41060688

Evaluating Heuristics Used When Designing Product Costing Systems
Author(s): Ramji Balakrishnan, Stephen Hansen and Eva Labro

Source: Management Science, Vol. 57, No. 3 (March 2011), pp. 520-541
Published by: INFORMS
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MANAGEMENT SCIENCE MUE
Vol. 57, No. 3, March 2011, pp. 520-541 DOI i0.1287/mnsc.ll00.1293
ISSN 0025-1909 1 EissN 1526-5501 1 11 1 5703 1 0520 © 2oil INFORMS
Evaluating Heuristics Used When D

Product Costing Systems
Ramii 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
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.
1. Introduction firms therefore employ simple rules of thumb, judg-

ment, and unavoidably incomplete statistical analy-
Long-run product and resource capacity planning
ses
decisions are among the most important issues to make choices such as how many cost pools to
that
have, which resources to group into a given pool, and
firms face. Because these decisions are computation-
ally complex and informationally demanding, how firmsto choose cost drivers. To our knowledge, few
often resort to simple and implementable decisionsystematically evaluate alternative practical
studies
rules (Cooper and Kaplan 1998b, Govindrajan approaches
and to cost system design and the consequent
implications for decision making. Thus, our objectives
Anthony 1983, Shim and Sudit 1995). Consequently,
in this paper are threefold. First, we examine how
a recent stream of literature in management account-
ing has focused on the efficacy of alternative choices
heuris- regarding the design of a cost system influ-
ence the accuracy of reported product costs. Second,
tics, especially those that rely on cost information
we provide guidance on the implementation of gen-
generated by product costing systems (Balakrishnan
erally worded (e.g., " group like resources'' or " focus
and Sivaramakrishnan 2002). However, the efficacy
of such decision rules crucially depends on on expensive resources") prescriptions in the practi-
charac-
teristics of the reporting system that providestioner
the literature. Third, we provide insights into the
characteristics of economic environments that exert
inputs to the heuristic. In practice, organizations offer-
the greatest influence on the preferences for system
ing diverse products that share numerous capacity
features.
resources do not have the granularity of informa-
tion needed to design a cost reporting system Tothat
capture complex interactions among the design
choices
reflects the production environment perfectly. Suchembedded in a cost system and to vary the
520
Balakrishnan, Hansen, and Labro: Evaluating Heuristics Used When Designing Product Costing Systems
Management Science 57(3), pp. 520-541, ©2011 INFORMS 521
when labor supervision

nature of the production environment, wecosts are added
resort toto the labor
cost pool or machine
simulation experiments. Specifically, we maintenance
simulate costs a
are added
multiproduct, multiresourcetomanufacturing
the machining cost pool). Surprisingly,
environ- this result
ment, where we parameterize holds even when thecost
critical set of small resources accounts
structure
dimensions such as heterogeneity
for up to 50%in resource
of total costs. costs
• A fairly low
and resource consumption patterns of number
various of cost pools, formed using
prod-
ucts in the product portfolio. Through
gross information aboutthis param-
consumption patterns, might
eterization, we are able to be
examine the sensitivity
acceptable (trading off the costs of adding more
of design and decision heuristics
pools with to
system
a rich
accuracy)
array
even forof
firms with a
manufacturing configurations, thereby
large number lending
of resources. gen-
Thus, we present the first
eralizability to our findings. Within
research findings each
in supportsuch con-
of intuitive prescriptions
figuration, we first construct by Turney (1991, p. 51)
error-free that "10-20
cost systemscost 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 practicetle down to between 35-50 activity cost drivers."
(e.g.,
Cooper and Kaplan 1998a, b; Cokins 2001); we view • A blended method, which groups resources into
each such noisy approximation as an instance "tiers" of an (using gross estimates of correlations in con-
observed costing system. We calculate the errorsumption in a 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 thoseenvironment 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. ImplementingWe next focus on the heuristics for selecting cost
drivers. The choice of a cost driver is critical because
a size-based rule requires only data on resource costs
the use of a single driver forces the costs of all
(usually available in accounting records). Correlation-
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 costlystruct 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 toWe 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 for
is 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 distributeinefficient. Economically significant gains obtain from
them over the large pools (as is done, for example, instead considering an indexed or composite driver,
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
do not havedata
rules to group resources. Furthermore, the information
show that required to compute
an indexed or composite driver that
product costscombines the
that fully reflect the underlying produc-
largest two to five resourcestion inenvironment.
a given pool into
Thus, again, firms have no choice
but to trade-off
an index might represent the best resort to simple decision rules to design sys-
between
tem features
accuracy and collecting additional such as theon
information number
theof cost pools and the
drivers of every resource in thechoice
cost ofpool.
cost drivers. Obviously,
Overall, we these choices (e.g.,
choosing
interpret these findings as pointing to5 potentially
versus 15 cost pools)
con- significantly affect
the product
siderable gains from using indexed driverscosts to
reported
reduce by the system. Taking
specification error (Datar and information
Gupta 1994), needs into account, we therefore examine
particu-
larly for ABC-type systems that howform
alternative design
cost rules for
pools by constructing product
grouping like resources. costing systems affect the accuracy of reported prod-
uct costs. We elaborate
Finally, we consider how characteristics of theonpro- 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
akrishnan for group- 2002). This exercise
and Sivaramakrishnan
ing resources. In particular, it becomes
in constrained increasingly
stochastic programming is complex
important to consider correlation-based methods
and informationally for
demanding to formulate, let
pooling resources when the system designer believes
alone solve.
that resource consumption patterns vary
Several considerably.
dimensions contribute to the computational
A practical implication is that a job shop
complexity of this with lit-
problem. First, once installed,
tle sharing of resources across capacity
products levelsmight need
are difficult to adjust in the short
a more sophisticated system term (e.g., more pools) to
in response to demand fluctuations. This inabil-
accomplish the same level of ity
accuracy
implies that asin a process
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
pay premiumof consumption
prices to acquire additional capacity
varies across products). in the spot market (Banker and Hughes 1994). Con-
We organize the remainder of sequently,
this paper firms as
havefollows.
to make capacity and product
In §2, we discuss the firm's joint product
planning and
decisions capacity
based on their beliefs about the
planning problem and the role of heuristics
demand distributioninforsolving
its products, demand-price
it. We describe our simulation protocol
relations, andin §3. Section
production 4 and technology
feasibility
discusses the properties of the generated systems
constraints, keeping in mind andresource interdependen-
also provides descriptive data oncies,
the
the role
production
of inventory, set-
and the costs of buying
additionalof
tings. We consider the performance capacity
the in the spot market. For instance,
candidate
when issues
heuristics in §5. In §6, we examine choosing ofcapacity
fit levels,
witha firm has to fore-
see future product
the production environment. Finally, we offer prices, which
addi- in turn are solutions
to the quadratic
tional thoughts concerning future research and con-program that reflects the allocation
of acquired capacity
clude in §7. The appendix provides a summary of our 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 ing
Heuristics?
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 suchpossibly make the problem nonconvex; and
tions
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 make
begin the problem intractable. All of these issues
by examining the underlying product pricing and that much more complex when we recog-
become
capacity planning decisions. We argue that itnize
is not
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-
mational complexity. Within a firm, capacity plan-
rules and heuristics. Although there are many heuris-
tics, surveys show that a popular approach is toning
use and product pricing decisions might be made by
different managers. Production managers, for exam-
product costs to decompose the general portfolio-level
ple, might know the details about resource con-
planning problem into many product- and resource-
sumption and costs, whereas marketing has greater
level problems. However, product costs themselves
insight into demand distributions. Moreover,

