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Assignment of Overhead Costs In a Service Organization Using Activity-Based

Author(s):

Henry F. Garcia, C.P.M.
Henry F. Garcia, C.P.M., Director of Administration, Center for Nuclear Waste Regulatory Analyses, San Antonio, TX 78238, 210/522-5148.

80th Annual International Conference Proceedings - 1995 - Anaheim, California

INTRODUCTION.
Financial and operating managers in a service organization should understand the cause-and-effect of costs, including both departmental, and general and administrative (G&A) overhead. They are responsible for selecting a suitable allocation methodology for determining the "true" costs associated with the development and delivery of a service. Further, their choice of such a methodology will allow them to: a) ascertain more clearly the business processes that drive costs, b) recognize those productivity enhancements that upgrade service delivery, and c) identify unambiguously the performance measures that affect cost control. These managers require relevant and useful information to operate their cost management systems. Activity-based costing (ABC) represents an innovation in cost management systems. It collects financial and operating performance information on the significant or key activities (cost drivers) of the organization, and relates these activities to the demands they make on the organization's resources. The cost of these resources, mostly labor, has risen faster than inflation in the last decade. Selecting the ABC system would permit the assignment of an individual service's cost based on the causal relationships of the activities required to develop and deliver each service. Managers from different industries value the ABC system, although designed primarily for manufacturing, for making critical operating decisions that require accurate cost reporting.

TRADITIONAL APPROACH TO OVERHEAD.
The present cost accounting systems, used almost universally in the United States, were developed over half a century ago. These standard systems fail to provide the activity analysis necessary to discover how and why cost are incurred and, ultimately, how they influence the bottom line. Through the application of an activity-based costing approach, managers can benefit from receipt of timely, relevant, and reliable information concerning the nature of work (activities) performed in their organizations. ABC supplies the requisite information for conducting the various analyses designed to yield continuous process improvement.

Cost accounting, in principle, is a relatively simple management tool that financial and operating managers employ to compare the planned cost of some activity with its actual cost. This tool assists them in controlling and analyzing an organization. In traditional cost accounting methodology, G&A overhead costs are often allocated by the amount of direct labor associated with each operating department of the organization. This methodology assumes that an operating department containing more direct labor will incur proportionately more G&A overhead cost. This practice often contributes to the inaccurate allocation of such costs, and it lessens the value of cost information for an effective analysis of an organization's operating departments because it fails to look at the causes of overhead.

Implementing cost accounting, however, can involve major problems. The traditional cost accounting methodology makes the allocation of fixed (indirect), variable (direct), semi-variable (part indirect and direct) costs extremely difficult in complex settings. In such settings, costs are associated with portions of activities related to service delivery, e.g., patients requiring the resources of certain hospital departments (emergency room, radiology, pharmacy) but not every patient using the same departments for the same duration during each visit. While hospital department resources are temporarily idle (awaiting the next patient), staff time, materials, and equipment lease charges accrue to that department's overhead account. In addition, these operating departments consume certain resources from the hospital's G&A overhead departments, e.g., medical records, central supply, and security, not necessarily in direct proportion to the patient load at any given time.

Good cost management systems should afford financial and operating managers with prompt and correct information for analysis of their operations, and they should offer an early warning of potential problems related to variances between planned and actual expenditures, including those related to overhead. These systems confront the familiar problem of appropriately assigning departmental and G&A overhead. Overhead includes, but is not limited to, those costs related to: a) executive, managerial, supervisory, and support staff salaries; b) organizational staff benefits; c) property, building, furnishings, fixtures, and equipment expenses; d) communication, travel, and entertainment expenses; and e) those expenses not otherwise directly related to the development and delivery of a particular service. Departmental overhead generally covers all costs other than direct labor and materials associated with the conduct of that operating department's activities. G&A overhead represents those indirect costs associated with providing overall management and support activities to the operating departments of the organization.

ABC APPROACH TO OVERHEAD.
Service organizations can adopt the ABC system to segregate the expenses of overhead resources by activities. The system then assigns costs based on the drivers of these activities. This system encourages financial and operating managers to think about the relationship between operating department activities and the G&A overhead resources they consume. If an organization assigns G&A overhead costs to a particular operating department only by the amount of direct labor, it will fail to recognize the widely different demands that individual operating departments make on G&A overhead resources and the disproportionate benefits provided by each G&A department. Service organizations also seek a reduction of overhead costs to make the organization more efficient and/or profitable.

