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MANAGEMENT SCIENCE informs ®
Ramji Balakrishnan
Tippie College of Business, University of Iowa, Iowa City, Iowa 52242, ramji-balakrishnan@uiowa.edu
Stephen Hansen
School of Business, The George Washington University, Washington, DC 20052, shansen@gwu.edu
Eva Labro
Kenan-Flagler Business School, University of North Carolina at Chapel Hill, Chapel Hill, North Carolina 27599,
eva_labro@unc.edu
T he academic and practitioner literature justifies firms’ use of product costs in product pricing and capacity
planning decisions as heuristics to address an otherwise intractable problem. However, product costs are the
output of a cost reporting system, which itself is the outcome of heuristic design choices. In particular, because
of informational limitations, when designing cost systems firms use simple rules of thumb to group resources
into cost pools and to select drivers used to allocate the pooled costs to products. Using simulations, we examine
how popular choices in costing system design influence the error in reported costs. Taking information needs
into account, we offer alternative ways to translate the vague guidance in the literature to implementable
methods. Specifically, we compare size-based rules for forming cost pools with more informationally demanding
correlation-based rules and develop a blended method that performs well in terms of accuracy. In addition, our
analysis suggests that significant gains can be made from using a composite driver rather than selecting a driver
based on the consumption pattern for the largest resource only, especially when combined with correlation-
based rules to group resources. We vary properties of the underlying cost structure (such as the skewness
in resource costs, the traceability of resources to products, the sharing of resources across products, and the
variance in resource consumption patterns) to address the generalizability of our findings and to show when
different heuristics might be preferred.
Key words: costing; estimation; activity-based costing; cost drivers; cost pools
History: Received September 6, 2009; accepted November 11, 2010, by Stefan Reichelstein, accounting.
Published online in Articles in Advance January 28, 2011.
nature of the production environment, we resort to when labor supervision costs are added to the labor
simulation experiments. Specifically, we simulate a cost pool or machine maintenance costs are added
multiproduct, multiresource manufacturing environ- to the machining cost pool). Surprisingly, this result
ment, where we parameterize critical cost structure holds even when the set of small resources accounts
dimensions such as heterogeneity in resource costs for up to 50% of total costs.
and resource consumption patterns of various prod- • A fairly low number of cost pools, formed using
ucts in the product portfolio. Through this param- gross information about consumption patterns, might
eterization, we are able to examine the sensitivity be acceptable (trading off the costs of adding more
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of design and decision heuristics to a rich array of pools with system accuracy) even for firms with a
manufacturing configurations, thereby lending gen- large number of resources. Thus, we present the first
eralizability to our findings. Within each such con- research findings in support of intuitive prescriptions
figuration, we first construct error-free cost systems by Turney (1991, p. 51) that “10–20 cost pools might
that serve as benchmarks. We then introduce noise be enough,” as well as by Cooper and Kaplan (1998a,
in these benchmark cost systems by using combina- p. 99) that “Activity-Based Costing (ABC) systems set-
tions of design choices that are rooted in practice (e.g., tle down to between 35–50 activity cost drivers.”
Cooper and Kaplan 1998a, b; Cokins 2001); we view • A blended method, which groups resources into
each such noisy approximation as an instance of an “tiers” (using gross estimates of correlations in con-
observed costing system. We calculate the error in a sumption patterns) and then uses a size-based rule
noisy system (or “accuracy”) by comparing reported within tiers, performs very well in terms of the accu-
and benchmark costs, which are obtained from the racy of reported product costs. This blended method
observed and benchmark systems, respectively, and resembles the structure of an ABC system but does
analyze how the error changes across heuristics and not demand as much information.
manufacturing configurations. For select heuristics, • Correlation-based rules perform well even when
we also consider how the coarsening of the informa- the precision of available correlation information is
tion available to implement the design choice affects low. Crude estimates of correlations in consumption
system accuracy. patterns (e.g., merely knowing whether the correla-
We first focus on heuristics that firms employ to tion is greater than 0.4) appear to be sufficient to
group resources into cost pools. Virtually all observed implement correlation-based rules effectively.
product costing systems group resources into a man- Overall, our results on cost pools show that sim-
ageable number of cost pools. Doing so reduces infor- ple costing systems that use size-based rules to seg-
mation needs because the firm only has to designate regate the largest resources work well when a few
and measure one allocation basis for each pool rather resources account for a majority of the costs. More
than for each resource. To form cost pools, practition- complex ABC systems that rely on correlation-based
ers and academicians advocate the use of two kinds of rules might be preferable when the manufacturing
heuristics: those that rely on resource size and those environment has many resources that are all equally
that rely on correlations in resource consumption pat- expensive. Our unique contribution in this regard is
terns. Size-based rules segregate the most expensive to provide estimates of the required dispersion in
resources in separate cost pools, the idea being that resource costs for size-based rules to be preferred over
errors related to low-cost resources do not matter as correlation-based rules.
much in determining system accuracy. Implementing We next focus on the heuristics for selecting cost
a size-based rule requires only data on resource costs drivers. The choice of a cost driver is critical because
(usually available in accounting records). Correlation- the use of a single driver forces the costs of all
based rules, in contrast, combine “like” resources into resources in the pool to be distributed in the same
one pool under the premise that similarity in how proportion, potentially introducing specification error
products consume these resources will reduce the (Datar and Gupta 1994). Moreover, one can either
consequent error. Correlation-based rules are informa- use simple, easy-to-identify drivers (e.g., number of
tion intensive, as they require information on resource setups as the driver for the pool of setup costs) or con-
consumption patterns, information that may be costly struct more complex drivers (e.g., intensity-adjusted
(if not impossible) to collect. setup hours) that might represent consumption pat-
Our experiments reveal the following insights with terns better but be informationally more demanding.
respect to the implementation of heuristics related to We find that when resource costs are disparate, the
forming cost pools: common practice of using the consumption pattern
• For both size- and correlation-based rules, it is for the largest resource (e.g., labor hours for the pool
preferable to group “small” resources into one mis- of all labor-related resources) as the cost driver is
cellaneous overhead cost pool rather than distribute inefficient. Economically significant gains obtain from
them over the large pools (as is done, for example, instead considering an indexed or composite driver,
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
522 Management Science 57(3), pp. 520–541, © 2011 INFORMS
particularly when we also employ correlation-based are outputs of a cost reporting system, and firms often
rules to group resources. Furthermore, data show that do not have the information required to compute
an indexed or composite driver that combines the product costs that fully reflect the underlying produc-
largest two to five resources in a given pool into tion environment. Thus, again, firms have no choice
an index might represent the best trade-off between but to resort to simple decision rules to design sys-
accuracy and collecting additional information on the tem features such as the number of cost pools and the
drivers of every resource in the cost pool. Overall, we choice of cost drivers. Obviously, these choices (e.g.,
interpret these findings as pointing to potentially con- choosing 5 versus 15 cost pools) significantly affect
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siderable gains from using indexed drivers to reduce the product costs reported by the system. Taking
specification error (Datar and Gupta 1994), particu- information needs into account, we therefore examine
larly for ABC-type systems that form cost pools by how alternative design rules for constructing product
grouping like resources. costing systems affect the accuracy of reported prod-
Finally, we consider how characteristics of the pro- uct costs. We elaborate on these arguments below.
duction environment (with moderate skewness in
2.1. The Capacity and Product Planning Problem
resource costs) affect the error in reported costs.