of capacity it upfront
to install is by trad
likely impossible to transferof
the large amounts
acquiring of
the resource now versus
relevant information possessed by different
basis depart- price later.
but at a premium
The focus in extant
ments and to implement a centralized solution when product-b
reporting is limited by feasibility and cost constraints
research has been on the computat
(Jordan 1989). and /or the difficulty in transferrin
In sum, because of the dimensions
acrossdiscussed above,
departments, as both are impo
we argue that firms must necessarily resort to
for decomposing thesomeGrand Program
simplification to overcome the computational
therefore takes as and
given the availab
informational complexity present
cost in the traditional
information (i.e., assumes that th
formulation of the product andpute
capacity planning
PQ). In pro-
contrast, we argue that
gram (which we refer to as theof"grand
product program").
costs is itself a complex
able literature suggests that it is n
2.2. Product-Based Planning firm to calculate error-free product
One way to address these informational and com-
and Gupta 1994, Hwang et al. 1993). R
putational issues is to decompose
culate the full-fledged
product costs (we term the col
grand program into many smaller, more manageable
procedures a costing system) based on
problems. Although firms may use many approaches,
incomplete information about resour
we focus on product-based planning because sur-
sumption patterns.2 Furthermore, fir
veys indicate this to be a popular, if not dominant,
of thumb in this process because th
approach. Recent research (e.g., Balachandran et al.
guidelines on how to construct a co
1997, Balakrishnan and Sivaramakrishnan 2002) jus-
other words, the product costs that firm
tifies this practice as the use of heuristics helping
selves the outcomes of heuristically desi
firms tackle an otherwise intractable problem. Banker
focus is on how the use of system-de
and Hughes (1994) note that this computationally eas-
affects the accuracy of reported pr
ier approach also simplifies communication between
therefore the efficacy of the capacit
departments because product costs,
that use thiswhich
information.aggregate
resource consumption patterns and resource costs,
serve as economically sufficient estimates of long-run
2.3. Product Costing Systems
marginal costs under certain conditions.
Product-based planning breaks We definethe
a benchmark costing system
product and(as implicitly
visualized
capacity planning problem into twoin extant literature)
pieces: as comprising two
setting
pieces: a vector of costs (RC) and a matrix of resource
product prices and determining resource quantities.
consumption
Product costs, which summarize patterns (RES_CONS_PAT)
data about the con- that mod-
els resource
sumption of resources by product andusage by individual
resource products.3 Each
costs,
element ofIn
are central in this decomposition. RC simple
is a dollar value,
terms,representing the
cost of a particular
product-cost-based planning involves resource. We interpret
calculating the each row
of RES_CONS_PAT as an allocation basis, i.e., the
product cost of each product i as PQ = £7;=1 r/yC;-,
cost driver, for
where r/; is the quantity of resource distributing
; used to themakecost of the associ-
ated resource across products.
one unit of product i, and Cy is the cost per unit of Thus, the elements are
resource ;. Then, the pricing problem is to choose P¡ to 100%. The
proportions, with each row summing
for each product i to maximize (Al -, - BiPi)(Pl -PQ),
where A, B > 0 are market demand parameters.
2 Jordan (1989) also In
investigates incomplete information as the
this simple formulation, note that resource
motivation constraints
for product costs. He derives a set of transfer prices
and demand shocks are absent;constructed
furthermore, resource
with limited information as might be found in a finan-
usage and costs only enter thecialpricing
accounting system. When communicated
problem indi- to marketing and
production managers making independent decisions, the prices
rectly via the calculation of product costs.1 Once the
lead to long-run optimum resource capacities, prices, and resource
pricing policy is determined, the implied
allocations. demand
We are not aware of work thatdis-
has followed up on
tribution can be derived for resource ; from
these insights. Moreover, product
we assert that system designers might
have more limited
demand distributions (see Banker and information
Hughes than is assumed
1994 available in
Jordan (1989).
for details). The firm can then determine the quantity
3 The calculation of PC for solving the grand program occurs before
resources are bought. However, observed cost systems are mostly
1 In line with Balakrishnan and Sivaramakrishnan
ex post in nature (i.e., (2002),
they allocatewe view
the costs of resources already
list prices as the prices set in this deterministic setting.
in place). We reconcile Once
this potential the by noting that
inconsistency
demand shocks for a particular periodfirmsareperiodically
known, the firm
replenish adjusts
their capacity resources and thereby
list prices to yield tactical prices. update resource costs.
output from a benchmark costingWe hasten to note that firms are is

system not devoid of infor-
a vector
mation that helps determine product costs. In par-
of product costs (PCb). Formally,
ticular, although incomplete and imperfect, a firm
likely has substantive information that it can bring
'RCX1T Y altn ... altlfIl [PCn7
to bear when constructing an observed cost system.
RC2 ... PCh2 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
RCj _alt}il <dtì,i' sharing byVPCÌ
products. Firms that_ organize their pro-
duction around postponing assembly of products
The calculations of product costs
and delaying from(e.g.,
customization detailed data
those that work
(as in Banker and Hughes with
1994)"vanillaand
boxes" in a product
as described in Swaminathancost-
ing system are closely related. Both
and Tayur 1998) approaches
are likely use
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 make-to-order
pattern context. of each resource
Production by
systems that make
use of workerconditions,
a given product. Under suitable rotation within a multiskilled
it can work- be
shown that the two approaches are
force also exhibit lessalternative views
resource traceability relative to
of the solution to the grand program.4
an assembly line that is organized around rigid job
classifications
As argued earlier, information (Hopp and Spearman
limitations bar 2000).
a Second,
firm
from implementing the firms benchmark system.
likely have coarse estimates of similarityThese
in con-
limitations mean that an observed
sumption patterns,cost allowing system
for clustering of nec-
"like"
resources. For example, arelative
essarily involves some aggregation firm would infer tohigh vari-
the
benchmark system. Consider ation inthe
the consumption
information patterns of volume-
that anda
batch-level resources
firm is likely to possess regarding when its products
resource vary widely
costs. Gen-
in terms of the volume
erally, we expect that accounting records,of production and batch size.
vetted by
Moreover,
auditors, provide reliable and the consumptionresource
detailed pattern for labor costs
hours is
likely to be more
(i.e., data on RC), albeit after highly correlated
applying with the consump-
some mate-
riality threshold. However, tion for
evenmachine hours than
here with the aggrega-
some consumption of
design activity.
tion is inevitable for resources In the support
that language of activity-based
multiplecost-
ing, the former are volume-based
activities. For example, the accounting record likely resources, whereas
the latter is a product-level resource. Based on this
reports only the total cost for a purchase office even
clustering into "tiers," the firm also might be able to
though the office might process many different types
identify the proportion
of orders; a benchmark system would of costs in batch resources.
require that
Finally, the data required for constructing the rows
the costs be separately identified for each activity.
of RES_CONS_PAT (i.e., the consumption patterns)
We also argue that firms possess incomplete informa-
might be available for a few large resources (e.g., the
tion about their production environment (i.e., as mod-
firm might track machine hours, but not marketing
eled in RES_CONS_PAT). Although they may know
hours, by product).
the number of machine hours consumed by a prod-
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-
fpCR~'T group
als. Practically, we therefore observe that firms
resources into cost pools; as a~AC1lT[cdn
result,...theycdlfIl use i u2 a single
driver to allocate the costs from a cost pool that might
contain many resources with different consumption
_ACK] '_cdKtl ...reduces
patterns. This approach considerably cdK)l' pcR infor-
mation needs because the firm has to collect data for
where AC is a vectorwe
fewer cost drivers. For example, of activity
only cost pools,
needand data
the labor
on total resource costs and elements of the activity consumption
hours consumed matrix by
(ACT_CONS_PAT)
each product to implement map activities tolabor-hour-
a one-pool, products. As
based cost system. with the benchmark system, each element of AC is
a dollar value and each element of ACT_CONS_PAT
is a proportion, with rows summing to 100%. This
4 The elements of the resource consumption
computation yields the vector of matrix,
reported productalt^ =
rijQi/(Hi rijQi)' are tne proportions
costs, of
PCR. resource ; consumed to make
Qi units of product i. Further, equating the supply and demand
How does the benchmark system relate to an
for resources, the capacity bought at time f = 0 is L; = £,- ^Qf/ and
RCj = CjxLr observed system? In the above representation, we
map each resource (i.e., elements in RC)

