# Presentation: 103207

## Cost Allocation - When Should the User Pay?

- Peter T. Smith,  Pacific Northwest National Laboratory
- &
-  Richard J. McFadzean, Fluor Daniel Hanford
- Institute of Management Accountants Seminar
- December 1, 1999

## Introduction

- Cost allocations - a tool to implement strategy
- Cost allocations can help or hinder cost-effective operations
- Cost allocations are often controversial
- Finance typically orchestrates/arbitrates/implements

- IMA Tri-Cities Seminar

- December 1, 1999

## Cost Allocations

- What are they and when should they be used
- Some examples
- Factors to consider
- Making decisions about allocations

- IMA Tri-Cities Seminar

- December 1, 1999

## What are They and When Should They Be Used

- Definition
- Why are allocations used?
- There are a variety of schemes to chose from
- Some examples

- IMA Tri-Cities Seminar

- December 1, 1999

**Notes:**
In this first part of the presentation I am going to review some of the basics about allocations.  We will review the definition, look at why allocations are used, talk briefly about some of the approaches or schemes that are used and then look at some examples.

## Definitions

*Allocate * means to assign an item of cost, or a group of items of cost, to one or more cost objectives.
*Cost objective  *means a function, organizational group, contract, or other work unit for which provision is made to accumulate and measure the cost of processes, products, jobs, projects, etc.

- IMA Tri-Cities Seminar

- December 1, 1999

**Notes:**
Let’s look at the definition of allocation:
Allocate means to assign an item of cost, or a group of items of cost, to one or more cost objectives. This term includes both direct assignment of cost and the reassignment of a share from an indirect cost pool.
Cost objective means a function, organizational subdivision, contract, or other work unit for which cost data are desired and for which provision is made to accumulate and measure the cost to processes, products, jobs, capitalized projects, etc.

## Why Are Allocations Used?

- To provide information for making economic decisions
- To establish or justify prices
- To satisfy financial reporting requirements
- To motivate management or employees

- IMA Tri-Cities Seminar

- December 1, 1999

**Notes:**
Ok, now let’s look at why allocations are used.  I’d like some help with this from the audience....
I found four reasons that I thought covered the gamut.
First and probably the broadest reason is that allocations are used to provide information for making economic decisions.
One of those economic decisions that is very important to any commercial enterprise is to be used to establish or justify prices.  Certain costs for activities cannot easily be attributed directly to the cost of producing products or services.  These costs are often allocated and assigned to products or services before prices are established.
Another reason is that the costs of some activities may need to be allocated to meet required external reporting requirements.  Meeting requirements to report financial results by segment, for example, typically require a number of allocations to properly show the results of operations by business segment. 

Finally, and something we’ll talk more about today, is that allocations can be used to incentive behavior and to motivate management and staff.

## Many Schemes to Choose From

- “Peanut butter spread”
- revenue
- headcount
- labor hours
- property  value
- “Pay by the drink”
- unit rate
- Combinations

- IMA Tri-Cities Seminar

- December 1, 1999

**Notes:**
Now let’s turn to the different types of allocations that can be used.

## Examples

- Corporate costs
- Research and development
- Manufacturing overhead
- Service centers
- Computer center
- Facility costs

- IMA Tri-Cities Seminar

- December 1, 1999

## Facility Space Costs

- Occupant pays by sq ft
- PNNL, LANL, & other examples
- Cost reduction motivated by cost allocation

- IMA Tri-Cities Seminar

- December 1, 1999

## Occupant Pays by Sq Ft

- Occupant pushes to reduce space occupied
- FY96 PNNL changed from labor hr to sq ft
- Changed from Facilities Group “Pull” to Organization ” Push”
- Created increased need for FUA
- Paying Organization wants reporting and  ability to control costs

- IMA Tri-Cities Seminar

- December 1, 1999

## PNNL Space Example

## Cost Reduction Motivated by Cost Allocation

- Sq ft charge motivates space reduction
- Type of space charge motivates moves to less costly space
- Occupant decides how space used
- Enhanced space billing & reporting
- Reduced centralized administration cost and more decentralized management

- IMA Tri-Cities Seminar

- December 1, 1999

## Decentralized Support

- Benefiting organization or project pays
- Examples:  Field Finance, HR, QA, ES&H, etc
- Results:  more teaming, less “policeman” type oversight, more demand for excellent service, and generally more customer satisfaction
- Implementation tough, but results excellent

- IMA Tri-Cities Seminar

- December 1, 1999

## Lessons Learned

- Use best “drivers” of cost to allocate
- Budget Responsibility = Decision Authority
- Users in control are more satisfied
- Run each central service like a business
- A good activity-based cost allocation process results in cost effectiveness, and avoids major cost reduction/tracking exercises

