INTRODUCTION

The Encoder Device division (EDD) at Digital Communications is a producer of communications devices for Government Agencies in the United States. The company works closely with Government Agencies and due to the nature of the devices they produce, and their application the Company works on a 'need to know' basis and as such production departments are compartmentalised.

Production of Voice Ratio Encoding (VRE) devices is on going, however a new microprocessor has been developed, rendering the existing microprocessor obsolete. As a consequence the microprocessor needs be fitted to all existing devices in the 'field' and all new devices in production. EDD wish to win this 'replacement contract'.

EDD have vast experience in 'ground up' bids for entire programmes but not on single sub-assemblies for resale. EDD are confident that they understand their business well, however they fear they lack the detailed information about the costs associated with sub assemblies.

They wish to make an attractive but profitable bid for the contract.

STRUCTURE OF EDD.

EDD has four separate production departments: Data Encoding (DE), Video Encoding (VE), Voice Ratio Encoding (VRE) and Variable Wire Encoding. This specific contract is exclusive to VRE.

EDD therefore need to ensure that they have the correct division of costs between each production department and that the cost for each department is then split correctly between the underlying manufacturing processes within the department.

EDD AND ACTIVITY-BASED COSTING.

EDD has already completed a great deal of work for "Activity Based Costing" (ABC), however their actual costing system needs to be capable of allocating the costs of multiple support departments in a refined and appropriate manner. As EDD has good product diversity, broad allocation of costs has becoming increasingly inaccurate and has probably already lead to either product 'overcosting' or 'undercosting' or both. A refined costing system will reduce the use of broad averages for assigning the cost of resources to cost objects and provide better measurement of the costs of indirect resources used by different objects, no matter how differently the individual cost objects use the different resources. ABC systems focus on the long term and identify all costs used by products, whether costs are variable or fixed in the short term. They also use 'Cost Hierarchy' to allocate total costs to product. Most importantly ABC systems;

1. Trace more costs as 'Direct Costs'.

2. Create homogenous cost pools linked to different activities.

3. For each activity cost pool, seek a cost allocation basis that has a 'cause-and-effect' relationship with costs in the cost pool.

Don Bryant, the controller of EDD must now manage the company and the forthcoming bid using 'Activity-based management', and as a result he needs activity based costing information that is accurate and appropriate.

ANALYSIS OF THE PROPOSALS.

The finance department's proposal on sheet one of the attached spreadsheet seems to show arbitrary percentages of costs attributable to the VRE component costs and as a consequence we see that the overall cost for each board is not that dissimilar. Not surprisingly, staff that have worked with these assemblies found that this assumption was alien to them, and as a consequence they put forward a modified proposal which is found on the second worksheet of the attached excel document. This worksheet (modified proposal) illustrates the greater costs for each of the boards and the halving of costs for the final assembly and harness. In comparison board 2, which is probably the most important component of the bid has a cost some 23 % greater than the original finance department proposal, similarly the mother board and board 3 have greater costs some 20 % and 16 % respectively. The cost of the final assembly and harness however has gone down by over 50 %. Due to the greater awareness of the supervisors and their input in this modified proposal it must be more acceptable.

SUPPORT COSTS

General support costs are distributed through the business and to ensure that the bid is realistic (and profitable) these costs need to be attributed correctly throughout the production departments. If we are to assume attributable costs for each of VRE's work-streams is as per the modified finance proposal, then we should concentrate on the overall allocation of support costs to the 4 production departments.

THE 'STEP-DOWN' METHOD IN ALLOCATING SUPPORT COSTS

The 'Step-Down' method as advocated by Rebecca Wills basically allocates support department costs between support departments and underlying operating departments in a sequential manner. This method partially recognises the mutual services between the different departments and will always distort the allocation of costs no matter the sequence of application.

A popular 'Step-Down' sequence begins with the support department that renders the highest percentage of it's total services to other support department's , the sequence continues with the next support department that has the next highest percentage of services allocated to other support department's and so on. Ms Wills takes two approaches in the 'Step-Down' sequence which are analysed below.

'Step-Down' Approach 1 - Ordered by Dollars in Original budget.

Budget $' s Plant Info Services Personnel Finance Production

3,011,960 Plant 0 % 6 % 4 % 10 % 80 %

2,738,860 Info Services 0 % 0 % 20 % 50 % 30 %

2,190,251 Personnel 0 % 0 % 0 % 16 % 84 %

1,682,000 Finance 0 % 0 % 0 % 0 % 100 %

The ranking is derived from the amount of Dollars charged out by the support department. The percentage of capital allocated from Plant Engineering and then Info Services to the other support departments remains as previously stated. For Personnel costs, from earlier tables we know that we should allocate 6 % of costs to Plant and 11 % of costs to Info Services however, the step down method only allows costs to be attributed in the prescribed sequence. In this case, Personnel costs can only be attributed to the Finance and Production departments and the costs that would have been attributed to the other departments (in this case 11 plus 6 %) are allocated on a pro-rata basis to the remaining departments (as above). The remaining costs are from the Finance department and the full 100 % is allocated to the Production Department (in comparison to estimation in Exhibit 4 of 65 %)

'Step-Down' Approach 2 - Ordered by Number serviced, second by Dollars.