observable to a cost
systems. poolsystem is a combina-
Each noisy
(i.e., an element in AC). Thus,tion
sum(RC) = sum(AC)
of the heuristics for selecting= the number of cost
sum(PCfo) = sum(PCR). The value pools,of for any given
assigning costto cost pools, and for
resources
pool is the sum of the costs of calculating
the resources cost driver mapped
rates. For each noisy system,
to that cost pool. Usually, the wenumber
compute the of activity
associated vector of reported prod-
pools is much lower than the uct costs. The use
number ofof heuristics
resources, means that this set
dim(AC) < dim (RC). Indeed, AC is a scalar
of reported productin firms
costs is computed with coarser
that employ a one-pool system, as found
information than isinuseda tolarge
compute benchmark costs.
fraction of firms (Horngren et Fourth,
al. 2003). for each noisy system,
Similarly, thewe compute an error
matrix of activity consumption metric by comparing
patterns the vectors of the benchmark
summarizes
the information about resource and reported product
consumption costs. We then analyze how
patterns.
variations
Because observed costing systems in the construction
coarsen informa- of noisy systems affect
this metric and
tion relative to benchmark costing systems, reported examine the robustness of specific
heuristics product
product costs differ from benchmark to available information
costs. In by coarsening the
data used to
particular, the grouping of resources implement
into cost the rule. We detail each of the
pools
above steps
results in aggregation error (Datar andin the following
Gupta paragraphs.5
1994,
Gupta 1993, Hwang et al. 1993). Reducing the cardi-
nality of the consumption matrix3.1. results
Step 1: Model a Production Environment
in specifica-
We parameterize
tion error because different resources in the same the cost structure
pool of a production
environment along
might have different consumption patterns. Finally, three dimensions. (We defer dis-
cussion about the
aggregation and specification errors interact in subtlespecific values we use for this and
other parameters
ways (Labro and Vanhoucke 2007). Indeed, as Chris- and the survey evidence that sup-
ports the choices.)
tensen and Demski (1997) demonstrate, there is no The parameter RC_VAR (resource
cost variance) determines
simple method to select the approach that results in the variation in the costs of
individual resources,
the lowest error. Thus, when choosing among cost the elements of RC. Low values
of RC_VAR
systems, a firm implicitly chooses among correspond to environments with many
portfolios
of errors. In sum, consistent resources with roughly equal
with intuition, prior monetary importance
(i.e., has
research indicates that the features of low variance
the cost insystem
resource costs) such as might
(e.g., number of pools, process be
offound in a firm producing
assigning resources a wide and varied prod-
uct line.
to pools, choice of cost drivers) exertHigh a values of RC_VAR indicate an environ-
significant
ment withproduct
influence on the accuracy of reported many smallcosts.
resource cost pools and a few
As noted earlier, we focus on large
the cost pools such as
heuristics might be found in a refinery
that
or a law firm where machine and human resources
firms employ to construct the vector of activity cost
accountconsumption
pools and the matrix of activity for a majority of costs,pat-
respectively.
terns. We refer to these choices asTheassigning
parameter DENS (density of consumption
resources
matrix) captures the
to pools and as selecting cost drivers, respectively.extent of resource traceability (or,
Conceptually, there are numerous options that a firmas measured by the
its counterpart, resource sharing)
might adopt for either decision.number of zeros in the resource
We therefore focus consumption
on matrix,
RES_CONS_PAT. When DENS is low, the resource
a few popular choices as documented in surveys and
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
trace
Our simulation protocol has four major steps. much of a lawyer's time to individual cases.
First,
we generate a set of production environments by a dense matrix implies a setting with
In contrast,
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.same
Eachline.
of
these draws represents a "firm" with a unique Thevec-
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 production
granular volume (volume-based resources) and
information available to model the consumption
with theofnumber 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" oron request.
the authors
by which we select
A large positive value induces similarity a cost driver.
between theFor example, as a
consumption patterns of batch baseline,
and volumewe use as the driver the consumption pat-
resources,
across products. This case models
tern afor
setting
the largest in which
resource contained in the cost pool
most resources are consumed (the
in big
proportion
pool method) toto vol-
allocate all of the costs in
ume. A negative value for COR implies
the pool; we detailsignificant
later the other methods that we
disparity between the consumption patterns
use. Formally, ofhelp
these rules batch
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
3.2. Step 2: Benchmark Costing Systems
of activity consumption patterns (ACT_CONS_PAT).8
For each production environment (i.e., a
We compute theunique
vector of com-
reported costs (PCR) by
bination of the values for RC_VAR, DENS,
multiplying and
the activity COR),
cost vector and the activity
we simulate 20 benchmark cost systems.
consumption matrix. For each
such draw, as in Datar and Gupta (1994, p. 571),
we assume that the firm knows the total resource
3.4. Step 4: Measuring the Error in Reported Costs
cost without error and set this value at $l,000,000.6
Given our focus on the decision role for product cost-
We distribute this total cost among 50 resources,
ing systems, ideally, we could study the difference
with the variance in the distribution governed by outcomes with the full-information-based
in decision
the parameter RC_VAR and a randomly generated
benchmark costs and the costs reported under heuris-
value for PERJBATCH determining the percentage
tically constructed noisy systems. However, even
of costs contained in batch-level resources. This dis-
within the context of decision making, costing sys-
tribution yields a vector of resource costs, RC. tems
We serve many needs such as setting product prices,
next simulate the matrix of resource consumption pat-
improving production processes, and directing atten-
terns (RES_CONS_PAT) to conform to the parame- tion. These diverse objectives likely are differentially
ters DENS and COR, which influence the density of sensitive to reported costs, meaning that we need
the consumption matrix and the correlation in con- alternate measures of economic loss for the various
sumption patterns respectively. We consider settings
decision contexts. Moreover, we expect that a change
with 50 products. Finally, we compute the vector ofin the decision outcome (e.g., set of prices) would
benchmark costs (PC*7) as the product of resource cost
change the total costs (e.g., change product quantities,
vector and the resource consumption matrix. Thus, and thus change the costs of resources needed), hin-
we have 20 data points (vectors of benchmark costs)
dering the comparison of alternate heuristics. Thus,
for each combination of the parameters relating to the
following the literature, rather than model a specific
production environment. context, we attempt to capture the applicability to
many decision contexts by considering a variety of
3.3. Step 3: Use Heuristics to Construct
error measures as the dependent variable.
"Noisy" Systems
The main error metric we report in tables and plots
For each benchmark cost system, we construct many
follows Babad and Balachandran (1993), Homburg
possible observable systems by varying three param-
(2001), and Labro and Vanhoucke (2007, 2008). This
eters that reflect potential heuristics that a system
designer could use. First, we vary the numbermetric of is the 2-norm, EUCD = VeLi (PCf -PCf)2,
where i indexes products, PC* is the benchmark
activity cost pools. The smaller is the number of activ-
ity pools, the greater is the aggregation in the costcost, and PCf is the reported cost. This measure,
which resembles the Euclidian distance between the
system. Formally, this step specifies the length of AC,
two vectors, is symmetric and, given we keep total
the vector of activity cost pools. Second, we vary
resource cost constant at $1 million, captures the mag-
the heuristic to assign resources to activity pools. We
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
each portion as a separate resource.
aggregating the vector RC. Third, we vary the rule
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
associated findings are intuitive.
for each unique activity and the associated resource, we map each
dollar terms. Moreover, the squareThus, in a baseline