The ABC approach fragments traditional G&A overhead components of cost into groups of activities or overhead pools. It addresses the bias in overhead cost allocation by charging only the portion of G&A overhead to those operating departments that benefit from the G&A overhead activity related to them. These activities may not necessarily correspond to specific functional G&A overhead departments. The accurate partitioning of each G&A overhead department's cost to specific operating departments requires a cost analyst to identify the quantity of each G&A overhead resources which different operating departments will consume over a certain time, e.g., one fiscal year. The ABC approach presents an improved methodology for relating a G&A overhead resource costs to operating departments by recognizing that these costs result from a group of activities that affect each operating department's work.

For example, an operating department of a research and development organization routinely requires the execution of contracts with consultants and/or subcontractors to accomplish, on behalf of its various clients, a unique task demanding certain skills not available within the organization. In the process of effecting such execution, this department will benefit from the resources of the following G&A overhead departments: a) Purchasing, b) Contracts, c) Legal, d) Accounting, and e) Executive Management. However, throughout an individual fiscal year this operating department may need the resources of Purchasing or Contracts only 10 percent of the time, based on the ratio of purchase orders or contracts it consumed relative to the total of such orders or contracts processed by the respective G&A overhead departments. Different ratios, of course, would apply to the other G&A overhead departments.

The allocation of either departmental or G&A overhead resources is not directly proportionate to the volume of work in a particular operating department. The nature and complexity of each operating department's activities will determine, to a large extent, the consumption of overhead resources. Measuring the cost of the different key activities associated with service delivery demands the efficient identification and assignment of the costs related to the nature and complexity of each operating department's activities. The ABC system attributes overhead first to these activities and then to the service that creates a demand for these indirect resources.

Consider an example where the ABC approach precisely illustrates the connection between an operating department's activities and their consumption of certain G&A overhead resources. The personnel department of a university performs a number of activities, e.g., recruitment, retention, counseling, that create demands for its services. A cost analyst may find that certain operating departments: a) have a disproportionately large number of tenured faculty, b) engage in little research or grant work, and c) experience a very low turnover rate. Those operating departments should not receive the allocation of a G&A overhead department's cost, attributable to the personnel department, based on the amount of direct labor in their department. Their key activities, teaching and some research, do not require the same amount of the personnel department's resources as other operating departments of about the same size that: a) have less tenured faculty, b) perform more research and grant work, and c) suffer a higher turnover rate. Only those personnel department's resources that are expended on specific activities in each operating department should be charged to that department.

OVERHEAD AND PRODUCTIVITY.
Financial and operating managers agree that it is important to understand the relationship of overhead costs, both departmental and G&A, to their organization's productivity measurement - the ratio of service delivery cost to the revenue or benefit received from delivery of the service. Increasing productivity through cost reduction calls for designing cost-out of the various operating departments that deliver distinct services by examining how overhead is allocated at all levels of the organization. The ABC system can assist these managers by: a) placing overhead components of cost into groups of activities or overhead pools, b) recognizing that overhead cost does not vary with the volume of service delivered, and c) assigning overhead cost to the significant activities in each operating department. Identifying key activities (cost drivers) allows these managers to predict costs and measure productivity performance more accurately. The ABC approach tends to focus attention on managing the actual activities rather than manipulating numbers. Working with activities also fosters an environment of continuous improvement and ongoing cost reduction/avoidance.

These managers often treat overhead costs as unmanageable and fixed. The ABC approach considers all cost as manageable and variable. Understanding their nature is integral to keeping them under control. G&A overhead departments' costs should be analyzed and assigned to the discrete services performed by the different operating departments. When accurately allocated to such services, they appear as a charge against that department's bottom line, and operating department managers will carefully scrutinize and challenge them. If the uses of certain G&A overhead activities are reduced or eliminated by one operating department, they will continue to act as cost drivers unless these activities are redeployed to other operating departments or reduced in scope. Operating departments should reduce their departmental overhead first by integrating their overhead activities with those of the G&A overhead departments. Mature service organizations, however, have formalized hierarchical structures in both departmental and G&A overhead activities that impede the integration of these activities and affect the organization's productivity. Employing the ABC approach affords the necessary information to recognize the activities that drive overhead costs, and it will provide the tool for identifying candidate activities for integration.

