A time-driven approach to capability costingcradpdf.drdc-rddc.gc.ca/PDFS/unc201/p802618_A1b.pdf ·...

A time-driven approach to capability costing

Mark RempelDRDC - Centre for Operational Research and Analysis

Defence Research and Development Canada Scientific ReportDRDC-RDDC-2015-R179September 2015

© Her Majesty the Queen in Right of Canada, as represented by the Minister of NationalDefence, 2015

© Sa Majesté la Reine (en droit du Canada), telle que réprésentée par le ministre de laDéfense nationale, 2015

Abstract

We present a novel method for calculating the cost of a military operational capability.First, a force structure’s cost is separated into two categories: (1) the equivalentannual cost of performing readiness training for each capability it provides; and (2)the force structure’s remaining equivalent annual cost. The first category’s costs aredirectly assigned to their respective capabilities. Using time-driven activity-basedcosting, the second category’s costs are attributed to the capabilities it providesbased on how many hours the force structure spends conducting readiness trainingfor each capability. The cost of a capability is the sum of the equivalent annualcosts of performing readiness training and the attributed force structures’ costs. Wepresent five examples that highlight unique aspects of force structures, and showhow these aspects are accounted for within the method. Lastly, we discuss severalimplementation issues, data requirements, and how the output of this approach maybe used within capability-based planning to inform resource allocation decisions.

Significance for defence and security

The significance of this work is that it provides decision-makers a simple and transpar-ent method to attribute a force structure’s costs to the capabilities a force structure pro-vides. By combining a capability’s cost with existing information from capability-basedplanning, such as a measure of a capability’s importance and its affluence/deficiencythroughout planning scenarios, decision-makers can make evidence-based resourceallocation decisions at the capability level rather than the force structure level.

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Résumé

Nous présentons une méthode de calcul novatrice permettant de déterminer le coûtd’une capacité militaire. À laide de la comptabilité par activités en fonction du temps,les coûts d’une structure de forces sont attribués aux capacités que celle-ci offreen fonction du nombre d’heures qu’elle investit dans l’instruction en disponibilitéopérationnelle pour chaque capacité. Le coût d’une capacité est la somme des coûtsattribués et de ceux de l’instruction en disponibilité opérationnelle. Nous présentonscinq exemples qui mettent en évidence les aspects particuliers de certaines structuresde forces et qui expliquent comment en tenir compte dans la méthode de calcul.Finalement, nous soulevons plusieurs questions relatives àà la mise en œuvre, précisonsles besoins en matière de données, et expliquons comment les résultats de cetteapproche peuvent éclairer les décisions quant à l’attribution de ressources dans lecadre de la planification axée sur les capacités.

Importance pour la défense et la sécurité

L’importance de cette méthode est qu’elle offre aux décideurs un moyen simple ettransparent d’attribuer les coûts d’une structure de forces aux capacités qu’elle fournit.En regroupant les coûts d’une capacité avec les renseignements tirés de la planificationaxée sur les capacités, comme la mesure de l’importance d’une capacité ainsi quele rapport fréquence/insuffisance dans les scénarios de planification, les décideurspeuvent prendre des décisions quant à l’attribution de ressources qui sont fondéessur des données probantes, et ce, sur le plan des capacités plutót que sur celui de lastructure de forces.

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Table of contents

Abstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i

Significance for defence and security . . . . . . . . . . . . . . . . . . . . . . . i

Résumé . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ii

Importance pour la défense et la sécurité . . . . . . . . . . . . . . . . . . . . . ii

Table of contents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii

List of figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

List of tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

2 Time-driven activity-based costing . . . . . . . . . . . . . . . . . . . . . . 3

2.1 Capacity cost rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2.2 Capacity usage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