of this metric experiment,
(i.e., we vary the number
the mean squared error) is a measure
of pools as of theparameter.
a design loss In a modified exper-
from incorrect pricing decisions iniment, we determine the
monopolistic and number of pools endoge-
oligopolistic markets (Vives 1990, nously
Banker to consider the robustness of the heuristics to
and Potter
available
1993, Alles and Datar 1998, Datar and information.
Gupta 1994,
Hwang et al. 1993). 3.5.1. Baseline Experiment. In this experiment,
We also calculate a "materiality"
we measure,
fix the number %ACC,
of pools to form and consider
as the percentage of products whose costs are resources to cost pools.
six heuristics for assigning
reported without substantial error (Labro and Van-
These heuristics vary in terms of the underlying
houcke 2007, 2008). Following Kaplan
rationaleand Atkinson
and in the information required to imple-
(1998, p. Ill), we define immaterial costing
ment them. Inerrors as ("random"), we randomly
our baseline
within a 10% symmetric interval assign
around the bench-
resources to activity cost pools. We also view
mark cost; %ACC = (I/I) EliU I 0.95 x PC» <as PC*
this assignment < that has grown organ-
a system
1.05 x PC»; 0 otherwise}. This metric
icallyis valid
over time. in
Thisdeci-
method needs no information
sion contexts where small errors are not important,
regarding resource costs or consumption patterns.
but large errors are costly (Dopuch Next,
1993). we consider two size-based methods that
The final metric we consider is the
examinemean percent
the intuitive "Willie Sutton rule" that design-
error, MPE = (I/I) EU(Ipc? " PCf ers
I)/PC? • This
of product costingchoice
systems should focus on the
follows Christensen and Demski largest
(1997), who
resources consid-
(Cooper and Kaplan 1998a). We were
ers percent errors per product andunable
mean percent
to find a consistenterror
definition of this rule in the
as dependent variables; and Gupta (1993),
literature. who
We thus uses
model two interpretations. Both
percent errors at the product level.
of In some
these contexts,
methods require only information regard-
management may be more interested in these
ing resource rela-in accounting records)
costs (available
tive measures, because a $10 cost difference for
and do not employ dataaregarding
$10 consumption pat-
product has a greater chance of terns.
inducing
First, thean incor- rule assigns the largest
"size-random"
rect decision than a $10 cost difference for
resources a $1,000 by size, to activity pools.
systematically,
product. To design a system with six pools, we assign the
Not surprisingly, all of our error metrics are highly six largest resources to individual activity pools. We
correlated. However, it is important to note that all of then randomly assign the remaining resources among
our error metrics are "closed" because we impose a the six pools. This approach reflects the practice of
tidy allocation. In the context of EUCD, this restric- adding smaller pools like labor supervision to a big-
tion means that the dimensions are not independent. ger pool like labor, or machine maintenance to the
In particular, the error for the last product is entirely pool for machine depreciation. Second, the "size-
specified by the errors of the other I - 1 products. misc" method also assigns the largest resources to
Despite this limitation, we use this simple concept of individual pools, but differs in its treatment of the
an error metric to avoid the additional specifications remaining resources. In the above example, we would
required and complexity involved in calculating the form five pools for the five largest resources and
economic loss from using heuristics. (We discuss this lump the costs of the remaining resources into a resid-
issue more in the final section.) ual pool. This approach reflects the use of an aggre-
We next provide detail on the heuristics we con- gate "miscellaneous" cost pool for resources not large
sider in Step 3 of our protocol. As noted earlier, we enough to warrant an individual cost driver but that
focus on two kinds of heuristics: grouping resources need to be allocated to products.
into pools and choosing a driver for the costs in The next two methods follow the prescription
each pool. to group like resources together. We define "like"
resources by the correlations among consumption pat-
3.5. Heuristics for Assigning terns. Thus, these methods for grouping resources
Resources to Activity Pools into cost pools are information intensive. First, in the
The number of pools formed is a key feature of "correlation-random" method, we seed the desired
observed systems. The desired number of pools is number of activity pools with a random choice of
likely to be affected by the assignment heuristic as resources. We then pick "like" resources to add to
well as the information available about resource con-
the base resource in an activity pool. "Like" resources
sumption patterns. We therefore consider a baseline
have the greatest positive correlation with the base
experiment in which we fix the number of pools andresource that seeds the pool. We restrict the num-
ber of resources added to a pool so that each activ-
focus on the assignment heuristic. Constructing fewer
pools is consistent with the firm using less infor-
ity pool contains approximately the same number of
mation when designing the product costing system. resources. Second, the "correlation-size" method is
similar to "correlation-random"3.6. Heuristics

except for Calculating
that we seed Driver Quantities
the desired number of activity The
pools with
other the largest
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 tovation"
group but also the "most costly aspect of ABC sys-
like resources together. This method also follows
tems"thebecause "reality takes hold" when designers
consider the associated information needs and costs.10
prescriptions to use multiple criteria when grouping
resources into activities (Cokins 2001, Fremgen and
In our context, the choice determines the elements of
Liao 1981). the activity consumption pattern, ACT_CONS_PAT,
Finally, because implementing correlation-based used to allocate activity costs to products. The choice
methods requires data on consumption patterns, we is complicated because each resource in a given activ-
investigate the performance of a "blended" method ity pool would have a distinct consumption pattern,
with reduced information needs. We employ a rough but we use one pattern to allocate the costs of all
estimate of correlation to group resources into tiers
resources in that pool.
and use a size-driven method within each tier.
The simplest approach in this context is to use the
In particular, we group resources into batch-driver forand
the largest resource in an activity cost pool
volume-based resources. Such grouping of resources
as the driver for all the costs in that pool. For exam-
is feasible in practice because these resource groups
ple, a firm can use direct machine hours on the largest
are likely to have dissimilar consumptionmachine
patterns.as the basis for allocating all costs in the
We then implement the size-misc assignment within
machining cost pool. This choice ensures that the cost
each tier.
of the largest resource is allocated without specifica-
3.5.2. Modified Experiment. In the baseline
tion error but induces such error when allocating the
experiment, we fix the number of activity costs
cost of the remaining resources in the pool. Whereas
pools
we refer
to isolate the effect of the assignment heuristic onto this as the "big pool" method, Hwang
system accuracy. However, it is reasonable et
to al. (1993) refer to it as the "high cost" method.
assert
that information about consumption patterns At the other end, we consider a consumption driver
affects
the number of pools to form. We therefore that is the average of the individual drivers for all
consider
a modified experiment in which we vary the number
of the resources in the cost pool ("average" method).
of pools endogenously. Using the "correlation
Thiscutoff"
method represents a system in which the time
method, we seed the first pool with the largest
spent on any machine in a production cell enters the
resource. We then add to this pool all thoseallocation
resources basis for the costs of that cell. Whereas the
whose consumption patterns are correlated big(above
pool and a average methods anchor two ends of a
specified cutoff value) with the consumption pattern
spectrum, intermediate methods might average only a
for the base resource. We then seed the second subsetpool
of the largest resources in a pool. For example,
with the largest among the remaining resources. We use only a combination of labor hours
a firm might
again consider correlations to decide the resources to hours to develop an indexed driver.
and machine
group into the second activity pool. We continue this
Such approaches (which can be viewed as improving
process until the number of remaining resources is
the specification of the cost driver) require more data
less than a specified number of resources, to when all than is required by the big pool method
implement
remaining resources are put into a miscellaneous cost
but less than the average method.
pool. Under this procedure, the number of resources Composite drivers are particularly relevant when
per pool and the number of pools formed will varyresource supports multiple activities (equiv-
the same
with the cutoff value and with the correlation in
alently, when multiple resources are pooled). For
consumption patterns. Note that a lower cutoff is
concreteness, consider a purchasing department that
consistent with coarser information about consump-processes both domestic and overseas orders. Concep-
tion patterns. We vary the cutoff correlation value
tually (as in a benchmark system), we should have
to determine the effect of reducing the precision of
a separate resource cost and an associated consump-
available information on the number of pools formed
tion pattern for each activity. However, the account-
and on system accuracy. We also vary the number ing system might not record the costs in separate
of resources to put into the miscellaneous pool to
ledger accounts. Observed systems deal with this
determine the effect of aggregation error on theseissue by using a composite driver of the activities.
outcomes.9
For example, the designer might construct a synthetic
9 We would need to model the cognitive and economic costs asso-

