Planning Internal Service Department Resources to Avoid Suboptimal Behavior

By Leslie Kren

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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.

This author 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.

Cost Assignment Based on Planned or Expected Cost Driver Rates

The following 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.

TechOne’s 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.

The cost 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 the company.

Managers 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.

On average, 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.

Note that 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 service.

The true 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 2.

The capacity 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.

Returning 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.

Senior management 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.

Perhaps the 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.

Senior management 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.

Cost Assignment Based on Capacity-Based Cost Driver Rates

The discussion 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.

Thus, an 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 3.

The unassigned 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.

Reporting 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.

Management 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.

Exhibit 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.

Central management 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 capacity.

Surveys of 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 management.

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