Last week Tara and I presented an educational program to a group of business professionals on the subject of cost accounting and current trends in cost accounting. As always this was an interesting conversation with a number of participants bringing issues to the group relative to problems they see in their everyday application of cost accounting standards while working in a variety of business environments. One of the more interesting questions had to do with an attendee who came from a service oriented environment where fixed costs accounted for a large portion of the total costs. This attendee’s question was in times of expanding services where the capacity of the company was being developed and expanded to take on new customers and perhaps new services, it seemed the cost of the those services decreased.
The question really relates to the allocation of fixed cost among an ever-increasing population of work to be done. His point was as capacity increases it reduces the fixed charge to existing customers thereby making them cheaper. He recognized that just because capacity changes the cost to provide other services is not any cheaper, and it can actually be misleading for management to believe that a service that cost one dollar before increased capacity now cost $.80 because of the fixed charge coverage ratio.
This is a reoccurring problem in cost accounting particularly in an environment that has a large component of total costs being fixed costs.
Part of the promise of ABC (activity-based costing) is that those fixed charges can be more precisely identified to the services that are using them thereby changing the fixed cost to something more like a variable cost and more precisely identified to the services that are using the cost. If this can be done then by all means that methodology should be chosen to more precisely identify those cost to the services that utilize them. However, if such allocations are very arbitrary and all you’re really seeking to do is another method of apportioning overhead, then the real question has to do with what impact that will have on the earlier-based services. Especially when new services are added which will thereby increase capacity. The attendee at this seminar’s point was that the cost does not get cheaper because of increased capacity. My response was well that depends! It depends on if you are attempting to use fully loaded cost as the method of analyzing the cost of your services then -yes it is probably true. Really for all services as capacity is increased, the per unit charge for those services is decreased. This is true because you have a much larger base now to spread those fixed charges over and in respect of how you do the accounting that does result in a lower price per unit for existing services and new services. However I believe what this attendee was referring to was not the total cost of providing services but rather the effects on the direct cost of providing those services and changes in fixed overhead. His point, I believe, was that the actual cost, the direct cost, of providing those services is not affected at all by the total increase in volume but rather those allocated costs tend to muddy the waters for purposes of management oversight and create a misconception that the services themselves are using less resources.
I would say this is probably a good example of choosing which cost you use to analyze the operations. In this case if you’re attempting to determine what the cost are of certain services you have to look exclusively then at just the direct cost of those services not including an apportioned or allocated overhead as part of that presumption.
We over and over again run into accountants who attempt to compute one cost for every purpose. If you’re trying to use one fully loaded cost to make all comparisons and provide all management information you’re going to find that misaligning results are going to be an absolute byproduct of that process.
I would suggest that different costs for different purposes get the most meaningful results and best suit management’s purposes when attempting to determine the actual total cost of the project or the profitability for some services. If virtually all of your costs are fixed cost then that leads to a whole other problem for purposes of analyzing the profitability or the total cost of services and there are several tools available to do that; however, that is a unique circumstance and has to be dealt with separately particularly in today’s business environment.