2.3 Practical issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

2.3.1 Estimating cost of capacity . . . . . . . . . . . . . . . . . . 6

2.3.2 Department or process view . . . . . . . . . . . . . . . . . . 8

2.3.3 Practical capacity . . . . . . . . . . . . . . . . . . . . . . . . 8

2.3.3.1 Lumpiness in acquiring capacity . . . . . . . . . . 9

2.3.3.2 Peak-load capacity . . . . . . . . . . . . . . . . . . 9

3 Allocating Costs to Capabilities . . . . . . . . . . . . . . . . . . . . . . . . 11

4 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

4.1 Basic force structure . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

4.2 Multiple readiness levels . . . . . . . . . . . . . . . . . . . . . . . . . 15

4.3 Different resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

4.4 Multiple different resources . . . . . . . . . . . . . . . . . . . . . . . 18

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4.5 Simultaneous capacity usage . . . . . . . . . . . . . . . . . . . . . . 21

5 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

5.1 Accuracy, not precision . . . . . . . . . . . . . . . . . . . . . . . . . 22

5.2 Simplified approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

5.3 Time equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

5.4 Data requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

5.5 Usage in capability-based planning . . . . . . . . . . . . . . . . . . . 25

6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

List of abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

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List of figures

Figure 1: Example of peak-load capacity. . . . . . . . . . . . . . . . . . . . 10

Figure 2: Relationship between TDABC components within capability costing. 12

Figure 3: Example breakdown of a force structure’s planned practical capacity. 13

Figure 4: Example 1 – Basic force structure. The red circles indicate thereadiness training associated with each capability. . . . . . . . . . 15

Figure 5: Example 2 – Multiple readiness levels. . . . . . . . . . . . . . . . . 16

Figure 6: Example 3 – Relationship between capacity cost rate and capacityusage when there is demand for different resources. . . . . . . . . 17

Figure 7: Example 3 – Different resources. . . . . . . . . . . . . . . . . . . . 18

Figure 8: Example 4 – relationship between capacity cost rate and capacityusage when there is demand for multiple different resources. . . . 19

Figure 9: Example 4 – Multiple different resources. . . . . . . . . . . . . . . 21

Figure 10: Capability costing usage within capability-based planning. . . . . 26

Figure 11: Capability importance and operational capacity. . . . . . . . . . . 27

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List of tables

Table 1: Fictional Example - capacity usage and costs. . . . . . . . . . . . 4

Table 2: Capacity usage and costs (continued). . . . . . . . . . . . . . . . . 5

Table 3: TDABC components and their interpretation within capabilitycosting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

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1 Introduction

Making good investment and divestment decisions is vital to the ability of the CanadianArmed Forces (CAF) meeting their strategic objectives. Since as early as 2005 theinvestment and divestment decisions regarding operational capabilities1 have beeninformed by the CAF’s Capability-Based Planning (CBP) process (Blakeney et al.2009, Christopher et al. 2009, Rempel 2010). This process gives decision-makersinsight into the importance of the CAF’s operational capabilities and the degree towhich the CAF’s capacity to provide each capability is affluent or deficient. Togetherthese assessments indicate to decision-makers which capabilities are candidates forinvestment and divestment.

When a capability is identified for investment or divestment, it is important to knowthe capability’s cost; that is, What is the CAF spending to provide the capability?In an investment case, this information helps decision-makers determine the level ofinvestment that may be required. For example, if a capability has a large deficiencyand its existing cost is large, then the capability may require a large investment. Inthe divestment case, knowing the capability’s cost helps decision-makers determinethe amount of financial resources that may be saved, which may then be reinvested inother capabilities. Thus, knowing a capability’s cost enables decision-makers to makeevidence-based resource allocation decisions at the capability level.