Capacity planning and product planning are joint
We find that the extent of resource traceability sig-
decisions that involve long-term commitment (Bal-
nificantly affects the preferred method for group-
akrishnan and Sivaramakrishnan 2002). This exercise
ing resources. In particular, it becomes increasingly in constrained stochastic programming is complex
important to consider correlation-based methods for and informationally demanding to formulate, let
pooling resources when the system designer believes alone solve.
that resource consumption patterns vary considerably. Several dimensions contribute to the computational
A practical implication is that a job shop with lit- complexity of this problem. First, once installed,
tle sharing of resources across products might need capacity levels are difficult to adjust in the short
a more sophisticated system (e.g., more pools) to term in response to demand fluctuations. This inabil-
accomplish the same level of accuracy as a process ity implies that in periods of demand spikes when
shop in which all products make use of the same installed capacity is not enough, firms may have to
set of resources (even if the pattern of consumption pay premium prices to acquire additional capacity
varies across products). in the spot market (Banker and Hughes 1994). Con-
We organize the remainder of this paper as follows. sequently, firms have to make capacity and product
In §2, we discuss the firm’s joint product and capacity planning decisions based on their beliefs about the
planning problem and the role of heuristics in solving demand distribution for its products, demand–price
it. We describe our simulation protocol in §3. Section 4 relations, and production feasibility and technology
discusses the properties of the generated systems and constraints, keeping in mind resource interdependen-
also provides descriptive data on the production set- cies, the role of inventory, and the costs of buying
tings. We consider the performance of the candidate additional capacity in the spot market. For instance,
heuristics in §5. In §6, we examine issues of fit with when choosing capacity levels, a firm has to fore-
the production environment. Finally, we offer addi- see future product prices, which in turn are solutions
tional thoughts concerning future research and con- to the quadratic program that reflects the allocation
clude in §7. The appendix provides a summary of our of acquired capacity among products, given demand
results. realizations for each product. The firm also has to
anticipate future spot prices for acquiring additional
capacity resources on an as-needed basis. Allow-
2. Why Do Firms Use Heuristics? ing for inventory requires that the firm incorporate
Our focus is on heuristics used to construct cost intertemporal considerations; nonlinear demand func-
accounting systems that report product costs. In such tions possibly make the problem nonconvex; and
an enquiry, it is important to understand the factors shocks to the demand parameters themselves likely
that lead to the use of heuristics. We therefore begin make the problem intractable. All of these issues
by examining the underlying product pricing and become that much more complex when we recog-
capacity planning decisions. We argue that it is not nize that even organizations of manageable size have
practically feasible to formulate and solve a general numerous capacity resources.
version of these decisions, forcing the use of decision Decentralized decision making contributes to infor-
rules and heuristics. Although there are many heuris- mational complexity. Within a firm, capacity plan-
tics, surveys show that a popular approach is to use ning and product pricing decisions might be made by
product costs to decompose the general portfolio-level different managers. Production managers, for exam-
planning problem into many product- and resource- ple, might know the details about resource con-
level problems. However, product costs themselves sumption and costs, whereas marketing has greater
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
Management Science 57(3), pp. 520–541, © 2011 INFORMS 523
insight into demand distributions. Moreover, it is of capacity to install upfront by trading off the costs
likely impossible to transfer the large amounts of of acquiring the resource now versus on an as-needed
relevant information possessed by different depart- basis but at a premium price later.
ments and to implement a centralized solution when The focus in extant product-based planning
reporting is limited by feasibility and cost constraints research has been on the computational difficulty
(Jordan 1989). and/or the difficulty in transferring information
In sum, because of the dimensions discussed above, across departments, as both are important rationales
we argue that firms must necessarily resort to some
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output from a benchmark costing system is a vector We hasten to note that firms are not devoid of infor-
of product costs (PCb ". Formally, mation that helps determine product costs. In par-
ticular, although incomplete and imperfect, a firm
likely has substantive information that it can bring
T T
alt11 alt1# I PC1b
RC1 $$$
to bear when constructing an observed cost system.
RC2 $$$ PC b
2 First, firms likely have a good sense of resource trace-
= $
ability. For example, indices of component common-
$$$ $$$ $$$
ality (Fisher et al. 1999) measure the extent of resource
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RCJ altJ # 1 altJ # I PCIb sharing by products. Firms that organize their pro-
duction around postponing assembly of products
The calculations of product costs from detailed data and delaying customization (e.g., those that work
(as in Banker and Hughes 1994) and in a product cost- with “vanilla boxes” as described in Swaminathan
ing system are closely related. Both approaches use and Tayur 1998) are likely to have more sharing of
information at the level of the individual resource and resources by products than firms that operate in a
consider the consumption pattern of each resource by make-to-order context. Production systems that make
a given product. Under suitable conditions, it can be use of worker rotation within a multiskilled work-
shown that the two approaches are alternative views force also exhibit less resource traceability relative to
of the solution to the grand program.4 an assembly line that is organized around rigid job
As argued earlier, information limitations bar a firm classifications (Hopp and Spearman 2000). Second,
from implementing the benchmark system. These firms likely have coarse estimates of similarity in con-
limitations mean that an observed cost system nec- sumption patterns, allowing for clustering of “like”
essarily involves some aggregation relative to the resources. For example, a firm would infer high vari-
benchmark system. Consider the information that a ation in the consumption patterns of volume- and
firm is likely to possess regarding resource costs. Gen- batch-level resources when its products vary widely
erally, we expect that accounting records, vetted by in terms of the volume of production and batch size.
auditors, provide reliable and detailed resource costs Moreover, the consumption pattern for labor hours is
(i.e., data on RC), albeit after applying some mate- likely to be more highly correlated with the consump-
riality threshold. However, even here some aggrega- tion for machine hours than with the consumption of
tion is inevitable for resources that support multiple design activity. In the language of activity-based cost-
activities. For example, the accounting record likely ing, the former are volume-based resources, whereas
reports only the total cost for a purchase office even the latter is a product-level resource. Based on this
though the office might process many different types clustering into “tiers,” the firm also might be able to
of orders; a benchmark system would require that identify the proportion of costs in batch resources.
the costs be separately identified for each activity. Finally, the data required for constructing the rows
We also argue that firms possess incomplete informa- of RES_CONS_PAT (i.e., the consumption patterns)
tion about their production environment (i.e., as mod- might be available for a few large resources (e.g., the
eled in RES_CONS_PAT). Although they may know firm might track machine hours, but not marketing
the number of machine hours consumed by a prod- hours, by product).
Formally, we represent an observed costing system
uct, they might not track the number of purchasing
as follows:
hours devoted to procuring associated raw materi- T
als. Practically, we therefore observe that firms group PC1R
T
resources into cost pools; as a result, they use a single AC1 cd11 $ $ $ cd1# I
R
driver to allocate the costs from a cost pool that might PC2
$$$ =
$$$ $$$ #
contain many resources with different consumption $$$
patterns. This approach considerably reduces infor- ACK cdK# 1 $ $ $ cdK# I
R
PCI
mation needs because the firm has to collect data for
fewer cost drivers. For example, we only need data where AC is a vector of activity cost pools, and
on total resource costs and labor hours consumed by the elements of the activity consumption matrix
each product to implement a one-pool, labor-hour- (ACT_CONS_PAT) map activities to products. As
based cost system. with the benchmark system, each element of AC is
a dollar value and each element of ACT_CONS_PAT
4
is a proportion, with rows summing to 100%. This
The elements of the resource consumption matrix, altji =
computation yields the vector of reported product
rij Qi /! i rij Qi ", are the proportions of resource j consumed to make
!
