Transforming cost improvement from a tooth-to-tail mentality: this author stresses the need to do careful analysis to ensure that funding goes to areas providing greatest value without regard to accounting definitions.

Background

Transformation has become a central focus of change within the Department of Defense (DoD). Ever-increasing competition for federal funding has caused the DoD, indeed, all federal agencies, to search for new ways of responding. Given the budget pressure of the war on terrorism and the infrastructure costs to rebuild from the recent natural disasters in Louisiana and Texas, this competition for budget dollars is certain to increase.

Private businesses frequently focus on cost reduction in an effort to maintain profits and a return on owners' investment. Government agencies similarly have been faced with pressures to provide ever-increasing value in return for taxpayer dollars. Both business and government often target the reduction of overhead costs in their response to increasing costs. In fact, many cost reduction efforts in the past decade have focused exclusively on overhead and indirect costs. However, it is fair to ask why there should be such a focus on overhead costs.

A need to maximize the use of limited resources to achieve organizational objectives is common among for-profit, not-for-profit, and government organizations. How has the DoD sought to address cost reduction challenges, and to what extent has there been a focus on indirect costs?

Cost Reduction in DoD

DoD's mission is to provide the military forces needed to deter war and to protect the security of our country. This mission is accomplished through the combat capability that the United States is able to deliver wherever needed around the globe. Because many billions of taxpayer dollars are needed each year to enable and sustain this capability, efforts to improve the cost effectiveness of the DoD can have large savings for the country and the taxpayer.

However, savings resulting from decreased mission capability can potentially be counterproductive. Much of the focus on cost effectiveness has therefore been to decrease the cost of support functions without decreasing the actual capability of the fighting forces. This has led to the concept of improving the tooth-to-tail ratio. The idea behind this concept is that cost effectiveness will be improved if the warfighter (the tooth) can be supported with less costly support (the tail).

While the tooth-to-tail ratio is a concept that has become popularized within DoD over the past decade or two, it actually is a representation of a larger popular view that holds that organizational cost effectiveness can be improved by focusing on the reduction of indirect costs. Today, it is quite common to find cost reduction initiatives focused squarely on reducing indirect costs. These initiatives can be found in almost every large organization, whether in the public or the private sector. At first glance, the logic is appealing, perhaps even compelling. Reducing overhead costs does not detract from those direct costs that get the job done. Instead, it simply is the support "fluff" that is trimmed.

While this logic may be attractive, it relies upon some tenuous assumptions. All too often, these assumptions cause well-meaning decision makers to oversimplify the issues involved and apply this valuable concept in inappropriate ways. The result is less, rather than more, cost-effectiveness. Before making the case for the weakness of underlying premises, however, a few terms first need to be defined.

Terminology

Terms like direct, indirect, and overhead are accounting terms that have specific meanings. It is important to understand what these terms mean--and do not mean--if we are to evaluate strategies focused on reducing overhead and indirect costs.

According to the Statement of Federal Accounting Standards Number 4, Managerial Cost Accounting Concepts and Standards for the Federal Government, direct costs are costs that can be specifically identified with an output. All direct costs should be included in the full cost of outputs. Typical direct costs in the production of an output include salaries and other benefits for employees who work directly on the output; materials and supplies used in the work; costs associated with office space, equipment, facilities, and utilities that are used exclusively to produce the output; and costs of goods or services received from other segments or entities that are used to produce the output.

Indirect costs are costs of resources that are jointly or commonly used to produce two or more types of outputs but are not specifically identifiable with any of the outputs. Typical examples of indirect costs include costs of general administrative services, general research and technical support, security, rent, employee health and recreation facilities, and operating and maintenance costs for buildings, equipment, and utilities.

Indirect costs include costs that frequently are referred to as overhead expenses (for example, rent and utilities) and general and administrative expenses (for example, resource management and comptroller department costs and personnel department costs).

The Fallacy of Unstated Assumptions 

The preceding accounting definitions are important for the consistent application of costs in an accounting system. However, while it is important to understand what is included in the definitions of direct and indirect costs, it is equally important to understand what is not included. Indirect costs are no less important, no less cost-effective, no less value-added, nor any other term that suggests less contribution to the mission of the organization than direct costs. The generally unstated but often accepted assumption is that direct costs are "good" while indirect or overhead costs are "bad." This is based on the notion that only direct costs are "hands-on" to the production of the goods or services in which the organization is involved.

Taken to its extreme, organizations sometimes focus exclusively on indirect cost reduction and ignore direct costs altogether. However, operations and processes directly involved in the production of products and services can be executed very inefficiently, while support operations and processes can be of world-class caliber. The definitions of direct and indirect costs are established to ensure the consistent application of costs in accounting systems. It is an unjustified leap in logic to assume that these definitions also define what is useful or valuable, and what is not.

The contribution of any resource to the accomplishment of an organization's mission, or even to the production of a specific product or service, is not simply a matter to be decided by its accounting classification as direct or indirect or overhead. Organizations and processes such as accounting, personnel, payroll, travel, shipping, security, and facility maintenance are all typically indirect costs. Is it logical to assume that an organization's waste and inefficiencies typically are bundled up into these support activities, rather than being shared with those activities that consume direct costs?