Calculating a capability’s cost is not a straightforward procedure. Although theStrategic Cost Model (Chouinard and Wood 2007) estimates the full EquivalentAnnual Cost (EAC) of generating and sustaining organizations (i.e., force structures)that deliver operational capabilities, since the majority of capabilities are providedby multiple force structures the annual cost to provide a capability is not simplythe sum of the relevant force structure’s EAC2. As an example, the primary Searchand Rescue (SAR) capability provided by the CAF is the provision of aeronauticalSAR (search for downed aircraft) and the coordination of aeronautical and maritimeSAR systems (National Defence and the Canadian Armed Forces). This capabilityis provided using a variety of resources, including operational commands, naval andair force structures, and volunteer organizations. The naval and air force structures’EAC costs should not be fully attributed to the SAR capability, since some of these1 A capability may be defined as a particular ability that contributes to the production of a desiredeffect in a given environment within a specified time and the sustainment of that effect for a designatedperiod. Capability is delivered by an appropriate combination of PRICIE components, where PRICIErefers to Personnel/Leadership/Individual training, Research and Development/Operational Research,Infrastructure, Environment and Organization, Concepts, Doctrine, Collective Training, InformationManagement & Technology & Equipment Support (Rempel 2010). See page 1.2 The equivalent annual cost of a force structure is the cost per year of owning and operating theforce structure over its entire lifespan. See the Strategic Cost Model for details on computing a forcestructure’s equivalent annual cost (Chouinard and Wood 2007, Solomon et al. 2008, Kerzner et al.2009).

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force structures provide other capabilities (e.g., the CH-124 Sea King helicopters andCP-140 Aurora aircraft provide aeronautical SAR, but their primary function is toprovide intelligence, surveillance, and reconnaissance). A more accurate estimate isto attribute the portion of the force structures’ EAC to the various capabilities theyprovide based on the hours of readiness training conducted for the capabilities. Thebenefit of using readiness training to attribute force structures’ EAC to capabilitiesis that the cost of a capability is then not dependent upon the decision to employ acapability, rather the investment decision to have the option to employ a capability.

In this scientific report we demonstrate how Time-Driven Activity-Based Costing(TDABC) may be used to calculate the cost of capabilities through attributingforce structures’ EAC to capabilities based on readiness training. TDABC, whichis a streamlined version of Activity-Based Costing3 in terms of data collection andprocessing, is a practical approach to calculate these costs (Kaplan and Anderson 2007).In addition, its output provides decision-makers insight into force structure utilization,identifies processes that may inefficient, and may support further studies regardingthe variety and mix of force structures and capabilities. The main contributions ofthis report are as follows.

1. A description of how TDABC may be used to attribute a force structure’s EAC tocapabilities based on readiness training (Section 3).

2. A set of examples that demonstrate the attribution process (Section 4), taking intoaccount several practical issues.

3. A discussion of implementation issues, data requirements, and how the output ofthis approach may be used within CBP to inform resource allocation decisions(Section 5).

Although this scientific report focuses on capability costing, TDABC may be appliedto other areas of the Defence, such as finance, human resources, and infrastructure,to enhance performance reporting and strategic decision-making. As an example, in2013–14 Defence Construction Canada implemented a strategic initiative4 to enhanceits business management and performance measurement reporting. This initiativeincluded a TDABC model that allowed the organization to standardize its operationalreporting.

The remainder of this scientific report is organized as follows. First, a summary ofthe concepts of TDABC relevant to capability costing is presented (Section 2). Thisis followed by an explanation of how a force structure’s EAC may be attributed to3 For comparison of activity-based costing and time-driven activity-based costing, see Hoozée and Hansen (2014).4 See http://www.dcc-cdc.gc.ca/english/annual_reports/2013-2014/20_initiatives.html.

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capabilities using readiness training (Section 3). Next, we present a set of examplesthat show how a capability’s cost is calculated using this approach (Section 4), anddiscuss several implementation issues and how the output of this approach may beused within CBP to inform resource allocation decisions (Section 5). The last sectionpresents a summary (Section 6).

2 Time-driven activity-based costing

TDABC is an approach to calculate the cost of an organization’s activities (or products).It calculates these costs by attributing the organization’s costs of resources to itsactivities using estimates of two parameters: the capacity cost rate of the resources andthe capacity usage by the activities (Kaplan and Anderson 2004, 2007). A resource’scapacity cost rate is the total cost of supplying the resource’s capacity divided bythe practical capacity of the resource. An activity’s capacity usage is the demand(typically time) for resource capacity.

In this section, we describe these concepts using an example, set within a militarycontext, similar to those found in the TDABC literature (Kaplan and Anderson2004, 2007). Using the example, we show how capacity cost rates are calculated(Section 2.1), how capacity usage and activity costs are calculated (Section 2.2),and discuss several practical issues that must be considered when performing thesecalculations (Section 2.3).