Qi units of product i. Further, equating the supply and demand costs, PCR .
for resources, the capacity bought at time t = 0 is Lj = i rij Qi , and
! How does the benchmark system relate to an
RCj = Cj × Lj . observed system? In the above representation, we
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
Management Science 57(3), pp. 520–541, © 2011 INFORMS 525
map each resource (i.e., elements in RC) to a cost pool observable systems. Each noisy system is a combina-
(i.e., an element in AC). Thus, sum(RC) = sum(AC) = tion of the heuristics for selecting the number of cost
sum(PCb " = sum(PCR ". The value of any given cost pools, for assigning resources to cost pools, and for
pool is the sum of the costs of the resources mapped calculating cost driver rates. For each noisy system,
to that cost pool. Usually, the number of activity we compute the associated vector of reported prod-
pools is much lower than the number of resources, uct costs. The use of heuristics means that this set
dim!AC" $ dim!RC". Indeed, AC is a scalar in firms of reported product costs is computed with coarser
that employ a one-pool system, as found in a large information than is used to compute benchmark costs.
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fraction of firms (Horngren et al. 2003). Similarly, the Fourth, for each noisy system, we compute an error
matrix of activity consumption patterns summarizes metric by comparing the vectors of the benchmark
the information about resource consumption patterns. and reported product costs. We then analyze how
Because observed costing systems coarsen informa- variations in the construction of noisy systems affect
tion relative to benchmark costing systems, reported this metric and examine the robustness of specific
product costs differ from benchmark product costs. In heuristics to available information by coarsening the
particular, the grouping of resources into cost pools data used to implement the rule. We detail each of the
results in aggregation error (Datar and Gupta 1994, above steps in the following paragraphs.5
Gupta 1993, Hwang et al. 1993). Reducing the cardi-
nality of the consumption matrix results in specifica- 3.1. Step 1: Model a Production Environment
tion error because different resources in the same pool We parameterize the cost structure of a production
might have different consumption patterns. Finally, environment along three dimensions. (We defer dis-
aggregation and specification errors interact in subtle cussion about the specific values we use for this and
ways (Labro and Vanhoucke 2007). Indeed, as Chris- other parameters and the survey evidence that sup-
tensen and Demski (1997) demonstrate, there is no ports the choices.) The parameter RC_VAR (resource
simple method to select the approach that results in cost variance) determines the variation in the costs of
the lowest error. Thus, when choosing among cost individual resources, the elements of RC. Low values
systems, a firm implicitly chooses among portfolios of RC_VAR correspond to environments with many
of errors. In sum, consistent with intuition, prior resources with roughly equal monetary importance
research indicates that the features of the cost system (i.e., has low variance in resource costs) such as might
(e.g., number of pools, process of assigning resources be found in a firm producing a wide and varied prod-
to pools, choice of cost drivers) exert a significant uct line. High values of RC_VAR indicate an environ-
influence on the accuracy of reported product costs. ment with many small resource cost pools and a few
As noted earlier, we focus on the heuristics that large cost pools such as might be found in a refinery
firms employ to construct the vector of activity cost or a law firm where machine and human resources
pools and the matrix of activity consumption pat- account for a majority of costs, respectively.
terns. We refer to these choices as assigning resources The parameter DENS (density of consumption
to pools and as selecting cost drivers, respectively. matrix) captures the extent of resource traceability (or,
Conceptually, there are numerous options that a firm its counterpart, resource sharing) as measured by the
might adopt for either decision. We therefore focus on number of zeros in the resource consumption matrix,
a few popular choices as documented in surveys and RES_CONS_PAT. When DENS is low, the resource
textbooks. We list the detailed choices we consider consumption matrix is sparse, meaning that only a
after we describe our simulation protocol. few products consume any given resource (that is,
we have many zeros in the consumption matrix). As
might occur in a job shop, there is high traceabil-
3. Simulation Protocol ity of costs to products. For instance, we can directly
Our simulation protocol has four major steps. First, trace much of a lawyer’s time to individual cases.
we generate a set of production environments by In contrast, a dense matrix implies a setting with
varying several dimensions of the economic envi- many common costs and low traceability. A bottler is
ronment. Second, for each such production environ- a good example because all products go through the
ment, we simulate many benchmark systems. Each of same line.
these draws represents a “firm” with a unique vec- The final parameter (COR) models the correlation
tor of resource costs and an associated consumption between resources whose consumption varies with
matrix. Using these data, which are the most granular production volume (volume-based resources) and
information available to model the consumption of with the number of batches (batch-level resources).
resources by products, we calculate the benchmark
vector of product costs. Third, for each benchmark 5
A formal description of the simulation protocol is available from
system, we construct many associated “noisy” or the authors on request.
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
526 Management Science 57(3), pp. 520–541, © 2011 INFORMS
A large positive value induces similarity between the by which we select a cost driver. For example, as a
consumption patterns of batch and volume resources, baseline, we use as the driver the consumption pat-
across products. This case models a setting in which tern for the largest resource contained in the cost pool
most resources are consumed in proportion to vol- (the big pool method) to allocate all of the costs in
ume. A negative value for COR implies significant the pool; we detail later the other methods that we
disparity between the consumption patterns of batch use. Formally, these rules help construct the activity
and volume resources across products. driver percentages used to allocate costs in an activ-
ity pool to products, and thereby generate the matrix
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activity cost pools. The smaller is the number of activ- where i indexes products, PCi is the benchmark
b
ity pools, the greater is the aggregation in the cost cost, and PCiR is the reported cost. This measure,
system. Formally, this step specifies the length of AC, which resembles the Euclidian distance between the
the vector of activity cost pools. Second, we vary two vectors, is symmetric and, given we keep total
the heuristic to assign resources to activity pools. We resource cost constant at $1 million, captures the mag-
use random size-based and random correlation-based nitude of the overall error in the costing system in
rules. At the end of this step, we have compressed
the vector of resource costs to generate a set of activ- resource indivisibly to one activity cost pool. In practice, accounting
ity pools and have assigned resources to individual records might contain resources that support multiple activities. In
pools;7 that is, we have generated the vector AC by this case, for the purpose of the benchmark system, we can view
aggregating the vector RC. Third, we vary the rule each portion as a separate resource.
8
We also varied the extent of measurement error in measuring
driver quantities. Low measurement error corresponds to a setting
6
Our tidy allocation scheme maintains comparability across experi- with a time clocking system for worker and staff time and where
ments. However, as in Hwang et al. (1993), our method can accom- estimates on driver consumption are regularly revisited. A high
modate partial allocation of resources by interpreting the last cost value represents a setting where there is no system to keep track
object as unused capacity. of staff’s time allocation and the system uses outdated estimates.
7
Consistent with our view that the benchmark system has a row We do not focus on the effect of measurement error because the
for each unique activity and the associated resource, we map each associated findings are intuitive.
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
Management Science 57(3), pp. 520–541, © 2011 INFORMS 527
dollar terms. Moreover, the square of this metric (i.e., Thus, in a baseline experiment, we vary the number
the mean squared error) is a measure of the loss of pools as a design parameter. In a modified exper-
from incorrect pricing decisions in monopolistic and iment, we determine the number of pools endoge-
oligopolistic markets (Vives 1990, Banker and Potter nously to consider the robustness of the heuristics to
1993, Alles and Datar 1998, Datar and Gupta 1994, available information.