10 Information costs also naturally influence the number of pools to
ciated with the number of cost pools to say more about the desired
form. This relation underscores the link between the decisions of
number of pools with size-based rules. Such an extension is outside
the scope of this study. how to form pools and how to pick drivers.
driver that defines an overseasAsorder

seen in panel
as A, as we increase the value of
a multiple
(say, three) of a domestic order. Other
DENS (the applications
density of the benchmark consumption
include distinguishing between matrix),
a major and a of
the percentage minor
zeros in the consumption
setup when allocating changeovermatrix decreases
costs from 71% to 6%.and
(Cooper The decrease in
Kaplan 1998a, p. 98) and weighting loan recalls
the traceability more
of resources leads to the number of
than item returns when allocating the costs
products sharing any given in a
resource increasing from
library (Ellis-Newman 2003).11 The use
14.52 to of
46.88 or indexed
from 29% toor 94% of all products. We
composite drivers appears to bealso
widespread. Fremgen
find more dispersion in consumption of resources
and Liao (1981) report that firms used indexed
across products cost
as we increase resource sharing. The
drivers to allocate about 10% of activity
average cost pools,
range of consumption (i.e., range in percent-
age of resource
with the proportion being significantly higher cost consumed
in areas by products for a
with low cost traceability. Theyresource, averaged
also report across
that resources) decreases from
firms
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, sume31%a resource, the more unequal their relative
of research and development pools, and 45% of the
consumption.
marketing cost pools. In a meta-analysis, ShieldsThe third section of panel A shows the impact
et al.
(1991) report a range of 8.9% to 46.3% for the ofuse of
changing COR, the correlation pattern we induce
multiple allocation bases in the United States; on
thethe
rate
drivers that describe resource usage by prod-
in Japan is 18.4%. Finally, Sakurai (1996, pp. ucts.
100-101)
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 We would expect such a negative correlation when
Statistics the ratio of the number of batches to the number
Table 1 provides descriptive statistics concerning our
of units varies across products. Such variance occurs
benchmark cost systems in the baseline experiment.12
We simulate 48 economic environments (comprisingfor example, a firm makes large-volume prod-
when,
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
between unit-level activities and batch-level activities
draw 20 samples for each environment, resulting in
960 benchmark systems. The top section of panel Ain 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
identical inferences. Because our interest relates to the ratio of the 14 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
environments.
15 The accounting literature provides limited insight about the cor-
relation in the consumption patterns of volume-based resources or
13 Although some kind of a Pareto rule is likely to apply, on we
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
has a mean of 4.55 with a minimum of 1.5 and a maximum of
resource costs. However, management accountants in a particular
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.
Table 1 Descriptive Statistics
Panel A: Benchmark cost systems- Characteristics systematically varied
Average values
Variation in resource Global Low dispersion Med dispersion High dispersion

costs (using parameter RC_VAR) Units average (RC_VAR = 0.25) (RC_VAR = 0.50) (RCJ/AR = 0.75)
A/ = 960 A/ = 320 . 0 = 320 /V = 320
Percentage of cost in largest pool/ Ratio 6.78 3.20 5.75 11.39

percentage of cost in smallest pool
Percentage of costs in top 10 resources Percent 34 30 34 39
Little sharing of Medium sharing of High sharing of V

Density of consumption matrix Global resources resources resources of resources
(using parameter DENS) average {DENS = -0.75) (DENS = 0) (DENS = 0.75) (D£/VS = 1.50)
/V = 960 /V = 240 A/ = 240 /V = 240 /V = 240
Percentage of zero entries in consumption matrix Percent 36.04 70.95 46.1 1 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 1 1 .43 23.22 1 1 .08 6.61 4.79
across products (given positive use)
Similar Intermediate Intermediate Dissimilar

consumption consumption consumption consumption
Importance of resources devoted to Global patterns patterns patterns patterns
batch activities (using parameter COR) average (COR = 0.33) (COR = 0.0) (COR = -0.33) (COR = -0.66)
/V = 960 /V = 240 /V = 240 /V = 240 A/ = 240
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
Panel B: Benchmark cost systems- Characteristics not systematically varied
Characteristic Unit Average Median Interquartile range
Percentage of resources in pools devoted to batch activities Percent

Correlation between largest pool and volume resources Number 29.36 29.60 15.60
Panel C: Error metrics- Univariate statistics (N = 17,280)
Mean Min Quartile 1 Quartile 2 Quartile 3 Max
EUCD 28,448 2,514 16,237 24,882 36,919 124,155

%ACC 25.84 0 14 22 34 100
MPE 16.8 1.47 9.66 14.92 21.82 62.59
Panel D: Correlation among error metrics (N =
EUCD %ACC MPE
EUCD 1.00 -0.745 0.955

%ACC 1.000 -0.769
MPE 1.000
Notes. Size-random method used for

designer (ACP). The costs of the rem
from activity pools to cost objects: d
Inferences in panels C and D were un
for selecting driver was used to alloc
percentages for every resource in th
pools. Higher values correspond to g
volume resource and batch resources.
sharing and lower traceability of res
the vectors of benchmark and report
error, which is the average of the rela
We next turn to the noisyassignment

systems associated
rules only start to dominate correlation-
with the benchmark systems. For clarity, in
based assignments we present significant way
an economically
descriptive data for the baseline experiment,
when for account
the top 20% of resources one for more than
method for assigning resources -75%
to of total cost.
activity pools (size-
random), and for one method for choosing drivers
(average). (As we see later, theFigure
value 1 reports
of theon the baseline experiment in
error
which we fix the
metric changes considerably based on the methods number of cost pools. Panel A
indicates that when resource
chosen.) We aggregate data over three levels for mea- costs are moderately
surement error (10%, 30%, and skewed, correlation-based
50% error methods dominate other
in measur-
approaches in terms
ing driver percentages)16 and over six values for the of reducing the error in reported
number of activity pools (1, 2, 4, 6, 8, and 10).17 Thus, the baseline ran-
costs (Result PI). More surprising,
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
size-based method (size-misc) handily. Furthermore,
In panel C, we report univariate statistics con-
within correlation-based methods, a size-based seed-
cerning the error metrics we consider. The percent-
age accurate metric, %ACC, shows that, on average, ing shows limited improvement over a random seed-
ing. Intuitively, a correlation-based method leads
25.84% of products have reported costs that are within
10% of their benchmark costs; the average mean per-to most costs being allocated with low specifica-
tion error because this method pools resources with
centage error (MPE) is 16.8%. However, there is wide
similar resource consumption patterns. Size-based
variation across different environments and noisy sys-
tems. The percent of products with accurate costsmethods suffer either because they pool smaller
(%ACC) ranges from 0 to 100%, and the mean per- costs with larger resources (size-random) or group
a large amount of costs into a miscellaneous pool
centage error (MPE) goes from 1.47% to 62.59%; thus,
system design exerts considerable influence on (size-misc).18
the
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 areof resources to find the point at which the
top 20%
skewed. system designer might prefer a size-based assignment
Data reported in panel D show that the metrics are rule (Result PI).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%
of resources account for 50% or more of the costs.
ucts with accurate costs is inversely related to error).
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 EUCDtheas
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 toNote that unlike the correlation-based rules, size-
Cost Pools
based rules require no information about how prod-
Result PI. 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 Our results
resources trigger less than 50% of cost). Size-based 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
thatpeople
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) bythe 37%, on
difference is not driven by this possible source of variation. We
average. thank Romana Autrey for suggesting this test.
17 The range for the number of activity pools is consistent with19 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.
Figure 1 Effect of the Method for Assigning Resources to Activity Pools
Notes. Panel A uses the average method for selecting the driver used for allocating costs from activity pools
are calculated as the average of the consumption percentage for all resources in the activity pool. Inference
consumption percentages. Random, resources are assigned randomly to activity pools. Size-random, larges
pools chosen by the system designer (i.e., ACP). The costs of remaining resources are assigned random
resources assigned to number of activity pools chosen by the system designer, with one pool left open. Th
last open pool (miscellaneous costs). Correlation-size, largest ACP resources assigned to the number of acti
For the first activity pool, select those resources with the highest correlation with the resource in the poo
pool. Repeat for the second activity pool and so on. Correlation-random, pick ACP resources randomly and
chosen by the system designer (ACP). For the first activity pool, select those resources with the highest co
total of 'NT(RCP/ACP) resources to this pool. Repeat for the second activity pool and so on. EUCD, metric
calculated as the 2-norm between the vectors of benchmark and reported costs. In panel B, ACP's fixed at
as the best method for the associated assignment rule.
one way to interpret our results is that