2.1 Capacity cost rate

Suppose a CAF unit performs three activities, labelled A, B, and C. The unit wouldlike to know how much it costs to perform each activity.

The unit has 12 personnel, including one manager, one support staff, and 10 analysts5,and a total annual operating budget of $5 million (M), including salary, professionaldevelopment, technology, contracts, etc. Each of the 10 analyst works 250 days ayear and 7.5 hours (h) per day—a total of 1875 h per individual per year. Not allof this time is available for productive work, due to Professional Development, sicktime, breaks, etc. Suppose each year each analyst takes 10 days of sick time, 15 daysof training, 20 days of vacation, and one hour of breaks per working day—a totalof 542.5 h per analyst. The practical capacity of the unit to perform the activities

5 Each analyst may be an officer, non-commissioned member, or civilian in a different occupation(e.g., Intelligence Officer, Marine Engineer, Imagery Technician). However, for the purposes of thisexample each is labelled as an ‘analyst’.


perform activities is:

Capacity Cost Rate =Cost of Capacity

Practical Capacity of Resources

=$5 M per year

13, 325 h per year= $375.23 per h .

(1)

This means, regardless of the activity, every hour of work costs $375.23.

2.2 Capacity usage

The consumption of the unit’s capacity by its activities may be estimated by directobservation of the unit or interviewing its personnel. Suppose it is determined thaton average it takes 75 h to perform activity A, 15 h to perform activity B, and 35 hto perform activity C. As well, these activities are estimated to be performed thefollowing number of times per year: 120, 240, and 25 for A, B, and C respectively.Each activity’s capacity usage, its cost, the total capacity usage, and total cost (totalcapacity usage × capacity cost rate) are shown in Table 1.

Table 1: Fictional Example - capacity usage and costs.Activity Capacity Usage (h) Quantity Total Usage (h) Total Cost ($)

A 75 120 9000 3 377 070B 15 240 3600 1 350 828C 10 25 250 93 808

Used Capacity (96.4%) 12 850 4 821 706Unused Capacity (3.6%) 475 178 234

Total 13 325 5 000 000

Recall that the practical capacity of the unit is 13,325 h per year. Table 1 shows thatabout 96% of the practical capacity of the resources supplied are used to performthe activities, and about 4% of the practical capacity (equivalent to over $175,000) isunused. With this information, the unit’s management can decide on a course of actionto address the unused capacity: reduce the practical capacity available (e.g., invest byincreasing training days, divest by reducing personnel) or reserve the unused capacityfor future growth (e.g., new activities, increased demand for current activities).

The above example uses an average capacity usage for each activity. In reality, thedemands for resources vary as an activity varies. For example, the resources requiredto perform activity A may vary based on several parameters. These variations can


is then 13,325 h per year ((1875− 542.5) · 10), assuming the manager and supportstaff do not perform the unit’s three activities. The capacity cost rate for the unit to

be accounted for using time equations, which are simply equations that compute thetime required to perform an activity. Suppose the unit is asked to perform activity Ain two formats: a simple format and a complex format. The simple format requireson average 50 h. The complex format on average requires an additional 50 h. Thetime required to perform activity A in either format is then:

Activity A (h) = 50 + 50× (if complex), (2)

where ‘if complex’ is 1 when the activity is in a complex format and 0 when it is in asimple format.

Given this additional information, Table 2 shows the updated capacity usage, assumingthat half of the requests to perform activity A are for the complex format.

Table 2: Capacity usage and costs (continued).Activity Capacity Usage (h) Quantity Total Hours (h) Total Cost ($)

A (Simple Format) 50 60 3000 1 125 690A (Complex Format) 100 60 6000 2 251 380

B 15 240 3600 1 350 828C 10 25 250 93 808

Used Capacity (96.4%) 12 850 4 821 706Unused Capacity (3.6%) 475 178 234

Total 13 325 5 000 000

Although including more detailed information about activity A doesn’t alter theconclusions, it does highlight that the complex format consumes half of the totalresources required to perform activity A. With this further information, the unit’smanagement can decide on a course of action: do nothing, only perform activity Ain a simple format, perform activity A in a simple format and a standard complexformat (perhaps thus reducing the additional time required), etc.

