRATEGIC PLANNING PROGRAM/ ACTIVITY PLANNING Cultural and Structural Changes BUDGET FOR RESULTS MONITOR AND ANALYZE RESULTS MEASURE FOR RESULTS Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 4 A Four Stage Approach to Cost Accounting and Performance Measurement Stage/type/ responsibility Stage 1: Improve the full cost Staff Stage 2: Assess cost behavior Staff Information Used Direct and Indirect Costs Fixed and Variable Costs Key Activities Choose cost object Assign costs to cost centers Choose allocation bases Allocate service center costs Analyze cost behavior Contribution analysis Managerial Uses Product line profitability Strategic decisions (programs, facilities, personnel to support product lines) Special prices Contracts for services Add/eliminate unprofitable programs Stage 3: Control costs Senior Management Stage 4: Design administrative systems Senior Management Program and/or Product Costs Process-related Costs Nonfinancial perf. measures Determine cost drivers Develop budget Determine resp. centers Assign variances to controlling agents Define admin. Systems Calculate costs by admin. Systems Develop nonfinancial perf. measures Cost control Motivation Performance measurement Involvement of professionals Performance measurement across functional boundaries Shift measurement focus to cross-functional processes Stage 1: Improve the Full Cost System [Financial Management Staff Function] 1. Need direct and indirect costs 2. Activities Choose cost object(s) Assign costs to cost centers Choose allocation bases Allocate service center costs to revenue centers 3. Managerial uses: Program profitability Strategic decisions (programs, facilities, personnel to support product lines) Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 6 2

3 Full Costing Winners, losers and cross subsidization Assign costs to programs/products when resources are consumed! Apply principles of ABC to improve mechanisms for allocating service center costs Don t let it impede decision-making with a short-term focus! Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 7 Activity-Based Costing (ABC) Trace OH costs to programs/products by the activity that links them to the final program (product). Measure activities by the degree to which they add value to the program. Helps to identify portions of activities that can have costs attached. Homogeneity of OH pools is the key to a good ABC system. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 8 Stage 2: Assess Cost Behavior [Financial Management Staff Function] 1. Need fixed and variable costs 2. Activities Analyze cost behavior by program Calculate a contribution margin Differential cost analysis 3. Managerial uses: Special or promotional pricing Contracts for services Retain/discontinue unprofitable operations Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 9 3

4 Differential Cost Analysis Alternative choice decisions Assess differences in costs associated with subcontracting Retain/discontinue unprofitable programs Helpful in bidding/negotiating Costs of capacity vs. marginal cost of the next program Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 10 Cost Terms Direct vs. Indirect cost Fixed, variable, semi-variable, stepfunction costs Sunk cost Differential cost Opportunity cost Marginal cost Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 11 Can You Identify Your Costs? VARIABLE FIXED DIRECT INDIRECT Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 12 4

5 Stage 3: Control Costs [Senior Management Function] 1. Need program and/or product costs 2. Activities Determine cost drivers Develop budgets using cost drivers Determine responsibility centers Assign variances to controlling agents 3. Managerial uses: Cost control Motivation Performance measurement/management Involvement of professionals in cost management Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 13 Cost Control Full costing (Stage 1) shows what costs are, not what they could be! Cost behavior (Stage 2) does not provide enough information for good cost control. Need to manage the cost drivers (unique to each environment). Manage the consumption of resources. Determine protocols based on target costing (think about costing during the design phase). Need to identify which managers control which resources. Need to identify standards for performance measurement. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 14 Identification of Controlling Agents Administrative efficiency protocols address input efficiencies. Program protocols address resources used per program. Ask managers to estimate the cost drivers they control. Integrate resource and cost driver information into the budgeting process. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 15 5

6 Responsibility Centers Align control with responsibility. Senior managers must ask: Who could control each resource? Who should control reach resource? Profit center structures hold managers accountable for an extensive set of resources. Juxtapose need to contribute to general OH with the mission of the organization. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 16 Stage 4: Design Administrative Systems [Senior Management Function] 1. Need process-related costs 2. Activities Define administrative systems Calculate costs by administrative systems Develop nonfinancial measures of performance 3. Managerial uses: Performance measurement across functional boundaries Shift measurement focus to cross-functional groups/processes Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 17 Administrative Systems Is the cost system a tool to identify opportunities? Stage 3 is oriented toward departments. What happens with administrative systems cut across two or more departments? Where are the added costs regardless of the existing departmental boundaries? Where are there opportunities for interdepartmental collaboration to reduce costs? Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 18 6