Hwang et al. 1993). 3.5.1. Baseline Experiment. In this experiment,
We also calculate a “materiality” measure, %ACC, we fix the number of pools to form and consider
as the percentage of products whose costs are
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similar to “correlation-random” except that we seed 3.6. Heuristics for Calculating Driver Quantities
the desired number of activity pools with the largest The other major decision in designing a cost system
resources. This method reflects a convex combina- is to select cost drivers. Cooper and Kaplan (1988;
tion of the Willie Sutton rule that focuses on size 1998a, p. 99) describe driver choice as a “central inno-
and the prescription of using correlations to group vation” but also the “most costly aspect of ABC sys-
like resources together. This method also follows the tems” because “reality takes hold” when designers
prescriptions to use multiple criteria when grouping consider the associated information needs and costs.10
resources into activities (Cokins 2001, Fremgen and In our context, the choice determines the elements of
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driver that defines an overseas order as a multiple As seen in panel A, as we increase the value of
(say, three) of a domestic order. Other applications DENS (the density of the benchmark consumption
include distinguishing between a major and a minor matrix), the percentage of zeros in the consumption
setup when allocating changeover costs (Cooper and matrix decreases from 71% to 6%. The decrease in
Kaplan 1998a, p. 98) and weighting loan recalls more the traceability of resources leads to the number of
than item returns when allocating the costs in a products sharing any given resource increasing from
library (Ellis-Newman 2003).11 The use of indexed or 14.52 to 46.88 or from 29% to 94% of all products. We
composite drivers appears to be widespread. Fremgen also find more dispersion in consumption of resources
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and Liao (1981) report that firms used indexed cost across products as we increase resource sharing. The
drivers to allocate about 10% of activity cost pools, average range of consumption (i.e., range in percent-
with the proportion being significantly higher in areas age of resource cost consumed by products for a
with low cost traceability. They also report that firms resource, averaged across resources) decreases from
used indexed cost drivers to allocate 44% of sell- 23% to 5%; that is, the fewer products that con-
ing, general and administrative expense pools, 31% sume a resource, the more unequal their relative
of research and development pools, and 45% of the consumption.
marketing cost pools. In a meta-analysis, Shields et al. The third section of panel A shows the impact
(1991) report a range of 8.9% to 46.3% for the use of of changing COR, the correlation pattern we induce
multiple allocation bases in the United States; the rate on the drivers that describe resource usage by prod-
in Japan is 18.4%. Finally, Sakurai (1996, pp. 100–101) ucts. We find that the average correlation between
discusses the construction and use of both weighted the consumption pattern for the largest pool and all
and unweighted composite cost drivers by Japanese other pools drops from 0.376 to 0.149 as we decrease
manufacturers. the value for COR. In addition, a similar correlation
with batch resources by themselves turns negative.
4. Data and Descriptive Statistics We would expect such a negative correlation when
Table 1 provides descriptive statistics concerning our the ratio of the number of batches to the number
benchmark cost systems in the baseline experiment.12 of units varies across products. Such variance occurs
We simulate 48 economic environments (comprising when, for example, a firm makes large-volume prod-
three levels of variance in resource costs and four lev- ucts in a few large batches but uses many small
els each of the extent of resource sharing and cor- batches to make low-volume products. In either case,
relation in consumption patterns; 48 = 3 · 4 · 4) and significant differences in consumption patterns exist
draw 20 samples for each environment, resulting in between unit-level activities and batch-level activities
960 benchmark systems. The top section of panel A in an ABC hierarchy.
shows that as we increase RC_VAR, the ratio of per- Finally, for several other elements of the cost struc-
centage costs in the largest to the smallest resource ture, we set bounds and vary them randomly for
cost pool increases monotonically from 3.20 to 11.39. each benchmark system, as shown in panel B. For
Furthermore, the percentage cost in the top 20% of instance, we simulate the average percentage of costs
resources increases from 30% to 39%.13 devoted to volume resources randomly to be between
50% and 80%.14 Similarly, we generate the unad-
11
In our context, the benchmark system assumes a unique activity justed consumption pattern for volume resources by
for each resource. Therefore, aggregating resources implies that the randomly inducing a positive correlation with the
resources in an activity pool support multiple activities. The use baseline resource. The average correlation of the con-
of a composite driver suggests itself. We do not weight drivers sumption pattern of the largest volume resource with
because we do not model the relative intensities of the underlying
activities. In our linear model, weighting drivers by resource cost
other volume resources, weighted by the percent-
recovers the benchmark system. age costs in each resource pool, is reliably posi-
12
Our main results relate to environments with 50 resources and tive at 29.36%.15
50 cost objects. Robustness checks for different combinations yield
14
identical inferences. Because our interest relates to the ratio of the This is in line with survey research (Foster and Gupta 1990) and
number of resources to the number of cost objects, our robust- case-based observations (Ittner et al. 1997, Goddard and Ooi 1998).
ness tests hold the number of cost objects, CO, at 50 and vary We vary the remaining resources between positive (additional vol-
the number of resource cost pools. We do not vary the number of ume resources), zero, and negative (batch resources) correlations.
cost objects because changing CO would systematically affect our Our data contain an average of approximately 35% batch costs.
error measures, thereby hindering comparability across simulated 15
The accounting literature provides limited insight about the cor-
environments. relation in the consumption patterns of volume-based resources or
13
Although some kind of a Pareto rule is likely to apply, we on relative product costs. In our data, the ratio of the costs of the
could not find reliable survey information about the distribution of products with the five highest to the five lowest benchmark costs
resource costs. However, management accountants in a particular has a mean of 4.55 with a minimum of 1.5 and a maximum of
firm should have an intuitive understanding of their own resource 16.27. The average ratio of the costs of the highest- and lowest-cost
cost distribution. products is 14.3.
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
530 Management Science 57(3), pp. 520–541, © 2011 INFORMS
Average values
Percentage of zero entries in consumption matrix Percent 36"04 70"95 46"11 20"87 6"22
Average number of products Number 31"97 14"52 26"94 39"56 46"88
consuming a resource (max. = 50)
Average range in consumption of a resource Percent 11"43 23"22 11"08 6"61 4"79
across products (given positive use)
Correlation between largest pool Number 0"264 0"376 0"298 0"232 0"149
and all resources
Correlation between largest pool Number −0"029 0"300 0"000 −0"061 −0"125
and batch resources
Percentage of resources in pools devoted to batch activities Percent 35"07 34"87 14"14
Correlation between largest pool and volume resources Number 29"36 29"60 15"60
Notes. Size-random method used for assigning resources to activity pools: largest resources were assigned to a number of activity pools chosen by the system
designer (ACP ). The costs of the remaining resources are assigned randomly to the activity pools. Average method for selecting driver used to allocate costs
from activity pools to cost objects: driver percentages were calculated as the average of the driver percentages for all resources in the activity cost pool.
Inferences in panels C and D were unaltered with other methods for assigning resources to activity pools or selection of driver pattern. The average method
for selecting driver was used to allocate costs from activity pools to cost objects. Consumption percentages are calculated as the average of the consumption
percentages for every resource in the activity pool. Inferences are unaltered with other choices for drivers. RC_VAR , dispersion in the size of resource cost
pools. Higher values correspond to greater dispersion. COR , magnitude of the (average) correlation in resource consumption patterns between the baseline
volume resource and batch resources. DENS , measure of the extent of resource sharing by products. Greater values correspond to a greater degree of resource
sharing and lower traceability of resources to cost objects. EUCD , metric of error between benchmark and reported costs, calculated as the 2-norm between
the vectors of benchmark and reported costs. %ACC , percent of products whose reported cost is within 10% of their benchmark costs. MPE , mean percentage
error, which is the average of the relative error in reported costs.