As the unit learns more about its activities, the time equations may be furtherdeveloped in order to provide the unit’s management with better quality informationto make investment and divestment decisions.

2.3 Practical issues

There are several issues that must be considered when calculating capacity cost rates,measuring capacity usage, and developing time equations (Kaplan and Anderson 2004,2007). These issues can be divided into three categories: (1) estimating the cost


of capacity, (2) using a department or process view, and (3) determining practicalcapacity. The remainder of this section discusses these issues.

2.3.1 Estimating cost of capacity

When estimating a resource’s cost of capacity several categories must be taken intoaccount, including:

• personnel salaries and benefits, including medical coverage and pension benefits;

• indirect labour salaries, benefits, and supervision of support personnel;

• equipment and technology costs;

• occupancy costs of space; and

• other indirect costs, such as human resources, finance, and corporate staff.

Together, these components (including sub-components, such as disposal, within thesecategories) constitute the life-cycle cost of a force structure (NATO Research andTechnology Organization 2003, 2009).

Three categories listed above require special attention: equipment and technology,occupancy, and corporate staff (Kaplan and Anderson 2007). The cost of equipment6and technology7 resources includes the depreciation8 expense, betterments, and oper-ating costs. In the Department of National Defence (DND)/CAF, these categoriesare defined as follows (Department of National Defence 2015).

• Depreciation expense: The Department uses straight-line amortization for thehistorical cost9 of equipment and technology. Therefore, the depreciation expenseis the EAC of the historical cost.

• Betterments : The cost of betterments includes costs associated with any activitiesthat: provide a significant improvement in the quality or quantity of the outputor performance; decrease operating costs; or extend the useful life by more thanone year.

6 Equipment, including weapons systems, includes arms and weapons, vehicles, aircraft, shipsand boats, machinery (e.g., engineering, industrial, test equipment), and various other equipment(e.g., navigational, optical aids, simulation and training) (Department of National Defence 2015).7 Technology includes software, computer networks, communications systems, etc. (Department ofNational Defence 2015).8 Depreciation measures the value of an asset over time (Wise and Cochran 2006). See page 7.9 Historical cost of equipment and technology includes purchase cost, indirect overhead costs, start-upand initial cadre training costs, and customization costs. It excludes in-service support costs, alltraining except start-up and initial cadre training, etc. (Department of National Defence 2015).


• Operating costs : Operating and maintenance costs of equipment includes costsassociated with activities such as replacing weapons having the same specifica-tions as the original weapons, replacing an engine with a spare engine, routinemaintenance of a system on a ship, aircraft, or other vehicle, and other routinemaintenance and repairs. Operating and maintenance costs for technologyincludes software updates that maintains previous capabilities.

Some organizations, such as railroad companies, that own long-lived capital assets alsoincorporate opportunity cost (to reflect the forgone interest in the original investment)and a price level index (to reflect changes in prices over time) in the depreciationexpense. However, these are considered advanced features in the TDABC approachare not typically included in initial implementations (Kaplan and Anderson 2007).

Occupancy costs, the second category, includes the prorated share of building depreci-ation, utilities, maintenance, and insurance costs of supplying space for personnel andequipment. When some components of an organization require more expensive space,such as a military unit that requires specialized space to house computer equipment,these costs should be directly assigned to the unit’s activities.

The final category is corporate staff. Not all corporate costs should be assignedto an organization’s activities. For example, costs related to executive boards andthe preparation of financial statements are activities that are independent of anorganization’s mix of activities. These costs should be categorized as corporate-sustaining expenses and not further allocated. The remaining corporate costs, such asthose related to hiring and training employees, supplying and maintaining computersystems, and processing employee paychecks, should be assigned to the organization’sactivities using TDABC models. This ensures that these assignments are based onunderlying casual relationships rather than arbitrary percentages.