- IMA Tri-Cities Seminar

- December 1, 1999

## Fire & Emergency Services

- Fire, hazardous material response & emergency medical services
- 3 stations serving  560 square mile area
- $12 million annual operating cost
- Multiple organizations benefiting
- Building replacement cost was used to allocate costs

- IMA Tri-Cities Seminar

- December 1, 1999

## Fire & Emergency Services

- Strategy is to prevent events, but to be prepared to respond when events occur
- Risks impact  levels of service
- Organizations were unhappy with their share of the cost
- Problems with facility replacement cost became apparent
- Users agreed to participate in a review

- IMA Tri-Cities Seminar

- December 1, 1999

**Notes:**
Risk was important.  Here was a case where management doe not want to leave it up to a vote to determine what level of service will be “adequate”.   Standards for responses to a variety of possible scenarios had been considered and resources established by service providers, not the users.  Over time, as areas are cleaned up and facilities are closed, the number of stations and the level of resources will be adjusted.  While “push back” from users is healthy, it is only healthy to a point.

## Activity Based Analysis

- Three principal groups:
- Emergency medical response
- Wildland fires
- Facilities for fire or hazardous material events

- IMA Tri-Cities Seminar

- December 1, 1999

## What Happened?

- Emergency medical response
- Driver:  number of staff per organization
- Wildlands
- Driver:  acres under control of each organization
- Buildings and facilities
- Drivers:  type of space and its usage

- IMA Tri-Cities Seminar

- December 1, 1999

## Lessons Learned

- A variety of allocation alternatives exist
- Engaging users & service providers paid off
- Able to use information which existed for another purpose
- Drivers of activity and cost, once understood, made recommendation to change allocation acceptable to users

- IMA Tri-Cities Seminar

- December 1, 1999

## Computing Costs

- Situation:
- Multiple companies and users sharing a large mainframe computer system
- Costs allocated on basis of CPU cycles, storage and number of pages printed
- Technology changing

- IMA Tri-Cities Seminar

- December 1, 1999

## Computing Costs

- Forecast demand
- Consider capacity
- Develop operating budget
- Calculate rates
- Track demand and bill Users using unit rates

- IMA Tri-Cities Seminar

- December 1, 1999

## Computing Costs

- Substantial cost reductions occurring
- Users migrating to client - server
- Paperless reporting
- Billing rates eventually had to increase substantially to recover costs

- IMA Tri-Cities Seminar

- December 1, 1999

## What Happened?

- Users  upset w/ higher unit rates
- Management assessment
- Users were engaged in the process
- Usage forecasts were developed
- Operating budgets were scrubbed & new rates were established
- Migration plans were developed
- “Going forward” strategy agreed to

- IMA Tri-Cities Seminar

- December 1, 1999

## Computing Costs - Lessons Learned

- Things change
- Minimum costs to operate - fixed costs
- Remaining users hit with cost increases beyond their control - “not fair”
- Involving users can ease the pain
- Strategy: move users off the mainframe
- What had been done to share cost fairly became mechanism to incent behavior

- IMA Tri-Cities Seminar

- December 1, 1999

## Factors to Consider

- The work process
- Service levels
- Drivers
- Nature of the costs
- Who controls the costs
- Management’s  strategy

- IMA Tri-Cities Seminar

- December 1, 1999

## Typical Service Process

- IMA Tri-Cities Seminar

- December 1, 1999

## Understand the Work Process

- What are the activities being performed?
- What drives the activities or work?
- What is the service level?  Is it appropriate? How is it established?  Who sets target?
- What are the components of cost?
- Are costs fixed or variable?
- Who controls the costs?

- IMA Tri-Cities Seminar

- December 1, 1999

## Costs to Administer

- Planning
- Execution
- Remember:                                                                                                                                                                                                                                                                                           Complexity drives cost

- IMA Tri-Cities Seminar

- December 1, 1999

## Should the User Pay?

**YES**
- Costs are variable & change with demand
- When behavior will change because the user pays
- Where  administrative costs < benefits gained
- When benefit is clear

**NO**
- Costs are fixed & won’t change with demand
- When behavior won’t change
- Where administrative costs > benefits gained
- When service is mandated

- IMA Tri-Cities Seminar

- December 1, 1999

## Making Decisions About Allocations

- Allocations can support company strategy
- Understand work activities, costs and drivers
- Consider the administrative costs
- Involve providers and customers
- Learn to forecast demand and manage capacity for services
- Make it clear who is responsible for what

- IMA Tri-Cities Seminar

- December 1, 1999

## Summary

- Cost allocations are often controversial
- Done poorly, they can consume a substantial amount of time, effort & resources.
- Done well, cost allocations can focus attention where it belongs and help achieve key corporate strategies

- IMA Tri-Cities Seminar

- December 1, 1999