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
Management Science 57(3), pp. 520–541, © 2011 INFORMS 531
We next turn to the noisy systems associated assignment rules only start to dominate correlation-
with the benchmark systems. For clarity, we present based assignments in an economically significant way
descriptive data for the baseline experiment, for one when the top 20% of resources account for more than
method for assigning resources to activity pools (size- ∼75% of total cost.
random), and for one method for choosing drivers
(average). (As we see later, the value of the error Figure 1 reports on the baseline experiment in
metric changes considerably based on the methods which we fix the number of cost pools. Panel A
chosen.) We aggregate data over three levels for mea- indicates that when resource costs are moderately
Downloaded from informs.org by [146.50.98.82] on 29 March 2023, at 02:55 . For personal use only, all rights reserved.
surement error (10%, 30%, and 50% error in measur- skewed, correlation-based methods dominate other
ing driver percentages)16 and over six values for the approaches in terms of reducing the error in reported
number of activity pools (1, 2, 4, 6, 8, and 10).17 Thus, costs (Result P1). More surprising, the baseline ran-
we have 18 associated observations for each of the 960 dom allocation is indistinguishable from one size-
benchmark systems, giving us 17,280 observations. based method (size-random) and beats the other
In panel C, we report univariate statistics con- size-based method (size-misc) handily. Furthermore,
cerning the error metrics we consider. The percent- within correlation-based methods, a size-based seed-
age accurate metric, %ACC, shows that, on average, ing shows limited improvement over a random seed-
25.84% of products have reported costs that are within ing. Intuitively, a correlation-based method leads
10% of their benchmark costs; the average mean per- to most costs being allocated with low specifica-
centage error (MPE) is 16.8%. However, there is wide tion error because this method pools resources with
variation across different environments and noisy sys- similar resource consumption patterns. Size-based
tems. The percent of products with accurate costs methods suffer either because they pool smaller
(%ACC) ranges from 0 to 100%, and the mean per- costs with larger resources (size-random) or group
centage error (MPE) goes from 1.47% to 62.59%; thus, a large amount of costs into a miscellaneous pool
system design exerts considerable influence on the (size-misc).18
error relative to benchmark costs. The data also show Panel B reports results obtained when we progres-
that for all error metrics the mean value exceeds sively increase the concentration of total costs into the
the median; that is, all of the error distributions are top 20% of resources to find the point at which the
skewed. system designer might prefer a size-based assignment
Data reported in panel D show that the metrics are rule (Result P1).19 We find that the size-misc rule is
highly correlated (note that the percentage of prod- preferred over random assignment when the top 20%
ucts with accurate costs is inversely related to error). of resources account for 50% or more of the costs.
This correlation also is robust to the choice of meth- The method also is preferred over the best correlation-
ods and untabulated checks indicate that our results based assignment when the top 20% of resources
are robust to changing the dependent variable. Thus, account for more than 65% of total costs. However,
in what follows we only report results with EUCD as the difference is not very large until the top 20% are
dependent variable. 70–75% of total costs. Overall, as expected, size-based
rules do well when resource costs are focused on a
5. Results: Performance of Heuristics handful of resources; our contribution in this regard
is providing insight into the cross-over percentages.
for Assignment of Resources to Note that unlike the correlation-based rules, size-
Cost Pools based rules require no information about how prod-
Result P1. Correlation-based methods for assign- ucts consume resources. Furthermore, driver selection
ing resources to pools (i.e., pooling “like” resources) is much simpler when each of the largest resources
lead to lower overall error relative to size-based forms its own pool (as in the size-misc method). Thus,
assignment rules when the distribution of resources
costs is moderately skewed (i.e., when top 20% of
18
resources trigger less than 50% of cost). Size-based Our results stand in a system in which we measured correctly
the driver pattern for the largest cost pools, which could be an
alternative way to interpret the Willie Sutton rule. We also note
16
Cardinaels and Labro (2008) find in a lab experiment that people that the number of resources per activity pool is similar between
overestimate the time they spend on all activities that constitute the size-random method and the correlation-random method. Thus,
their job description (a form of measurement error) by 37%, on the difference is not driven by this possible source of variation. We
average. thank Romana Autrey for suggesting this test.
17 19
The range for the number of activity pools is consistent with For this comparison, we calculated driver percentages using the
the Drury and Tayles (2005) survey of 187 firms about their man- methods that worked best with a given assignment rule to present
agement accounting systems. Their Table 3 shows that the median each method advantageously. Specifically, we used the average
number of cost pools was between 6 and 10. The minimum was method for correlation-based assignments and the big pool method
one, and 85% of the organizations had 50 or fewer cost pools. for size-based assignments.
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
532 Management Science 57(3), pp. 520–541, © 2011 INFORMS
70,000
50,000
25,000
40,000
20,000
30,000
15,000
20,000
10,000 10,000
1 2 4 6 8 10
Number of activity cost pools 0
40–45 45–50 50–55 55–60 60–65 65–70 70–75 75–80
Random Size-random Percentage of cost in top 20% of resources (%)
Correl-random Size-misc
Correl (avg) Random (BP)
Correl-size
Size-random (BP) Size-misc (BP)
Notes. Panel A uses the average method for selecting the driver used for allocating costs from activity pools to cost objects whereby consumption percentages
are calculated as the average of the consumption percentage for all resources in the activity pool. Inferences are unaltered with other choices for calculating
consumption percentages. Random, resources are assigned randomly to activity pools. Size-random, largest ACP resources assigned to number of activity
pools chosen by the system designer (i.e., ACP ). The costs of remaining resources are assigned randomly to the activity pools. Size-misc, largest ACP-1
resources assigned to number of activity pools chosen by the system designer, with one pool left open. The costs of remaining resources are assigned to the
last open pool (miscellaneous costs). Correlation-size, largest ACP resources assigned to the number of activity pools chosen by the system designer (ACP ).
For the first activity pool, select those resources with the highest correlation with the resource in the pool. Assign a total of INT(RCP/ACP ) resources to this
pool. Repeat for the second activity pool and so on. Correlation-random, pick ACP resources randomly and allocate one each to the number of activity pools
chosen by the system designer (ACP ). For the first activity pool, select those resources with the highest correlation with the resource in the pool. Assign a
total of INT(RCP/ACP ) resources to this pool. Repeat for the second activity pool and so on. EUCD , metric of error between benchmark and reported costs,
calculated as the 2-norm between the vectors of benchmark and reported costs. In panel B, ACP is fixed at 10. We used the method indicated in parentheses
as the best method for the associated assignment rule.
one way to interpret our results is that simple sys- about consumption patterns to implement this heuris-
tems might suffice when resource costs are concen- tic. Figure 2 presents the results.
trated and that ABC like systems are likely to have Result P2. The blended method performs well in
the greatest benefit when resource costs are diffused all production environments. In particular, an ABC-
across categories. like system that employs rough estimates of correla-
The remainder of this section examines how reduc- tions to group resources into tiers and then uses a
ing the information available to implement an assign- size-based rule within each tier results in error mag-
ment heuristic affects its efficacy. We first consider nitudes similar to that obtained with the more infor-
the effects of blending size- and correlation-based mationally demanding correlation-based rules.
heuristics. We next investigate reducing the precision We find that the performance of the blended
of information about correlations. Third, recognizing method is often superior to the performance of the
that system designers might want to limit the number correlation-based allocation methods even though it
of cost pools, we study alternate ways to deal with uses less information.20 Untabulated results show that
the costs of small resources. Finally, we further inves- the gain from the blended method increases as the
tigate the trade-offs relating to how many cost pools distinction in the consumption patterns of volume-
to form. and batch-level resources increases (as captured in the
value of the parameter COR).21 Even using a gross
5.1. Blended Method
Recall that the blended method uses gross estimates 20
The gain tapers off as we increase the number of activity pools.
of correlations to group costs into tiers and uses This finding obtains because the separation of resources into vol-
ume and batch resources occurs naturally as the number of activity
size-based methods inside each tier. In this way, pools approaches the number of resources to be assigned.
it combines aspects of size- and correlation-based 21
A large negative value for COR is consistent with batch resources
assignments even as it reduces information needs. being consumed in patterns that differ from the patterns for
In particular, we need relatively coarse information volume-based resources.