Within the DND/CAF there are several military and civilian corporate staff whosecosts should be attributed to corporate-sustaining expenses. For example, the costsof the Chief of Defence Staff, Vice Chief of Defence Staff, Army/Navy/Air Forcecommanders, Chief Financial Officer, etc. are independent of the mix of capabilities.However, the activities of corporate staff (e.g., employees of the Director GeneralFinancial Management (under the Chief Financial Officer), Director General CivilianHuman Resource Management (under the Assistant Deputy Minister Human Resources-Civilian), etc.) are dependent upon the mix of capabilities and thus their costs shouldbe allocated.

Recall the military unit discussed in Table 2. Their $5 M annual cost of capacityincludes the depreciation expense, betterments, and operating costs of the equipmentand technology used to perform its activities, the prorated occupancy cost of thebuilding the unit works within, plus the occupancy cost of any specialized space


required. In addition, it includes the cost of the one manager and one support staffwithin the unit, and relevant corporate costs as assigned through TDABC models.

2.3.2 Department or process view

When calculating an organization’s capacity cost rate, a decision must be made toview the organization as a single department or as a set of processes. The departmentview assumes that each of the organization’s products/activities uses the same setof resources, and thus a single capacity cost rate is sufficient. However, if theproducts/activities require different resources, then different capacity cost rates arerequired. This is known as a process view. Kaplan and Anderson (2007) suggestthat the initial version of a TDABC model use a department view and later versionsmigrate to a process view, if required.

Recall the military unit discussed in Table 2. Each activity uses the same capacity costrate, and this implies that each activity requires the same set of resources. However,suppose specialized technology is required to perform the complex format of activity A,and that this technology is not used for any other activity. In this case, two capacitycost rates are required: first, one for the complex format of activity A that includesthe cost of the specialized technology; and second, one for the remaining activitiesthat does not include the cost of the technology.

In addition, different activities may require different capacity cost rates if theirconsumption of resources are measured differently10. For example, the key driverof the resources required to perform activity A (simple or complex) may be time(i.e., hours), whereas the key driver of the resources required to perform activity Cmay be space related (i.e., square kilometres). In this case, the capacity cost rate usedby activity A should be measured in dollars per hour and the rate used by activity Cshould be measured in dollars per square kilometre.

2.3.3 Practical capacity

A simple approach to estimating the practical capacity of resources is to assumethat their practical capacity is a fixed percentage of their theoretical capacity. Forexample, if an employee works 37.5 h per week and 20% of their time is consumedfor training, breaks, etc., then their practical capacity is 80% (30 h per week) oftheir theoretical capacity. Although using a fixed percentage is simple, it may appearsomewhat arbitrary. A more analytical approach is to subtract the explicit quantities10 This approach is similar to the attribution approach used in the Strategic Cost Model (Solomonet al. 2008). Three attribution rules are used in the Strategic Cost Model – number of peoplefor training and personnel support, equipment operating costs for maintenance and overhaul, andpersonnel and operation and maintenance costs for total demand such as base support. See page 19of Solomon et al. (2008).


of time when a resource is not available from the theoretical capacity, and use theresult as the practical capacity—this is what was done in Section 2.1.

There are other factors that may arise when estimating practical capacity, namelylumpiness in acquiring capacity and peak-load capacity.

2.3.3.1 Lumpiness in acquiring capacity

In some situations the capacity of resources acquired by an organization may exceedthe planned required capacity. In particular, there are two types of situations:

1. The planned required capacity per year is less than the capacity purchased. Forexample, the military unit employs 10 analysts, but no more than eight will berequired per year.

2. The planned required capacity per year is initially less than the capacity purchased,but will ramp up over time to the full capacity purchased. For example, the militaryunit employs 10 analysts and in the first year expects its activities will require onlyfive, 15 in the second year, and 20 in the third year and beyond.