about simple sys-
consumption patterns to implement this heuris-
tems might suffice when resource tic. Figure
costs 2 presents
are concen- the results.
trated and that ABC like systems are likely to have
Result P2. The blended method performs well in
the greatest benefit when resourceallcosts are diffused
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-
nitudes similar to that obtained with the more infor-
ment heuristic affects its efficacy. We first consider
the effects of blending size- and correlation-basedma tionally demanding correlation-based rules.
heuristics. We next investigate reducing the precisionWe 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
20 The gain tapers
Recall that the blended method uses gross estimates off as we increase the number of activity pools.
This finding obtains because the separation of resources into vol-
of correlations to group costs into tiers and uses
ume and batch resources occurs naturally as the number of activity
size-based methods inside each tier. In this way, the number of resources to be assigned.
pools approaches
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
beingneeds.
consumed in patterns that differ from the patterns for
In particular, we need relatively coarse information
volume-based resources.
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
increase in error is small even if we decrease the cut-
off correlation used to define "like" resources to 0.40.
In Table 2, consider the row that reports data

for the setting in which we group as many as 15
resources (30% of all resources) into the miscella-
neous cost pool. Even a value of 0.4 for the cutoff
correlation leads to system accuracy that is compara-
ble to the information-intensive method (correlation
with size-based seeding) we employed in the baseline
experiment (see Figure 1). As we increase the cutoff
correlation value we find a steady increase in system
accuracy as well as a steeper increase in the number
of cost pools formed. The trade-off is between the per-
ceived benefits of increased accuracy versus the costs
of adding more pools. Correlation-based methods that
employ crude
Notes. Individual series relate to various methods for measures
assigningof resources
the underlying correlation
might
to activity pools. Blended, resources are first be a practical
separated as perway for grouping
whether they 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
are assigned randomly to the activity
Costs connected with creating and maintaining a large
pools. Correlation-random, pick ACP
number
resources randomly and allocate one each to of cost pools
the number as well aspools
of activity the expectation of
diminishing
chosen by the system designer (ACP). For the returns
first activity to system
pool, select detail
those suggest that it
resources with the highest correlation might
with be worthwhile
the resource to deal
in the with
pool. low-cost resources
Assign
a total of 'HJ(RCP/ACP) resources to this pool. Repeat
in an ad for the
hoc fashion. secondtwo
We consider activ-
alternatives:
ity pool and so on. EUCD, metric of error between benchmark and reported
costs, calculated as the 2-norm between pool
the all such costs
vectors into a miscellaneous
of benchmark and cost pool
reported costs. The average method was
or distribute the costs for these low-cost resources
used for selecting the driver used
for allocating costs from activity pools to among the poolsUnder
cost objects. for thethis
high-cost resources.
method, We note
consumption percentages are calculated as that pooling small
the average resources
of the into one
consumption pool requires
percentage for all resources in the activity pool. Inferences
less information areresource
about unaltered
costs with
relative to dis-
other choices for calculating consumption percentages.
tributing these costs over all cost pools.
guess about correlation structureResult

isP4. Firms can in
useful group a large portion of their
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
Panel A ofour
Figureknowledge,
1 (related to the baseline experi-
ment) showsthat
these are the first research findings little difference
support across
thealternate correla-
ABC prescription of classifyingtion-based assignments,
resources as the
per preferred
the choice. How-
ever, dataseparate
activity hierarchy and constructing in panel B showpools thatforwhen size-based
assignments
each tier of resources. The results also are preferred,the
support we obtain
use lower error
when we
of multiple criteria for assigning group "small" to
resources resources
pools into a single mis-
and suggest that size might be cellaneous
a good costcandidate
pool than whenfor we distribute them
a secondary criterion for grouping
over the resources.
larger pools. The size-misc heuristic outper-
forms the size-random heuristic over the entire range
5.2. Modified Experiment: Reducing theprefers
in which the firm Precision
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
Table 2 Endogenously Determined Number of Activity Pools
Notes. Reported are the average value for EUCD, [average number of activity cost pools], an
of activity pools formed). Values in italics indicate that the value is at the exogenously
number of activity pools (30). The grey shaded areas indicate experiments where the
created ACP hits the maximum number of ACP possible (the number of RCP minus t
miscellaneous cost pool) or the number of pools is very small (e.g., 2). The first pool i
resource. Additional resources that satisfy the correlation cutoff (relative to the firs
added to pool. The second pool is seeded with largest among remaining resources. Addit
correlation cutoff are added. Continue process until the number of remaining resource
remaining resources put into miscellaneous cost pool). We also grouped all remaining
if the number of activity pools became 30 (the maximum number of possible activity
method for calculating driver percentages for an activity cost pool.
data show
costs) are grouped as miscellaneous costs that
(last we
rowcontinue to obta
significant
of Table 2), the error metric only registers a(but economically small) g
marginal
increase to 19,610, whereas the number
activity ofpools
cost activity
even when the ratio
pools drops to 6. Data reported of activity
in the pools
other to the number of reso
columns
show a similar pattern. as 80% (40 pools for 50 resources). Unta
confirm a similar inference when resou
5.4. Determining the Numbersion
of Pools
is high (size-based rules dominate)
increase the number
Result P5. Regardless of the method of resources we consider.
for assigning
resources to pools, although increasing the number
Data in Table 2 provide additional support. For the
of cost pools leads to statistical gains
modified in accuracy,
experiment and for a given correlation cut-
the economic gains are small after wefive
off, when reach ~12
additional costare taken out of
resources
pools. In practice, a relatively small number
the miscellaneous of optimal
pool, the pools number of pools
seem adequate. formed increases at a lower rate. We conclude that a
firm might be able to devise a "good enough" system
Panel A of Figure 1 suggests that the number
with a relatively small number of activity pools. Thus,
of activity pools matters greatly. The average error
(EUCD value) reduces from 37,657 we provideforthe first
one research
pool findings
to in support of
intuitive prescriptions by Turney (1991, p. 51) as well
23,675 with 10 pools when we use the size-random
method; the decline is from 37,929as by Cooper and Kaplan
to 16,603 (1998a, the
with p. 98) that a system
in which the ratio of the number of pools to the num-
correlation-random method. The error is decreasing
ber of resources is small might be enough in terms of
and concave in the number of pools.22 Untabulated
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 productsData from other methods lead to qualitatively similar conclusions.
6. Results: Performance of Heuristics Figure 3 Effect of Method for Selecting Cost Driver (Indexing)
for Selecting Cost Drivers

We parameterize the heuristic for selecting cost
drivers by the number of resources within an activ-
ity pool whose consumption patterns we average to
obtain the allocation rate. At one end, the big pool
method considers only the pattern for the largest
resource in the pool. At the other extreme, the aver-
age method equally weights all the resources in an
activity pool. Intermediate indexing methods consider
the two, three, four, or five largest resources in a pool
to calculate the allocation base at a cost pool. Such
indexing is consistent with a system designer seeking
more information to refine cost drivers and reducing
specification error.
Result Dl. Using an indexed (composite) driver

leads to lower error than obtained from using a driver
that considers only the consumption pattern for the
largest resource (the "big pool" method).
As Figure 3 shows, there is a significant gain to

using the average method relative to the big pool
method, with the change eliminating about 50% of the
error resulting from use of the big pool method. Thus,
not surprisingly, an improvement in specification
(by considering the consumption patterns for several
resources) has a large effect on system accuracy.23
Although effective, the average method is information
intensive because it requires data on the consump-
tion pattern for all of a firm's resources. Thus, we
consider intermediate composite rates that consider
fewer resources. Consider the data for NUM = 3 (i.e.,
we consider the top three resources in a pool to cal-
culate driver percentages) in panel A of Table 3. Rel-
ative to the big pool method, the gain is only Notes.
5.71% Individual series relate to various methods for calculating driver per-
when we have a one-pool system. However, the gain used to allocate costs from activity pools to cost objects. Data per-
centages
tain to 50 resources. BIG POOL, the allocation percentages are those of the
rapidly increases and reaches 52% when we consider
largest resource in the activity cost pool. NUM, calculated driver percentages
a 10-pool system, because the number of resources per
as the average of the largest NUM resources in the activity cost pool. AVG,
pool declines as we increase the number of activity
calculated driver percentages as the average of the driver percentages for all
pools, whereas the number of resources averaged
resourcesisin the activity cost pool. EUCD, metric of error between bench-
the same. Nevertheless, we find a gain of 30.7%
markeven
and reported costs, calculated as the 2-norm between the vectors of
benchmark and reported costs.
with six activity pools, meaning that each pool has
8.33 resources, on average.
The data in panel A also show that a system
Result D2. With 8-12 cost pools, using an indexed
(composite) driver that considers the consumption might be better off with an index of a limited
designer
number
patterns of the largest four or five resources in a of resources in the pool relative to a simple
averaging of all resources when selecting an allocation
cost pool could lead to lower error than obtained
base. In particular, a driver that considers only four or
from using a driver that considers only the consump-
five resources beats the average method (in terms of
tion pattern for all resources (the "average method"
method) when using size-based assignment methods. in reported costs) when the number of activity
errors
pools is at a medium level (8-10 pools). Intuitively,
with 7 to 10 resources pooled into an activity pool, the
23 This set of results focuses on the case of moderately skewed
average
resource costs. Driver selection is a straight forward issue when method starts to weigh the consumption pat-
costs are concentrated in a few resources and each largetern of the smaller resources in the pool too heavily,
resource
forms its own pool. moving away from the weighted average that is the
536 ■ Management Science 57(3), pp. 520-541, ©2011 INFORMS
Table 3 Gain from Using an Indexed Cost Driver
Percentage of gain relative to error from using the big pool method for select
Average of all resources

