Internal Service Department Resources to Avoid Suboptimal Behavior
JANUARY 2008 - The
cost of operating an area of responsibility in a business entity
includes directly traced cost from external transactions, as well
as cost assigned from internal service areas (internal transactions).
Typically, internal transactions include cost assigned from a
service department to a line department (e.g., a production department).
A cost driver
is configured in each service department to use as the basis for
assigning costs to line departments. The cost driver is the value
added by the service department and should be based on a cause-and-effect
relationship between the service cost and the use of the service
department resource in line departments. Typically, the procedure
is to calculate a cost driver rate for each service department
based on the total planned or expected use of the service department
resource by all line departments.
suggests an alternative cost assignment procedure—one in
which the cost driver rate is calculated based on the capacity
level of the resource that is available in each service department,
rather than the planned level of resource use. This change provides
several benefits: The cost of internal services will better approximate
the market cost for those services; performance evaluation in
service departments and line departments will be improved; and
the motivation for suboptimal management behavior will be reduced.
Assignment Based on Planned or Expected Cost Driver Rates
example illustrates the typical cost assignment procedure based
on planned or expected resource use. Consider the hypothetical
case of TechOne Manufacturing, which operates in the highly competitive
market of electronic controllers.
engineering division is staffed with highly skilled engineers
recruited from the best schools. The division is primarily responsible
for supporting development of new production processes. This is
a critical function at TechOne, because the value life of a new
product is often less than three years. Expertise in product development
contributes significantly to the company’s competitive advantage.
driver in the division, engineering hours, is used to assign engineering
costs to users of the division’s resources. The division’s
cost budget is shown in Exhibit
1. Over one year, virtually all cost is fixed. Personnel cost
is for the salaries of 10 staff engineers and the department supervisor,
who is strictly an administrator. Technology cost is fixed and
assigned from other service departments (cost centers) within
of line departments (e.g., production and product design) use
the engineering division’s services but have the authority
to use outside engineering companies for process development,
even when comparable skills are available in-house. When using
outside companies, production managers authorize direct payments
for services, which are then charged to their responsibility area
(cost center). Nothing indicates that the quality of service provided
by the engineering division is inadequate.
14,000 engineering hours per year have been provided to line department
managers over the past three years. This is also the total engineering
hours planned for all users in the current year. Thus, as shown
in Exhibit 1, the rate per hour of engineering services is $247.50.
If the fabrication department, one of TechOne’s line departments,
budgets 2,300 engineering hours for the year, it would be charged
$569,250 ($247.50 x 2,300 hours) for engineering services for
the year. This is the procedure typically followed in most companies.
The plan or budget rate in the service department is multiplied
by the planned cost driver rate to assign costs to user departments.
Is this a
reasonable approach? Perhaps. From the user’s perspective,
assuming the quality of service from the engineering division
is acceptable, the real question is whether the charge for in-house
engineering service is comparable to the cost of engineering services
from an outside provider. Evaluating this question involves estimating
the “true” cost and value of the service provided
by the engineering division. As noted, the division has 10 staff
engineers. Assuming that each engineer is available for 2,000
engineering hours annually, 20,000 engineering hours are available.
the average cost per hour at the plan activity level ($247.50)
is not really the true cost of providing engineering service by
the engineering division, because the cost includes the service
provided, as well as the cost of service that is available but
not provided. Thus, the cost of not providing service
is being spread over the service that is provided. The budget
per-hour cost of $247.50 represents both the cost of engineering
services used by line departments plus the cost of service that
is available but not needed. The cost of excess capacity is being
passed on to users, thereby inflating the cost of engineering
cost of service provided by the engineering division is the minimum
cost of service, given present technology. The minimum cost is
at the capacity level of service, not the planned level of service.
At the capacity level of service, there is no excess capacity
cost to burden the engineering service that is being provided.
The rate at the capacity service level would be the cost per hour
of service if all hours were needed by line departments. The rate
at capacity should approximate the true cost of engineering service
because no unused service is being spread over the service used.
The cost per hour at capacity is shown in Exhibit
rate for engineering service gives an indication of the market
cost of similar services. An efficient market will not reimburse
providers for the cost of excess capacity. Thus, the reimbursable
cost in the marketplace for engineering services will approximate
the economic cost of $173.25. For example, if the standard industry
markup for engineering services is 30%, the market price will
approximate $225.23 ($173.25 x 130%) per hour.
to the fabrication department, which planned to use 2,300 engineering
hours for the year, the charge from an outside vendor would be
approximately $518,029 ($225.23 x 2,300 hours). Thus, the fabrication
department manager could save $51,221 ($569,250 – $518,029)
by using an external provider of the engineering resource. From
the company’s perspective, using an external provider would
be costly, because the incremental cost to provide the engineering
service internally is virtually zero, given that the engineering
division’s cost is primarily fixed. Even the average cost
of providing the service ($173.25) is lower than the market price
if excess capacity cost is not included in the cost of providing
the engineering service.
may decide to mandate the use of an in-house engineering service.
