Indianapolis: Activity-Based Costing Essay
Indianapolis: Activity-Based Costing
1- Yes, government should perform a cost analysis before privatization, especially if the government will remain as a participant in the bidding process. The cost analysis will provide the government with cost information for accurately pricing the bid. In case the government is not going to be a participant in the bidding process, the cost estimate will provide the government with an estimate on how much to pay for a service. For example, if the government wants to engage in a firm fixed price contract, a cost analysis will provide an accurate estimate of the cost and government can adjust the estimate for labor contractor rates and profit to price the contract.
2- For pothole filling activity direct labor and materials are relatively easy to trace directly, but it is more difficult to allocate indirect costs to the service. In order to apply ABC in Department of Transportation, reconciling with controller’s records, the team correctly identified in phases 1 and 2 all the basic activities. There were 35 activities, one of them being “pothole patching”. The labor hours and direct materials assigned for this activity were easy to be traced so the direct labor and materials were precisely determined in the “Pothole Filling Cost” table.
A few comments about the overhead costs:
The model allocated costs for fixed assets and unused equipment, which is one of the strengths. The model also adjusted the current year capital purchases and added back the depreciation (the consumed portion of the purchase price). We think that was an appropriate decision in order to have a true cost for this activity. The city already had an accounting system to trace the depreciation, and that was an advantage.
It is debatable the decision not to include the headquarters expenses. In fact those costs may vary up or down depending on who does the pothole filling – municipal workers or private contractors. Decision was that these expense to “remain in the city” but they don’t necessarily have to. A true cost for the service would be to allocate them in the overhead costs.
It is a bit unclear if the overhead costs captured in the “Pothole Filling Cost” table are strictly associated with pothole filling activity. We know that the team identified the indirect and support costs associated with the 35 primary activities. It is difficult however to allocate those costs to pothole filling activity only. For example how much would be Facility Expense slice for this service? We should assume that a reliable allocation method was utilized, since the other 34 activities should also have overhead costs traced for other potential bids.
Regarding overhead costs allocation by region, a brief calculation reveals that some sort of allocation was utilized for costs, however it is not clear on what basis. Four fixed costs out of seven do follow the same allocation pattern, however that allocation does not follow the “tons filled” ratio.
We should also notice that the model analyzed the cost occurred during winter months, in order to prepare a bid for spring. If pothole filling is a season specific activity, the actual costs could be slightly different and the bid should be adjusted accordingly. Maybe a better idea was to apply the ABC model considering actual costs incurred during the previous spring.
3- Yes, letting the municipal employees see the ABC estimates and giving them the opportunity to reduce their costs was a good practice as it provided several benefits. Due to several past factors, the city’s departments had been operating on a less than optimal level and had high overhead costs. For example the supervisor to worker ratio was too high, and the department of transportation carried excessive capital assets (vehicles). Sharing the ABC estimates and giving the opportunity to reduce costs allowed them to improve efficiency. The municipality was able to pinpoint the problem issues and fix them, such as half the supervisors were dismissed. This would allow the city to be competitive with the private sector in the bidding process.
ABC estimate sharing provided an additional benefit as a buy-in from the employees and the union. As the employees and the ABC estimators worked together to generate the estimates, they realized the data was showing the problems that they did not anticipate such has the high supervisor ratio. They recognized that ABC will be very essential for them to lower their costs and become competitive. The employees needed to be competitive with the private sector to keep their jobs.
4- We will assume that the “Indirect Cost Pool” includes supervisor’s expenses (which should be reduced by 50%) and overhead costs. In this case the bids for Northwest and Northeast quadrants are calculated in Exhibit B. Comparing with the actual pothole filing costs per ton in January-March, we could clearly see a dramatic decrease of indirect costs and rolling stock costs. Overall the bid for both quadrants is by far more competitive than it would have been without the ABC analysis and cost reduction.
5- If the administration continues to outsource city services through competitive bidding and assuming the private sector is able to aggressively under bid the city, the administration will have to dismiss the idle workforce, selloff unused fixed assets and update the ABC estimates accordingly. As the number of outsourced contracts grows in count and size, the administration will also need to enhance its contracting and performance management capabilities.