ACP NUM= 2 (%) NUM= 3 (%) NUM= 4 (%) NUM= 5 (%) in activity pool (AVG) (%)
Panel A: Resources assigned to activity pools using the size-random method

1 6.28 5.71 7.91 8.53 47.99
2 1.61 5.21 10.30 13.86 51.38
4 10.23 18.84 28.14 36.23 55.96
6 16.85 30.69 44.46 56.08 57.09
8 22.46 42.09 58.20 64.72 55.99
10 30.81 52.82 63.85 63.26 55.49
Panel B: Resources assigned to activity pools us

1 6.34 5.78 7.82 10.03 48.20
2 14.40 24.08 32.06 37.45 65.68
4 24.20 37.25 46.30 53.31 67.24
6 29.49 44.51 53.84 60.08 66.12
8 34.20 50.34 59.19 64.68 66.33
10 37.76 54.17 62.07 65.20 65.45
/Voies. Data pertain to 50 resources. BIG POOL, th

NUM, calculated driver percentages as the average
percentages as the average of the driver percentag
factors that affect

benchmark system's the performance of different heuris-
consumption patt
linear setup. tics because in the long run, it might be possible for
As shown in Table 3, manage
a firm to partially panel B,
features of its we f
production
environment
general conclusion (e.g., organizing if
holds for production
wein work use
based method to cellsassign
potentially increasesresources
resource traceability relative to
to a single
The potential gains assembly line). averaging ar
from
65% relative to 55% for the size-ran
7.1. Heuristics for Pooling
because the assignment Resources
method redu
Table 4 provides insight
bility that we will average dissimila into how characteristics of
the production
patterns. However, although indexinenvironment (with moderate skew-
yield significant ness in resource costs)
gains, the affect the error in reported
performan
that costs in the baseline
with the average experiment for two assignment
method. Overal
methods: size-random and correlation-random. Not
thatrefining drivers has the potential
improve system surprisingly,
accuracy, the extent of correlations in consump-
particula
rent system usestion patterns matters a great deal in determining
correlation-based me
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
of the size-based assignment method worsens consid-
ing the efficacy of alternative heuristics for an aver-
age production environment. In particular, althougherably by about 55%.
we examined how variation in the dispersion ofResult P6. It becomes increasingly important to
resource costs affects the ranking of the heuristicsconsider 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 to not
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
resource sharing by products would make it harder
obviously affects the choice of heuristics for assigning
for an allocation to capture true resource consump-
resources and for selecting cost drivers. In this sec-
tion. However, we find that a greater degree of
tion, we provide some insight into the cost structure
Table 4 Effect of Environmental Parameters on Assignment Heuristics
Panel A: ANOVA of percent gain in EUCD of using the correlation-random

size-random assignment
Source of variation . d.f. F p>F
Number of activity pools (>1Í7P) 5 193.81 <0.0001

Measurement error (MSMT_ERR) 3 470.26 <0.0001
Variance in resource cost (RC_VAR) 2 12.35 <0.0001
Extent of resource sharing {DENS) 3 1 1 .49 <0.0001
Correlation between batch and volume driven 3 183.02 <0.0001
resources (COR)
Residual <0.0001
Adjusted R2 (%) 74.80
Panel B: Effect of environmental parameters on the reduction in the error

costs (correlation-random versus size-random assignment)
Variance in resource cost
Value of construct RC_VAR = 0.25 RC_VAR = 0.5 RC_VAR = 0.75
EUCD (size-rand) 27,381 28,860 29,101

EUCD (corr-rand) 22,044 22,275 23,616
Percentage gain (%) 19.49 22.82 18.85
Correlation in consumption pattern between volume and batch resources
Value of construct COR = -0.66 COR = -0.33 COR = 0 COR = 0.33
EUCD (size-rand) 35,162 29,837 26,201 22,591

EUCD (corr-rand) 25,050 22,701 22,004 . 20,824
Percentage gain (%) 28.76 23.92 16.02 7.82
Extent of resource sharing by products
Value of construct DENS = -0.75 DENS = 0.0 DENS = 0.75 DENS = 1. 50
EUCD (size-rand) 41,610 29,549 23,029 19,602

EUCD (corr-rand) 32,014 23,176 18,767 16,622
Percentage gain (%) 23.06 21.56 18.51 15.20
Notes. Average method for selecting driver was used to allocate costs from activity po
cost objects. RCJ/AR, variance in the size of resource cost pools. COR, magnitude of the
age) correlation in resource consumption patterns between the baseline volume resourc
batch resources. DENS, measure of the extent of resource sharing by products. Greater
correspond to a greater degree of resource sharing and lower traceability of resources
objects. EUCD, metric of error between benchmark and reported costs, calculated as the 2
between the vectors of benchmark and reported costs, d.f., Degrees of freedom.
resource sharing reduces error in same level

reported of accuracy
costs. We as a process sho
observe this effect regardless of the method
products used
make to of the same set of res
use
assign resources to pools. One explanation is that
if the pattern of consumption varies acros
when we pool resources with a However,
sparse matrix, we
the relative effect of resource sh
increase the probability that the costs
difference of the
between aneffectiveness
unre- of the correlation-
lated resource are allocated to a product. This error method is not large.
based method and the size-based
reduces as resource sharing increases and seems
The change in the gain from tousing 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 gain
(the percent sharing
decreases of
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,
increasing the extent of resource sharing reduces the
24 This comparison rests crucially on the fact that we fix the num-
ber of pools. Firms with high traceability overall
mighterror
also in the it
find system.
cost-However, this environ-
mental
efficient to create more cost pools than firms factor
whose does not significantly
products share favor one method
resources, thereby leading to systems withfor grouping
lower resources
overall error.into cost pools over another.
Table 5 Determining the Number of Activity Pools Endogenously: Interaction with
Value of construct RC_VAR = 0.25 RC_VAR = 0.5 RC_VAR = 0.75
EUCD 17,088 17,557 18,636

Average no. of ACP 12.23 12.31 12.21
Correlation in consumption pattern between volume and batch resour
EUCD 18,171 17,303 16,999 18,570

Average no. of ACP 7.75 14.62 15.69 10.95
Value of construct DENS = -0.75 DENS = 0 DENS = 0.75 DENS = 1 .50
EUCD 21,841 18,294 16,069 14,838