However, forcing use of internal services when services are available
at a lower cost in the marketplace is rarely palatable to managers
who are evaluated on their ability to control costs. Because line
managers are often aware of the market price of needed services,
they might search for ways to circumvent such edicts. Alternatively,
line managers might grumble about unreasonable demands from senior
management, but basically comply.
most serious problem with requiring managers to purchase internal
services at above-market prices is that higher prices may depress
demand for the service to less-than-optimal levels. This may be
a particular problem for strategic resources, such as engineering,
because it may impair the organization’s competitiveness.
may decide to outsource engineering services entirely and eliminate
the in-house engineering division. Nonfinancial considerations
aside, such a decision should not be made based on flawed cost
information. The conclusion that the engineering division’s
average hourly cost of service ($247.50) is higher than the market
cost ($225.23) is misleading. The outsourcing decision should
be made with the understanding that the engineering division is
cost-competitive, but capacity management is required.
Assignment Based on Capacity-Based Cost Driver Rates
thus far suggests that the commonly used procedure of assigning
service department cost to line departments based on planned (or
expected) cost driver rates can have negative consequences. Line
managers evaluated on their ability to control costs will be motivated
to search for alternative, perhaps even illegitimate, ways to
outsource internal services they perceive to be overpriced. They
may view senior management edicts requiring use of internal services
as unreasonable, and resent the interference. Most important,
the demand for critical strategic services, such as engineering,
will be reduced, perhaps to suboptimal levels. Because service
department resources should be used until marginal cost equals
marginal benefit, increasing the cost will invariably reduce demand.
effective method is needed to motivate line managers to use the
division’s services appropriately. Rather than using planned
(or expected) cost driver rates, a better approach is to charge
service cost to line departments using the economic cost of service,
based on capacity cost driver rates. TechOne’s engineering
division services should be charged at $173.25 per hour, the capacity
rate. Costs are assigned using the capacity, or economic rate,
multiplied by the planned hours of service required. The economic
rate, using the capacity cost driver, represents the lowest cost
for service, given the engineering division’s technology,
because excess capacity cost is not included. The economic rate
also approximates the reimbursable cost in the market for engineering
services. The total cost assigned to users would be $2,425,500
($173.25 x 14,000 hours), as shown in Exhibit
cost of excess capacity ($1,039,500) represents the cost of unneeded
service that should not be assigned to line departments, because
line department managers have no control over capacity management
in service departments.
and Use of Capacity Information
Lack of system
capabilities has hampered reporting of capacity information in
legacy cost management systems. However, currently available enterprise
resource planning (ERP) systems overcome these early limitations
and can routinely provide information for capacity management.
For example, SAP, one of the largest ERP systems, allows capacity
planning for all cost centers in a company. Exhibit
4 shows a planning screen for a department’s cost driver
(activity type). Selecting the appropriate “plan price indicator”
will cause the system to calculate a cost driver rate (plan price)
using the capacity level of the cost driver.
reports showing capacity management information are also readily
available in today’s ERP systems using delivered reporting
tools or third-party report writers. Various options for effective
reporting of capacity information are available in advanced systems.
5 shows a reporting example. Excess capacity cost is shown
for each responsibility area and accumulated across responsibility
areas. Excess capacity is shown as a line item to separate the
cost of providing service (assigned using the capacity rate) from
the cost of service that is available but not provided (excess
capacity cost). Thus, central management can readily control firm-wide
capacity separately from cost efficiency. Because managing the
cost of excess capacity and the efficiency with which service
is provided require different management actions, they should
be shown as separate line items.
should have the flexibility to decide whether to hold local managers
responsible for capacity management in any particular responsibility
area, because responsibility for excess capacity could reside
either with local managers or with central management. The latter
case may arise in departments in which excess capacity results
from central management’s strategic decisions, perhaps when
anticipating expansion. Thus, reporting for excess capacity depends
upon the responsibility for capacity management.
If the local
manager is held responsible for capacity management, the cost
of excess capacity should be included in the results for the manager’s
responsibility area and in evaluating the manager’s performance.
If the local manager is not held responsible for capacity management,
capacity information can be withheld from responsibility area
reports and shown only at the corporate level. The cost of excess
capacity should continue to be charged as a line item in corporate-level
reports. In either case, excess capacity cost should not be charged
to users of service from the responsibility area to separate capacity
management from management of efficiency. Line department managers
should not be charged for excess capacity cost in service departments,
because line managers have no control over service department
experienced accountants in the author’s cost management
classes indicate that capacity information is not frequently reported
in most companies. Often the cause is system limitations. Even
when system capabilities are available, however, capacity information
might not be reported, typically due to management’s lack
of familiarity with the benefits of capacity management. Discussions
by the author with SAP consultants and experts at cost management
system installations yield similar conclusions. Few companies
use capacity information, and neither the consultants nor their
clients are familiar with the benefits of capacity management.
Nonetheless, aggregate capacity information across an organization’s
cost centers can be a powerful tool for cost control and capacity
Kren, PhD, CPA, is an associate professor in the Lubar
School of Business of the University of Wisconsin at Milwaukee.