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
Management Science 57(3), pp. 520–541, © 2011 INFORMS 533
Figure 2 Performance of the Blended Method for Assigning Result P3. Correlation-based rules can be imple-
Resources to Activity Pools mented with relatively coarse information. The
40,000 increase in error is small even if we decrease the cut-
off correlation used to define “like” resources to 0.40.
35,000
In Table 2, consider the row that reports data
Error in reported costs (EUCD)
25,000
neous cost pool. Even a value of 0.4 for the cutoff
20,000 correlation leads to system accuracy that is compara-
ble to the information-intensive method (correlation
15,000 with size-based seeding) we employed in the baseline
experiment (see Figure 1). As we increase the cutoff
10,000 Blended method
correlation value we find a steady increase in system
Size-random
5,000 accuracy as well as a steeper increase in the number
Correlation-random
of cost pools formed. The trade-off is between the per-
-
1 2 4 6 8 10
ceived benefits of increased accuracy versus the costs
Number of activity pools of adding more pools. Correlation-based methods that
Notes. Individual series relate to various methods for assigning resources employ crude measures of the underlying correlation
to activity pools. Blended, resources are first separated as per whether they might be a practical way for grouping resources into
are batch or volume resources. The size-random method is used for each activity pools.
group, with each category having half the number of available cost pools.
Size-random, largest ACP resources assigned to number of activity pools 5.3. Dealing with the Low-Cost Resources
chosen by the system designer (i.e., ACP ). The costs of remaining resources
Costs connected with creating and maintaining a large
are assigned randomly to the activity pools. Correlation-random, pick ACP
resources randomly and allocate one each to the number of activity pools number of cost pools as well as the expectation of
chosen by the system designer (ACP ). For the first activity pool, select those diminishing returns to system detail suggest that it
resources with the highest correlation with the resource in the pool. Assign might be worthwhile to deal with low-cost resources
a total of INT(RCP/ACP ) resources to this pool. Repeat for the second activ- in an ad hoc fashion. We consider two alternatives:
ity pool and so on. EUCD , metric of error between benchmark and reported
pool all such costs into a miscellaneous cost pool
costs, calculated as the 2-norm between the vectors of benchmark and
reported costs. The average method was used for selecting the driver used or distribute the costs for these low-cost resources
for allocating costs from activity pools to cost objects. Under this method, among the pools for the high-cost resources. We note
consumption percentages are calculated as the average of the consumption that pooling small resources into one pool requires
percentage for all resources in the activity pool. Inferences are unaltered with less information about resource costs relative to dis-
other choices for calculating consumption percentages.
tributing these costs over all cost pools.
Result P4. Firms can group a large portion of their
guess about correlation structure is useful in reduc-
costs into a “miscellaneous” pool without signifi-
ing error when assigning resources to activities, par-
cantly degrading system accuracy.
ticularly when we have an ex ante reason to suspect
dissimilar consumption patterns. To our knowledge, Panel A of Figure 1 (related to the baseline experi-
these are the first research findings that support the ment) shows little difference across alternate correla-
ABC prescription of classifying resources as per the tion-based assignments, the preferred choice. How-
activity hierarchy and constructing separate pools for ever, data in panel B show that when size-based
each tier of resources. The results also support the use assignments are preferred, we obtain lower error
of multiple criteria for assigning resources to pools when we group “small” resources into a single mis-
and suggest that size might be a good candidate for cellaneous cost pool than when we distribute them
a secondary criterion for grouping resources. over the larger pools. The size-misc heuristic outper-
forms the size-random heuristic over the entire range
5.2. Modified Experiment: Reducing the Precision in which the firm prefers a size-based assignment
of Available Information rule. The data in Table 2 (relating to the modified
With correlation-based rules, the precision of available experiment) provide another indication of this find-
information about consumption patterns might affect ing. Consider the column for the cutoff correlation
the desired number of pools. We therefore consider a of 0.4. Here, our measure of the error in reported
“correlation cutoff” method in which we determine costs (EUCD) has a value of 17,018 when we allow
the number of pools endogenously. We also view this only five of the 50 resources to be in the miscella-
experiment as providing guidance on the robustness neous cost pool. At this level, the average system has
of correlation-based assignment heuristics to available 19 activity pools. When 50% of the available resources
information. (25 of 50 resources, containing as much as 31% of total
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
534 Management Science 57(3), pp. 520–541, © 2011 INFORMS
Notes. Reported are the average value for EUCD, [average number of activity cost pools], and (range for the number
of activity pools formed). Values in italics indicate that the value is at the exogenously specified maximum for the
number of activity pools (30). The grey shaded areas indicate experiments where the number of endogenously
created ACP hits the maximum number of ACP possible (the number of RCP minus the number of resources in
miscellaneous cost pool) or the number of pools is very small (e.g., 2). The first pool is seeded with the largest
resource. Additional resources that satisfy the correlation cutoff (relative to the first resource in the pool) are
added to pool. The second pool is seeded with largest among remaining resources. Additional resources satisfying
correlation cutoff are added. Continue process until the number of remaining resources is less than specified (all
remaining resources put into miscellaneous cost pool). We also grouped all remaining resources into the last pool
if the number of activity pools became 30 (the maximum number of possible activity pools). We used the average
method for calculating driver percentages for an activity cost pool.
costs) are grouped as miscellaneous costs (last row data show that we continue to obtain statistically
of Table 2), the error metric only registers a marginal significant (but economically small) gains of adding
increase to 19,610, whereas the number of activity activity cost pools even when the ratio of the number
pools drops to 6. Data reported in the other columns of activity pools to the number of resources is as high
show a similar pattern. as 80% (40 pools for 50 resources). Untabulated results
confirm a similar inference when resource cost disper-
5.4. Determining the Number of Pools sion is high (size-based rules dominate) and when we
Result P5. Regardless of the method for assigning increase the number of resources we consider.
resources to pools, although increasing the number Data in Table 2 provide additional support. For the
of cost pools leads to statistical gains in accuracy, modified experiment and for a given correlation cut-
the economic gains are small after we reach ∼12 cost off, when five additional resources are taken out of
pools. In practice, a relatively small number of pools the miscellaneous pool, the optimal number of pools
seem adequate. formed increases at a lower rate. We conclude that a
Panel A of Figure 1 suggests that the number firm might be able to devise a “good enough” system
of activity pools matters greatly. The average error with a relatively small number of activity pools. Thus,
(EUCD value) reduces from 37,657 for one pool to we provide the first research findings in support of
23,675 with 10 pools when we use the size-random intuitive prescriptions by Turney (1991, p. 51) as well
method; the decline is from 37,929 to 16,603 with the as by Cooper and Kaplan (1998a, p. 98) that a system
correlation-random method. The error is decreasing in which the ratio of the number of pools to the num-
and concave in the number of pools.22 Untabulated ber of resources is small might be enough in terms of
delivering desired system accuracy cost effectively.
22
For additional insight, consider the correlation method with size-
based seeding and the average method for selecting a driver. In this with more than 50% error in reported costs. This accuracy rate
case, analysis of the percentage error shows that with 8–10 pools, decreases rapidly as the number of pools decreases. We also find
slightly more than 50% of products have reported costs that lie instances of extremely large (both positive and negative) errors.
within 10% of the true cost. Furthermore, there are few products Data from other methods lead to qualitatively similar conclusions.