7 The Manager s Perspective Administrative systems focus expands the manager s perspective to the entire set of activities in the organization. Each department is part of an organizational whole. How does the department contribute to an administrative system? What is its relationship to the other departments? Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 19 Nonfinancial Performance Indicators Indicators can monitor the activities of each administrative system. Balanced scorecards integrated into logic models. Remain cognizant of mission and goals. Alignment of goals across managers and departments. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 20 Define, Analyze and Manage Administrative Systems Indicators can help to monitor the day-to-day activities. Questions for department managers: What do you manage? What information do you need to do so effectively? What is the relationship between the outputs and inputs of a given activity in your department? What is the relationship between the activities in other departments and your outputs and inputs? Administrative systems can be interdepartmental! Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 21 7

8 Crossing Departmental Boundaries Define the information needs across departments. Nonfinancial performance measures to monitor and control the process of information gathering. Eliminate redundancies in the system. Fill gaps. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 22 Moving Through the Stages Stages 1 and 2 are basic. Stage 3 requires some analysis beyond just living by the formulae! Moving to Stage 4 requires thinking of the organization as a set of interlocking and related systems. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 23 What does it cost? Why do I want to know? First, we must define it cost object It depends: Different cost information for different decisions, audiences, purposes Opportunity cost the value of the foregone alternative. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 24 8

9 Direct vs. Indirect Costs Direct Costs Use of resources is directly related to the production of a good or service. Associated with mission or service centers. Direct costs can be traced! Indirect costs Use of resources that are not traceable to a specific product or service; also known as overhead or costs from support centers Whether or not a cost is indirect depends on your cost object. Indirect costs are cost allocated to programs Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 25 Fixed vs. Variable Costs Fixed costs do not vary with volume Variable costs vary with volume Step-function costs are fixed over small ranges of activity Relevant range: the range over which we don t have additional fixed costs Semi-variable costs have a fixed component and a variable component Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 26 Unit Cost Average cost: Holds only at volume used to calculate it! Marginal Cost: Not the same as variable cost! Relationship of volume and per unit cost Make / Buy example Differential Cost Accounting Think: avoidable and unavoidable costs Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 27 9

10 Analytic Tools Contribution Margin Price Variable Cost (P-VC) The amount by which one additional customer will chip away at your fixed costs. Break Even Total Revenues = Total Expenses Multiple product break even uses weighted average contribution margin Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 28 Cost Allocation Process to assign indirect costs (overhead or cost from support centers) to mission (or revenue) centers Key decision is determining the cost base (aka basis of allocation). Examples of Cost Bases Payroll number of people in each mission center Purchasing number of purchase orders completed for each mission center Rent/utilities/etc square feet of space Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 29 Cost Allocation Cost allocation is a procedure that assigns indirect costs (overhead or cost from support centers) to mission (or service) centers The simplest, most common (but perhaps least meaningful) formula: Total agency indirect costs Total agency direct costs = Indirect Cost Rate ( ICR ) ICR x Individual Program direct costs = Program s indirect costs Program direct costs + Program indirect costs = Total program costs Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 30 10

11 Cost Allocation (continued) More sophisticated cost allocation requires the determination of the cost base (aka basis of allocation). Examples of Cost Bases payroll number of people in each mission center purchasing number of purchase orders completed for each mission center Rent square footage of occupied office space Prior to allocating costs, you must first check to see if any direct costs should be redistributed among programs. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 31 Cost Categories: Which type of cost? Direct Indirect Variable Fixed Traceable Allocate Beware of treating all allocated costs as unavoidable; sunk costs are irrelevant for decision making. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 32 Direct Distribution Method An approach to allocation that allocates indirect costs only to mission/revenue centers Does not account for the fact that support centers may spend a time and resources supporting other support centers Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 33 11

12 Direct Distribution Method Diagram Support Center A Support Center B Mission/Revenue Center 1 Mission/Revenue Center 2 Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 34 Step-down Distribution Method An approach for allocating service center costs where each center is allocated to every other center (service and mission/revenue) that has not allocated its costs yet Requires a decision about the order of allocations To minimize distortion, start by allocating costs from the support centers that are most heavily utilized by other support centers A way to minimize cross-subsidization Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 35 Step-down Distribution Method Diagram Support Center A Support Center B Support Center C Mission/Revenue Center 1 Mission/Revenue Center 2 Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 36 12