Similar to the exercise carried out in Approach 1 above we derive the figures below;

Plant Personnel Finance Info Services Production

Plant 0 % 4 % 10 % 6% 80 %

Personnel 0 % 0 % 14 % 12 % 30 %

Finance 0 % 0 % 0 % 13 % 84 %

Info Services 0 % 0 % 0 % 0 % 100 %

COMPARISON OF BOTH APPROACHES.

PERCENTAGE SUPPORT COSTS ALLOCATED TO PRODUCTION

Company Estimations Approach 1 Dollars Charged Approach 2 Departments serviced

Finance 65 % 100 % 87 %

Info Services 30 % 30 % 100 %

Personnel 70 % 84 % 74 %

Plant 80 % 80 % 80 %

As we can see from the comparison there is a great deal of difference between the two approaches. The second approach could be ruled out almost immediately due to the fact that 100 % of the Info services costs are being attributed to Production when the actual usage is more toward 30 %. As stated previously the 'Step-Down' method will almost always distort the allocation of costs no matter the sequence of application. However, using the 'Step-Down' approach on the figures given for the percentage of services rendered, does produce figures which seem to be a lot more reasonable.

'Step-Down' Approach 3 - number of departments serviced only.

Info Services Finance Personnel Plant Production

Info Services 0 % 50 % 20 % 0% 30 %

Finance 0 % 0 % 6 % 22 % 72 %

Personnel 0 % 0 % 0 % 8 % 92 %

Plant 0 % 0 % 0 % 0 % 100 %

Following from this when we transpose the Percentage figures for actual Dollars we get;

Budget Department Info services Finance Personnel Plant Production

2738860 Info Services $0 $1,369,430 $547,772 $0 $821,658

3051430 Finance $0 $0 $183,086 $671,315 $2,197,030

2921109 Personnel $0 $0 $0 $233,689 $2,687,420

3916963 Plant $0 $0 $0 $0 $3,916,963

TOTAL $0 $1,369,430 $730,858 $905,003 $9,623,071

Then by allocating all productions costs to the individual production departments we get the following;

Budget Dept / Sub Dept VWE VRE DE VE

$821,658 Info Services $136,943 $410,829 $136,943 $136,943

$2,197,030 Finance $732,343 $366,172 $732,343 $366,172

$2,687,420 Personnel $671,855 $671,855 $671,855 $671,855

$3,916,963 Plant $979,241 $1,468,861 $489,620 $979,241

TOTAL $2,520,382 $2,917,717 $2,030,762 $2,154,210

Taking all of the individual 'Step-Down' approaches together we can then compare all of the Costs attributed to individual production departments.

Step Down used VWE VRE DE VE

Dollars in Original Budget $2,657,280 $2,601,723 $2,357,084 $2,007,986

Numbers serviced then dollars $2,282,105 $3,414,581 $1,980,909 $1,945,475

Numbers serviced only $2,520,382 $2,917,717 $2,030,762 $2,154,210

Average $2,486,589 $2,978,007 $2,122,918 $2,035,890

Standard Deviation 189857 409769 204320 107129

SUMMARY OF EDD's 'STEP-DOWN' APPROACH.

As can be seen from the final table for the comparison of 'Step-Down' approaches, the figures derived for each individual department differ significantly, with the most important department VRE showing the largest difference as can be seen in the individual figures for each approach. This is further illustrated trough the Standard Deviation taken for each individual department (though a sample of 3 may be rather small for a Standard Deviation exercise).

It is plainly illustrated that the costs allocated from support departments are distorted no matter what order for the 'Step-Down' is taken; the 'Step-Down' process is a simple arbitrary accounting way of allocating costs and should be used with some care.

ALTERNATIVES.

Another simple way of allocating costs is the 'Direct Method', which allocates each support departments costs to operating departments only, and does not allocate support departments cost to other support departments. This like the 'Step-Down" method would be inappropriate for EDD.

Bearing in mind the findings above it is imperative that EDD use a better method of allocating Support service costs to operating departments. As the contract is most important and there is a need to bid competitively but profitably, EDD really do need to understand the costs that are attributable to the VRE department. This can be done by using the 'Reciprocal Method' which allocates support department costs to operating departments by fully recognising the mutual services provided among all support departments. The calculations for EDD are at the worksheet entitled 'Reciprocal Method'.

The 'Reciprocal Method' is conceptually the most precise method because it considers the mutual services provided among all support departments, and though more complex than either the 'Direct' or 'Step-Down' method, it is not that difficult to introduce due to the current technology.

As can be seen from the worksheet, the reciprocal method highlights the complete reciprocated costs of support departments and how these costs differ from budgeted or actual costs. Knowing the complete reciprocated costs of the support departments is a key input to Ed Bryant for his decision about where to price the bid, and whether or not outsourcing is an option.

Lastly, we can compare the current cost allocations from the 'Reciprocal Method' and the current financial system (from Exhibit 1), and see that there is a marked difference in the cost allocations for the VRE department. The 'Reciprocal Method' highlights the fact that support services to the VWE, DE and VE departments are currently being over-charged, and the VRE department is benefiting from this. If the bid for the 'replacement contract' was made based on current information then it may lead to marked 'undercosting'.

Comparison of Cost Allocations for Individual Production Departments

VWE VRE DE VE

Reciprocal Method Results $2,548,727 $2,861,362 $2,140,229 $2,072,751

Current Financial System $2,315,310 $3,327,372 $1,941,554 $2,038,837

Variance -$233,417 $466,010 -$198,675 -$33,914