Average no. of ACP 13.10 12.54 11.74 11.63
Notes. The first pool is seeded with the largest resource. Additional resou
ative to the first resource in the pool) are added to the pool. The second
ing resources. Additional resources satisfying correlation cutoff are adde
remaining resources is less than the specified number (all remaining re
We also grouped all remaining resources into the last pool if the number
number of possible activity pools). We used the average method for calcu
pool. Data pertain to a setting with a cutoff correlation of 0.4 and with
cost pool. RC_VAR, dispersion in the size of resource cost pools. High
COR, magnitude of the (average) correlation in resource consumption pat
and batch resources. DENS, measure of the extent of resource sharing b
greater degree of resource sharing and lower traceability of resources to
benchmark and reported costs, calculated as the 2-norm between the vec
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-
versus the big pool method) in different production
ment toward zero in the correlation in consump-
environments. The descriptive data in panel A and
tion patterns reduces the ability of the heuristic to
the results from an analysis of variance (ANOVA)
separate out batch and volume resources, degrad-
in
ing performance and generating systems with manypanel 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-
tion matrix), the higher the gain is from indexing.
25 Not surprisingly, the method also does well when all resources
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
Table 6 Interaction Between the Method for Choosing the Driver and Environmen
Panel A: Effect of environmental parameters and other system design choices on t

in the error in reported costs (big pool versus using index of top three resour
Value of construct RC_VAR = Q25 RC_VAR = 0.5 RC_VAR = 0.75
Difference in F¿7Í7D 21,084 20,112 19,408

Percentage gain (%) 33.53 33.65 33.05
Correlation in consumption pattern between volume and batch resources
Difference in £¿/¿7Z7 22,860 17,719 18,200 22,027

Percentage gain (%) 35.32 30.97 31.27 35.77
Value of construct DENS = -0.75 DENS = 0 DENS = 0.75 £O/S = 1.50
Difference in E¿7CD 36,332 22,755 12,344 9,376

Percentage gain (%) 33.93 36.01 30.71 29.88
Panel B: AN0VA of percentage difference in EUCD (EUCD with the

big pool method minus EUCDwih index of largest three resources
Source of variation d.f. F p> F
Number of activity pools (ACP) 5 867.39 <0.0001

Measurement error (MSMT_ERR) 3 205.29 <0.0001
Variance in resource cost {RC_VAR) 2 0.22 0.8050
Extent of resource sharing (DENS) 3 21.19 <0.0001
Correlation between batch and 3 25.52 <0.0001
volume driven resources (COR)
Residual <0.0001
Adjusted R2 (%) 85.21
Notes. Correlation with random initial seeding was used for assigning resources to activity cost pools
persion in the size of resource cost pools. Higher values correspond to greater dispersion. COR, m
(average) correlation in resource consumption patterns between the baseline volume resource and bat
DENS, measure of the extent of resource sharing by products. Greater values correspond to a greater degre
sharing and lower traceability of resources to cost objects. EUCD, metric of error between benchmar
costs, calculated as the 2-norm between the vectors of benchmark and reported costs, d.f., Degrees of
the number of activity pools (mechanically, the for

cost drivers num-the resulting cost pools. To our kno
ber of resources per pool declines, leading to greater
edge, this paper is the first to compare the altern
accuracy for indexing). This result suggests
heuristicsthat such by system designers. Although
employed
indexing or use of composite drivers for
offers the same
important insights into the design of prod
activity pool may be particularly important in job
costing systems, we believe that the area is ripe f
shop environments. Overall, our findings indicate
further that
enquiry. Four avenues look promising. Fir
although it is useful to consider the consumption pat-
the grand program is a multiperiod program, wher
terns of all resources in an activity pool, it might
we consider be
a single-shot framework and assume t
economically enough to calculate drivers using only
capacity is fully utilized. Thus, it is of particular in
the largest few resources in a pool. This
est tofinding
model a can
setting that can accommodate the id
be restated as follows:
tification of unused capacity. Such a dynamic sett
could then be useful when considering alternate u
Result D3. Even marginal improvements in spec-
for ABC systems such as cost control and proc
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 forsystem to potential changes in the
ness of the cost
grouping resources into cost pools and for generating
production processes. For instance, the use of cellular
Acknowledgments
manufacturing techniques provides greater traceabil-
ity of costs than provided under a regular
The authors appreciateassembly
comments from Anil Arya, Romana
line system. Although we have provided
Autrey, some
Dennis Campbell, pre-
John Christensen, J. Harry Evans,
liminary analyses in §6, it is of Thomas Hemmer, Susan
considerable Kulp, Karen
interest to Sedatole, Naomi
examine how the granularity of Soderstrom,
the data K. Sivaramakrishnan,
from the cost Jeroen Suijs, and direc-
tors of the Foundation
system affects product and process-design for Applied Research at the Insti-
decisions.
We believe that such extensions are of considerable tute of Management Accountants (IMA). Two anonymous
referees, the associate editor, and the departmental editor
interest because product planning is but one decision
(Stefan Reichelstein) provided invaluable help in improv-
context in which firms use data from product costing
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 PI; 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 Ä)
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, accounting 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.
• A moderate number of cost pools (10-20) seem
serve as an empirical proxy of the theoretical con-
struct of precision. Our hope is that such translation
enough, regardless of the method used to group resources
will help ground the often normative literatureinto on cost pools (Result P5; Figure 1, Table 2). For both size-
product costing in information economics, providingand correlation-based methods, the gain from adding more
it with a solid theoretical base. pools is concave in the number of pools formed.
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Evaluating Heuristics Used When Designing Product Costing Systems

Author(s): Ramji Balakrishnan, Stephen Hansen and Eva Labro

Evaluating Heuristics Used When D

1. Introduction firms therefore employ simple rules of thumb, judg-

when labor supervision

particularly when we also employ correlation-based

insight into demand distributions. Moreover,

output from a benchmark costingWe hasten to note that firms are is

map each resource (i.e., elements in RC)

dollar terms. Moreover, the squareThus, in a baseline

similar to "correlation-random"3.6. Heuristics

9 We would need to model the cognitive and economic costs asso-

driver that defines an overseasAsorder

Table 1 Descriptive Statistics

Panel A: Benchmark cost systems- Characteristics systematically varied

Variation in resource Global Low dispersion Med dispersion High dispersion

Percentage of cost in largest pool/ Ratio 6.78 3.20 5.75 11.39

Little sharing of Medium sharing of High sharing of V

Similar Intermediate Intermediate Dissimilar

Panel B: Benchmark cost systems- Characteristics not systematically varied

Characteristic Unit Average Median Interquartile range

Percentage of resources in pools devoted to batch activities Percent

Mean Min Quartile 1 Quartile 2 Quartile 3 Max

EUCD 28,448 2,514 16,237 24,882 36,919 124,155

Panel D: Correlation among error metrics (N =

EUCD %ACC MPE

EUCD 1.00 -0.745 0.955

Notes. Size-random method used for

We next turn to the noisyassignment

5. Results: Performance of Heuristics handful of resources; our contribution in this regard

Figure 1 Effect of the Method for Assigning Resources to Activity Pools

one way to interpret our results is that

In Table 2, consider the row that reports data

guess about correlation structureResult

Table 2 Endogenously Determined Number of Activity Pools

22 For additional insight, consider the correlation method with size-

for Selecting Cost Drivers

Result Dl. Using an indexed (composite) driver

As Figure 3 shows, there is a significant gain to

Table 3 Gain from Using an Indexed Cost Driver

Average of all resources

Panel A: Resources assigned to activity pools using the size-random method

Panel B: Resources assigned to activity pools us

/Voies. Data pertain to 50 resources. BIG POOL, th

factors that affect

Table 4 Effect of Environmental Parameters on Assignment Heuristics

Panel A: ANOVA of percent gain in EUCD of using the correlation-random

Source of variation . d.f. F p>F

Number of activity pools (>1Í7P) 5 193.81 <0.0001

Panel B: Effect of environmental parameters on the reduction in the error

Variance in resource cost

Value of construct RC_VAR = 0.25 RC_VAR = 0.5 RC_VAR = 0.75

EUCD (size-rand) 27,381 28,860 29,101

Correlation in consumption pattern between volume and batch resources

Value of construct COR = -0.66 COR = -0.33 COR = 0 COR = 0.33

EUCD (size-rand) 35,162 29,837 26,201 22,591

Extent of resource sharing by products

Value of construct DENS = -0.75 DENS = 0.0 DENS = 0.75 DENS = 1. 50

EUCD (size-rand) 41,610 29,549 23,029 19,602

resource sharing reduces error in same level

Table 5 Determining the Number of Activity Pools Endogenously: Interaction with

Variance in resource cost

Value of construct RC_VAR = 0.25 RC_VAR = 0.5 RC_VAR = 0.75

EUCD 17,088 17,557 18,636