13 FULL COST Direct and Indirect Costs Indirect costs must be allocated Cost drivers ABC Direct costs are traceable and don t have to be allocated. Pricing decisions and cost control/comparison Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 37 COST BEHAVIOR Variable, fixed, step-function, semivariable Sunk costs Which costs vary in direct proportion to volume? Which may vary in other ways? Units within other units in an organization Indirect variable cost concept can be confusing Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 38 DIFFERENTIAL COSTS Costs used for certain decisions. Which costs will be different in the new scenario? Which costs are irrelevant for this type of decision making? Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 39 13

14 The Fixed Cost Line Cost Fixed cost Volume Relevant Range Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 40 The Variable Cost Line Cost Variable cost Volume Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 41 The Semi-variable Cost Line Cost Semi-variable cost Volume Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 42 14

15 The Step-function Cost Line Cost Step-function cost: Fixed in the short term Volume Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 43 Cost Terms Direct vs. Indirect cost Fixed, variable, semi-variable, stepfunction costs Sunk cost Differential cost Opportunity cost Marginal cost Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 44 ABC at the Evans School Identified redundancies in administrative processes Averages proved not to be useful; homogeneity of cost pools is critical in an ABC system! What s a transaction anyway? How do we count them? Personnel issues were a problem What to do about sick/vacation leave? Who pays for services not rendered but legitimately part of administrative overhead? Decentralized practices were a positive result Customer reaction Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 45 15

16 Performance Management: Key Results Need Key Measures Is it worth doing? Can you identify what needs to be measured (make the selection of measures more efficient)? Mission Priorities Measures, strategic goals, performance targets Can you focus the activities and resources on your strategic outcomes? WHAT IS THE COST OF ALL RESOURCES? WHAT IS THE COST OF MONITORING? Resource allocation is often done in a backwards way! How much do we have and what can we do with it? Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 46 The Traditional Logic Model Activities Inputs Resources Outputs Immediate Outcomes < 1 year Intermediate Outcomes 1-3 years Longer Term Outcomes 3-5 years Ultimate Outcomes > 5 years Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 47 Traditional Budgeting STEP 1 $$ How much do we have to work with? $$ STEP 2 $$ How much work can we do? $$ STEP 3 $$ Are we getting results? $$ Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 48 16

17 Performance Budgeting Strategic Outcomes For each work process or activity, cost it out: HR Equipment Working capital Adjust the targets to fit the budget reality. Client Benefits Work Processes/ Activities Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 49 Implement Strategic Planning Strategies are methods to achieve public goals. We can implement strategies by delivering/conduction programs. For example highway maintenance is a strategy for improving road rideability and preserving the useful life of highways. What do the resources cost to achieve this? Cost/benefit analysis How does the work benefit? Who benefits? What activities should we perform to achieve the program mission? Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 50 POG AND GMAP POG is about budgeting: where do we invest to get the results that matter most to citizens? GMAP is about managing: feedback on how well the money is being used to achieve the results. THE MORE THE BUDGET IS ALIGNED WITH PERFORMANCE MEASURES, THE EASIER IT WILL BE. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 51 17

18 POG AND GMAP (continued) Use ABC to determine if goals and objectives are out of line with spending decisions? (ABC helps to outline the underlying activities.) Need valid cost data to justify policy tradeoffs (should we buy more of this or less of that?). Traditional government accounting systems yield reports that are of little value to program managers. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 52 Perform an Activity Analysis High Cost Low Alignment High Cost High Alignment Low Cost Low Alignment Elimination Redesign/Reengineer Low Cost High Alignment COST Potential Elimination or Redesign Process Improvement ALIGNMENT WITH ORGANIZATION S GOALS/OUTCOMES Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 53 Program Funding/Resource Shifts High Cost Low Alignment High Cost High Alignment Low Cost Low Alignment Eliminate Cut Costs Low Cost High Alignment COST Eliminate or Redesign Desired Result ALIGNMENT WITH STRATEGIC GOALS/OUTCOMES Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 54 18

19 Lessons Learned Understand the relationship of costs to results. Relate costs to outputs. Takes time to relate costs to outcomes. Maintain a balance between costs and effectiveness. Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 55 The Balance Quality Cost Service Dr. Leslie K. Breitner COSTING FOR PERFORMANCE MEASURES 56 19