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
Management Science 57(3), pp. 520–541, © 2011 INFORMS 535
6. Results: Performance of Heuristics Figure 3 Effect of Method for Selecting Cost Driver (Indexing)
for Selecting Cost Drivers Panel A: Use size-random method to assign resources
We parameterize the heuristic for selecting cost to activity pools
80,000
drivers by the number of resources within an activ-
ity pool whose consumption patterns we average to 70,000
Percentage of gain relative to error from using the big pool method for selecting driver pattern
Notes. Data pertain to 50 resources. BIG POOL, the allocation percentages are those of the largest resource in the activity cost pool.
NUM , calculated driver percentages as the average of the largest NUM resources in the activity cost pool. AVG, calculated driver
percentages as the average of the driver percentages for all resources in the activity cost pool.
benchmark system’s consumption pattern given our factors that affect the performance of different heuris-
linear setup. tics because in the long run, it might be possible for
As shown in Table 3, panel B, we find that our a firm to partially manage features of its production
general conclusion holds if we use a correlation- environment (e.g., organizing for production in work
based method to assign resources to activity pools. cells potentially increases resource traceability relative
The potential gains from averaging are larger (about to a single assembly line).
65% relative to 55% for the size-random method)
because the assignment method reduces the proba- 7.1. Heuristics for Pooling Resources
bility that we will average dissimilar consumption Table 4 provides insight into how characteristics of
patterns. However, although indexing continues to the production environment (with moderate skew-
yield significant gains, the performance never beats ness in resource costs) affect the error in reported
that with the average method. Overall, we conclude costs in the baseline experiment for two assignment
that refining drivers has the potential to significantly methods: size-random and correlation-random. Not
improve system accuracy, particularly if the cur- surprisingly, the extent of correlations in consump-
rent system uses correlation-based methods to assign tion patterns matters a great deal in determining
resources to pools. the absolute and relative performance of the assign-
ment rules. At an absolute level, the accuracy of any
assignment method worsens as consumption patterns
7. Results: Fit with Production become increasingly dissimilar (COR moves from 0.33
Environment to −0.66). The relative decline with the correlation-
Our analyses thus far can be construed as examin- based method is only 20%, whereas the performance
ing the efficacy of alternative heuristics for an aver- of the size-based assignment method worsens consid-
age production environment. In particular, although erably by about 55%.
we examined how variation in the dispersion of
Result P6. It becomes increasingly important to
resource costs affects the ranking of the heuristics
consider correlation-based methods for pooling
(with resource cost variation increasing error in the
resources when the system designer has grounds
system and favoring size-based rules), we did not
to believe that resource consumption patterns vary
consider the effects of variations in other dimensions
considerably.
of the production environment. However, the preci-
sion of available information about these dimensions Intuitively, we expect that a greater degree of
obviously affects the choice of heuristics for assigning resource sharing by products would make it harder
resources and for selecting cost drivers. In this sec- for an allocation to capture true resource consump-
tion, we provide some insight into the cost structure tion. However, we find that a greater degree of
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
Management Science 57(3), pp. 520–541, © 2011 INFORMS 537
<0.0001
Extent of resource sharing (DENS) 3 11"49 <0.0001
Correlation between batch and volume driven 3 183"02 <0.0001
resources (COR)
Residual <0.0001
Adjusted R2 (%) 74.80
Value of construct DENS = −0"75 DENS = 0"0 DENS = 0"75 DENS = 1"50
Notes. Average method for selecting driver was used to allocate costs from activity pools to
cost objects. RC_VAR , variance in the size of resource cost pools. COR , magnitude of the (aver-
age) correlation in resource consumption patterns between the baseline volume resource and
batch resources. DENS , measure of the extent of resource sharing by products. Greater values
correspond to a greater degree of resource sharing and lower traceability of resources to cost
objects. EUCD , metric of error between benchmark and reported costs, calculated as the 2-norm
between the vectors of benchmark and reported costs. d.f., Degrees of freedom.
resource sharing reduces error in reported costs. We same level of accuracy as a process shop where all
observe this effect regardless of the method used to products make use of the same set of resources (even
assign resources to pools. One explanation is that if the pattern of consumption varies across products).
when we pool resources with a sparse matrix, we However, the relative effect of resource sharing on the
increase the probability that the costs of an unre- difference between the effectiveness of the correlation-
lated resource are allocated to a product. This error based method and the size-based method is not large.
reduces as resource sharing increases and seems to The change in the gain from using the correlation-
offset the greater error in specification.24 A practical based method over the size-random method is small
implication is that a job shop with little sharing of (the percent gain decreases from 23% to 15%) over the
resources across products might need a more sophis- range we consider.
ticated system (e.g., more pools) to accomplish the
Result P7. Holding the number of pools constant,
24
increasing the extent of resource sharing reduces the
This comparison rests crucially on the fact that we fix the num-
ber of pools. Firms with high traceability might also find it cost-
overall error in the system. However, this environ-
efficient to create more cost pools than firms whose products share mental factor does not significantly favor one method
resources, thereby leading to systems with lower overall error. for grouping resources into cost pools over another.
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
538 Management Science 57(3), pp. 520–541, © 2011 INFORMS
Table 5 Determining the Number of Activity Pools Endogenously: Interaction with Environmental Parameters
Notes. The first pool is seeded with the largest resource. Additional resources that satisfy the correlation cutoff (rel-
ative to the first resource in the pool) are added to the pool. The second pool is seeded with largest among remain-
ing resources. Additional resources satisfying correlation cutoff are added. Continue the process until the number of
remaining resources is less than the specified number (all remaining resources are put into miscellaneous cost pool).
We also grouped all remaining resources into the last pool if the number of activity pools became 30 (the maximum
number of possible activity pools). We used the average method for calculating driver percentages for an activity cost
pool. Data pertain to a setting with a cutoff correlation of 0.4 and with as many as 15 resources in the miscellaneous
cost pool. RC_VAR , dispersion in the size of resource cost pools. Higher values correspond to greater dispersion.
COR , magnitude of the (average) correlation in resource consumption patterns between the baseline volume resource
and batch resources. DENS, measure of the extent of resource sharing by products. Greater values correspond to a
greater degree of resource sharing and lower traceability of resources to cost objects. EUCD , metric of error between
benchmark and reported costs, calculated as the 2-norm between the vectors of benchmark and reported costs.
We next consider the effect of environmental pattern obtains even though we find an accompany-
parameters when we let the number of cost pools be ing reduction in the number of activity pools as the
determined endogenously in Table 5. Here, recall that density of consumption matrix increases. Overall, our
we seed each new pool with the largest remaining findings indicate that, next to resource cost disper-
resource and added additional resources as dictated sion, the density of consumption matrix is perhaps
by a correlation cutoff. Results are generally consis- the most important feature of the production environ-
tent with the findings reported for the baseline exper- ment to consider when making choices about param-
iment. Consistent with Result P6, we find that the cor- eters of the cost system.
relation pattern between batch and volume resources
matters greatly. The correlation cutoff method per-
7.2. Heuristics for Selecting Cost Drivers
forms well when these two groups of resources have
Table 6 reports data that examine the influence of
distinct resource consumption patterns. Intuitively,
environmental parameters on the performance of
with dissimilar consumption patterns, batch and vol-
heuristics for selecting cost drivers. For parsimony, we
ume resources form separate activity pools, each of
focus on the gain from one case of indexing (NUM = 3
which is allocated well to products. However, a move-
ment toward zero in the correlation in consump- versus the big pool method) in different production
tion patterns reduces the ability of the heuristic to environments. The descriptive data in panel A and
separate out batch and volume resources, degrad- the results from an analysis of variance (ANOVA)
ing performance and generating systems with many in panel B both indicate that the gain is general in
cost pools.25 nature. We continue to average about a 30% gain
Finally, consistent with Result P7, we find a mono- from indexing, relative to the big pool method, across
tonic decline in error in reported costs as the extent a wide range of environmental parameters. We note
of sharing of resources by products increases. This that the less resource sharing there is in the pro-
duction environment (low density of the consump-
25
Not surprisingly, the method also does well when all resources
tion matrix), the higher the gain is from indexing.