OVERHEAD MEASUREMENT.
An efficient cost management system would measure each activity (cost driver), and it would allocate overhead costs to each activity. The ABC system distinguishes itself from conventional cost accounting systems by using different cost drivers to improve the accuracy of the information it generates - an effective measurement of each activity. This measurement would demand a complex and integrated accounting system that would be relatively expensive to develop and implement, since each activity to be measured (costed) could represent an accounting area. Each area, i.e., pharmacy prescriptions filled, contracts executed, and employment applications processed, would have a "charge number." Considerable recordkeeping detail would introduce additional cost into the cost management system, and, historically, skilled employees in operating departments dislike maintaining and updating detailed cost records.

A standing problem in allocating overhead costs remains the selection of an acceptable unit of measurement. Cost drivers would need a common bond of identity. The ABC system can reduce the measurement of costs associated with these drivers by selecting cost drivers that use information that is relatively easy to obtain. The requisite information for such drivers may be readily available because a transaction is recorded each time an activity is performed. Each time a pharmacy prescription is filled, a contract executed, or an employment application processed an accounting record is created - especially in those service organizations that have developed comprehensive patient tracking, project management, or personnel record systems. Some service organizations have already implemented computer-based labor and material cost allocation systems. Of course, an efficient and effective information management systems (IMS) department is integral to the successful implementation and maintenance of an ABC system.

ABC IMPLEMENTATION.
The amount of time and energy that all overhead and operating departments will consume in implementing and maintaining an ABC system understandably concerns financial and operating department managers, especially those in the Accounting and IMS departments. All departments should understand and appreciate the cause-and-effect relationship between the cost drivers in G&A overhead departments and the activities of the operating departments. Integration and cooperation are necessary to understand this relationship. Widespread cooperation and total organizational involvement are necessary to achieve a sustained commitment that will mitigate a nonreceptive organizational culture associated with the existence of formalized hierarchical structures. This commitment demands the full support of the organization's top management.

A recommended approach to establishing an ABC system for an efficient allocation of departmental and G&A overhead would consist of the following. First, top management would instill an organization-wide awareness that improvements in the cost management system are possible by examining how the organization operates.

Second, an interdepartmental team, consisting, for example, of representatives from accounting, purchasing, and structural engineering in a research and development organization could be formed to develop an operational model that would enable the organization to monitor the nature, scope, and methods of assisting a particular client. This team would: a) identify relevant activities and organize them by activity center (purchasing), b) search for simple activity cost drivers that relate consumption of activities by operating departments, and c) determine the cost of each activity and assign this cost from the general ledger to a certain activity center (purchasing) and a corresponding cost object (structural engineering). For example, purchasing's costs could be allocated to structural engineering based on a single driver, i.e., purchase orders. This team would increase the awareness of the cause-and-effect relationship between the cost drivers in the purchasing department and the activities of the structural engineering department.

Third, the organization's management can use computer technology to facilitate the identification and recording of relevant costs as well as the application of significant activities (cost drivers) to resource consumption. The organization's IMS department can convert this model to an applied ABS system that will permit the analysis of various "what if" scenarios.

CONCLUSION.
The ABC system assigns overhead costs more accurately than a traditional cost accounting system from a cost management perspective. Adopting this system will yield: a) a better understanding of those business processes that drive costs, b) an improved methodology for recognizing those productivity enhancements that upgrade service delivery, and c) a clear identification of the performance measures that improve cost control. These are essential components of continuous improvement and total quality management programs integral to an organization's attainment of its objectives and goals.

REFERENCES

  1. Anklesaria, Jimmy. (1992) "Cost Management Strategies for the 1990's," 79th Annual NAPM International Purchasing Conference Proceedings.
  2. Blaxill, Mark F. and Hout, Thomas M., "The Fallacy of the Overhead Quick Fix," Harvard Business Review, July-August 1991.
  3. Brimson, James A. Activity Accounting: An Activity-Based Costing Approach. New York: John Wiley & Sons, Inc., 1991.
  4. Compton, Ted R., "Using Activity-based Costing in Your Organization - Part 2," Journal of Systems Management, April 1994.
  5. Cooper, Robin, "System Design," Accountancy, November 1990.
  6. Cooper, Robin and Kaplan, Robert S., "Profit Priorities from Activity-Based Costing," Harvard Business Review, May-June 1991.

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