The Games People Play 

Efforts to improve the tooth-to-tail ratio, or to reduce the percentage of indirect costs as a percent of total costs, also cause some organizations to play games with numbers. For example, the percentage of indirect costs can be reduced simply by reclassifying such costs as vacation time, retirement costs, and other personnel benefits as direct rather than indirect. Indeed, there is a strong argument for classifying such costs as direct costs when they are associated with persons doing work that can be directly associated with specific outputs of the organization. In this case, these benefit costs can justifiably be reclassified as direct costs.

One U.S. Army agency, under pressure by the agency head to reduce overhead rates, reclassified personnel benefits as direct costs to the extent they could be associated with direct personnel payroll. When this change was made, the organization suddenly "improved" by reducing its overhead costs. Of course, in reality, nothing had changed in the cost-effectiveness of the organization.

This shows the fallacy of trying to evaluate organizations solely by reviewing their overhead rates. Such rates ultimately depend on the accounting system used to assign costs to direct and indirect categories. When different organizations employ different approaches to the assignment of those costs, a comparison of overhead rates can lead to invalid conclusions.

Value Management

Once biases of what constitutes "bad" costs are set aside, most managers would agree that resources should be funneled to those areas that provide greatest value in contributing to the organization's mission and outputs. Sounds simple, but how does one identify these areas of greatest value?

Although value is a subjective term, it can be tied down by thinking of it as the relationship of benefits gained to costs consumed. In other words, Value = Benefits / Costs. This definition is inherent in decisions we make daily, whether in our professional or our personal lives. For instance, when investing for retirement, we consider a stock not for its high per-share price but for its high return for every dollar invested.

Value, whether consciously recognized or unconsciously acted upon, is the basis for most of our decisions throughout the day. Unfortunately, we so often throw out this fundamental concept when we seek organizational cost-reduction opportunities.

Every use of resources in an organization must be open to challenge concerning the value returned in exchange for the loss of those resources. No "tooth" should be above reproach when having to justify costs incurred, any more than we should seek opportunities to lessen dependence on the "tail." Every organization-whether categorized as direct or overhead--must be able to justify costs consumed based on support to the organizational mission and objectives, and to show that those resources consumed are used in an efficient manner consistent with best practice.

Providing this assurance admittedly is more difficult in an "overhead" organization. This is because support organizations do not directly contribute to the production of the products or services for which the organization was established. As a result, the cause-and-effect linkage between resource consumption and mission accomplishment is not direct, but has intermediate steps. While those linkages may not be direct, it does not mean that they do not exist.

An activity-based costing (ABC) study conducted at NASA's Langley Research Center found that approximately 80 percent of the costs for the administrative support organization were in direct support of the center's mission requirements. The ABC study identified outputs of the overhead organization, which in turn were used by other portions of the organization that were considered direct labor.

Because ABC allowed managers to clearly under stand how overhead support costs contributed to the direct work of the center, its leadership was better able to understand the basis for the level of overhead costs. In some cases, managers were better able to justify the level of existing overhead costs. In other cases, managers were better able to challenge the costs as not providing value commensurate with the costs incurred. This improved ability to assess value of work performed without regard to the accounting definition of overhead or direct was particularly helpful in responding to potential budget cuts with much more insight into the impact of various alternatives.

In another study, a federal agency asked a management consulting firm to investigate opportunities to reduce overhead costs, even though these overhead costs constituted only 5 percent of the organization's total costs. Upon review of the organization's cost structure, the consultants concluded that the majority of inefficiencies were caused by the dispersed geographical structure of the organization and the significant overstaffing of field offices doing direct-cost work. The overcapacity of the organization's direct work was, in fact, several times the total overhead cost of the organization. Had the agency continued with its initial focus on indirect costs, it would have missed the opportunity to address the real source of cost inefficiencies within its direct costs.

Teeth, Tails, and Value

The tooth-to-tail ratio points out the trap into which any organization can fall by not controlling spending and not adequately challenging how resources will be applied to support mission accomplishment. Like any good concept, however, it can be oversimplified and misapplied.

The objective should never be simply to minimize the tail while maximizing the tooth. What good would it be, for example, if the DoD had tremendous stockpiles of the most advanced weapons systems sitting in its arsenals but could not adequately deliver those weapons to the point of engagement in the time required? It is quite easy to imagine scenarios where a focus purely on the tooth can have a detrimental impact on mission accomplishment.

A cheetah, the world's fastest land animal, depends on its teeth to attack and kill its prey. However, without its tail for balance and assistance in maneuvering, it would be a far less effective hunter. Both teeth and tail are valuable to the cheetah.

So, too, both direct and indirect costs are valuable to the organization. Assessing the value of resources consumed, without particular regard to their accounting classification, should be the focus of leaders who truly seek to transform their organizations and achieve their mission in the most cost-effective manner.

Doug Webster, PhD

Doug Webster, PhD, is a senior manager for Grant Thornton LLP and an adjunct professor of Managerial Accounting & Financial Management for Central Michigan University.