are highly correlated, as might happen when all products have sim- Of course, consistent with the data in Table 4, the
ilar batch sizes. ANOVA in panel B indicates a significant effect due to
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
Management Science 57(3), pp. 520–541, © 2011 INFORMS 539
Table 6 Interaction Between the Method for Choosing the Driver and Environmental Parameters
Panel A: Effect of environmental parameters and other system design choices on the reduction
in the error in reported costs (big pool versus using index of top three resources)
Notes. Correlation with random initial seeding was used for assigning resources to activity cost pools. RC_VAR , dis-
persion in the size of resource cost pools. Higher values correspond to greater dispersion. COR , magnitude of the
(average) correlation in resource consumption patterns between the baseline volume resource and batch resources.
DENS, measure of the extent of resource sharing by products. Greater values correspond to a greater degree of resource
sharing and lower traceability of resources to cost objects. EUCD , metric of error between benchmark and reported
costs, calculated as the 2-norm between the vectors of benchmark and reported costs. d.f., Degrees of freedom.
the number of activity pools (mechanically, the num- cost drivers for the resulting cost pools. To our knowl-
ber of resources per pool declines, leading to greater edge, this paper is the first to compare the alternate
accuracy for indexing). This result suggests that such heuristics employed by system designers. Although it
indexing or use of composite drivers for the same offers important insights into the design of product
activity pool may be particularly important in job costing systems, we believe that the area is ripe for
shop environments. Overall, our findings indicate that further enquiry. Four avenues look promising. First,
although it is useful to consider the consumption pat- the grand program is a multiperiod program, whereas
terns of all resources in an activity pool, it might be we consider a single-shot framework and assume that
economically enough to calculate drivers using only capacity is fully utilized. Thus, it is of particular inter-
the largest few resources in a pool. This finding can est to model a setting that can accommodate the iden-
be restated as follows: tification of unused capacity. Such a dynamic setting
could then be useful when considering alternate uses
Result D3. Even marginal improvements in spec-
for ABC systems such as cost control and process
ification have the potential to reduce error consider-
ably in a wide range of environments. analysis.
Second, within limits, managers can modify the
production environment to affect resource cost disper-
8. Discussion sion and traceability. We could investigate the robust-
Our paper uses simulation data to rank heuristics for ness of the cost system to potential changes in the
grouping resources into cost pools and for generating production processes. For instance, the use of cellular
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
540 Management Science 57(3), pp. 520–541, © 2011 INFORMS
context in which firms use data from product costing (Stefan Reichelstein) provided invaluable help in improv-
systems. ing this paper. They also thank workshop participants at
Third, consistent with prior works that examine the following universities and conferences: the Account-
cost system design, we employ an error metric that ing Research Workshop, Bern; Carnegie Mellon University;
compares benchmark and reported costs. Although Florida International University; the George Washington
we verify robustness with other measures such as University; Global Management Accounting Research Sym-
mean absolute percentage error, all of our error met- posium Conference, Copenhagen; Management Accounting
rics employ benchmark costs as the goal. Thus, as Section midyear meetings; Stanford University; Tilburg Uni-
discussed earlier, these comparisons arithmetically versity; University of Houston; University of Iowa; Uni-
induce correlations among errors in reported prod- versity of North Carolina at Chapel Hill; and University
uct costs. Abandoning error metrics to judge the per- of Southern Denmark. Fang Yang, Saurav Pandit, and
formance of heuristics requires that we revert to the Vasu Balakrishnan provided programming assistance. The
grand program and examine changes in the value of authors gratefully acknowledge funding from the IMA
its objective function as the ranking criterion. In a mul- Foundation for Applied Research. An earlier version of this
tiperiod setting, such an extension could also allow paper was titled “Heuristics for Evaluating and Refining
us to endogenously determine the error metric as the Product Costing Systems.”
difference between an actual and a predicted cost.
Such approaches obviously involve considerably more Appendix. Select Results
structure and add a great deal of complexity. How-
ever, the broader view also allows for an examina- Forming Cost Pools
tion of heuristics other than product-based planning. • When the distribution of resource costs is moder-
For example, we can investigate whether resource- ately skewed (top 20% of costs account for less than 40%
based planning dominates product-based planning of total costs), correlation-based methods dominate size-
in certain production environments. Under resource- based methods. When the distribution of resource costs is
based planning, we estimate opportunity costs at the highly skewed (top 20% account for greater than 75% of
resource level, obviating the need for heuristically total costs), size-based methods dominate correlation-based
designed product costing systems. Furthermore, such methods (Result P1; Figure 1).
an enquiry does not require the assumption that the • A blended method that groups resources into tiers and
benchmark product cost is the best possible estimate uses a size-based rule within each tier results in error that is
of opportunity costs at the product level. comparable to the error obtained with more information-
Last, this stream of research is also of interest to intensive methods (Result P2; Figure 2)
researchers who examine the antecedents and/or con- • Correlation-based methods are robust to reductions in
sequences of the provision in organizations of more the precision of information available information regard-
(or less precise) information. For example, account- ing correlation patterns (Result P3; Table 2). This finding is
ing literature links the precision of information to robust to the variance in resource costs and to the similar-
properties of disclosure (see Verrecchia 1990, Dye ity in consumption patterns. The effect of coarsening infor-
and Sridhar 2007, Langberg and Sivaramakrishnan mation is more acute when many products share the same
2008). Empirical testing of these theoretical hypothe- resource (Table 5).
ses requires that we understand how information pre- • For all methods for assigning resources to cost pools,
cision might translate into properties of observable it is generally preferable to group the costs of low-cost
data such as the properties of costing systems studied resources into one pool rather than distribute them over the
here. Further research could combine these observ- other pools (Result P4; Figure 1, Table 3). Such a miscella-
able properties into a composite index that might neous cost pool could contain up to 50% of total costs.
serve as an empirical proxy of the theoretical con- • A moderate number of cost pools (10–20) seem
struct of precision. Our hope is that such translation enough, regardless of the method used to group resources
will help ground the often normative literature on into cost pools (Result P5; Figure 1, Table 2). For both size-
product costing in information economics, providing and correlation-based methods, the gain from adding more
it with a solid theoretical base. pools is concave in the number of pools formed.
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
Management Science 57(3), pp. 520–541, © 2011 INFORMS 541
Selecting Cost Drivers Dye, R., S. Sridhar. 2007. The allocational aspects of the precision
• In every environment and method for grouping of accounting estimates. J. Accounting Res. 45(4) 731–769.
resources into cost pools, an indexed driver is preferred to Ellis-Newman, J. 2003. Activity-based costing in user services of an
the “big pool” method of using the consumption pattern for academic library. Library Trends 51 333–348.
the largest resource (Result D1). Fisher, M., K. Ramdas, K. Ulrich. 1999. Component sharing in the
• Indexed drivers (using four or five resources) might management of product variety: A study of automotive brak-
ing systems. Management Sci. 45(3) 297–315.
even do better than the more information-intensive average
driver with a moderate (8–12) number of cost pools (Fig- Foster, G., M. Gupta. 1990. Manufacturing overhead cost driver
analysis. J. Accounting Econom. 12(1) 309–337.
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