In the first situation a decision was made to purchase the unused capacity. In thiscase, the practical capacity used to calculate the capacity cost rate should be theplanned required capacity rather than the purchased capacity (i.e., 10,660 h per year).In the second situation a decision was made to purchase unused capacity knowingthat the required capacity will ramp up over time. In this case, two approaches arefeasible to selecting a practical capacity: first, use the maximum practical capacity(i.e., 13,325 h per year); and second, use the total useful hours over the lifetime of theresources (i.e., 13,325 h per year × number of years they work). Regardless of thesituation and approach used, the key is that the practical capacity should be linkedto the decision to purchase the capacity.

2.3.3.2 Peak-load capacity

Organizations often purchase resources in bulk for an entire year, however the demandfor those resources may vary throughout the year. If this situation occurs and theorganization purchases resources to meet its peak demand, then for part of the yearthere may be unused capacity.

For example, suppose the demand for the military unit described in Table 2 to performactivity C, which is 250 h per year, varies such that the peak demand is 31.25 hper month in January through April (month 1–4) and a lower demand equal to halfof the peak demand (i.e., 15.625 h per month) exists from May through December(month 5–12). The demand profile is shown in Figure 1. Furthermore, suppose the


unit purchased sufficient technology, which cost $11,725 per month, to meet the peakdemand and that it would cost half this amount to meet the lower demand. Thisdecision will result in unused capacity during the lower demand portion of the year.

Unused Capacity

1 4 12 Month

15.625

31.25

Demand (h)per month

$11 725 per month

$5 863 per month

Figure 1: Example of peak-load capacity.

Kaplan and Anderson (2007) suggest that the capacity cost rate during the peak timeshould account for the resources used during the peak period and those not usedduring the non-peak period. In the above example, the capacity cost rate during thepeak time would be:



=$11, 725 per month · 4 months+ $5, 863 per month · 8 months

125 h= $750.43 per h .

(3)

The capacity cost rate for the lower demand period should only include the capacityrequired in the period:



=$5, 863 per month · 8 months

125 h= $375.23 per h .

(4)


These capacity cost rates reflect that it costs more to provide the required resourcesduring the peak demand time and less to provide the required resources during theremainder of the year.

3 Allocating Costs to Capabilities

TDABC has been applied within a variety of domains, including electronics (Stoutand Propri 2011), healthcare (Demeere et al. 2009, Kaplan and Porter 2011), librarysciences (Pernot et al. 2007), and tourism (Dalci et al. 2010) with no modificationof its basic components. However, since the CAF does not perform activities, orcreate products, in a business sense, the components of TDABC must be interpretedwithin a defence context. Table 3 lists the high-level TDABC components and theirinterpretation within the capability costing problem.

Table 3: TDABC components and their interpretation within capability costing.TDABC component interpretation

Standard Capability costing Explanation

Organization Force structure An organization (e.g., the military unit in Section 2.1) is replaced by a force structure (e.g., fleet of aircraft, ships, vehicles), since force structures are the entities that produce capabilities. In this interpretation, a force structure includes all components (i.e., personnel, in-frastructure, equipment, etc.), both direct and indirect, required to produce its associated capabilities.

Activity Capability An organization’s activities are replaced with capabili-ties, since capabilities are the products of force struc-tures.

Activity cost Capability cost An activity’s annual cost is replaced with a capability’s annual cost.

As noted in the introduction, a capability (see footnote 1) is delivered by an appro-priate combination of Personnel / Leadership / Individual training, Research andDevelopment / Operational Research, Infrastructure, Environment and Organization,Concepts, Doctrine, Collective Training, Information Management & Technology& Equipment Support (Rempel 2010). Since force structures provide capabilitiesand each includes all components, both direct and indirect, required to produce itsassociated capabilities, an operational capability can be fully defined by its associatedforce structures11.11 Some capabilities, such as Search and Rescue, may be provided by force structures or organizationsthat are not themselves part of the DND/CAF. For example, the Civil Air Search and Rescue


Association is a volunteer organization funded by DND to provide, in part, air search assistance and thus contributes to the Search and Rescue capability. In this type of situation, these entities may be considered as force structures for the purposes of capability costing.

offensive air capability so that it may be used when required; however, this capabilitymay never be used within an operation. Thus, using training to attribute forcestructures’ EAC to capabilities ensures that the cost of a capability is not dependentupon the decision to employ a capability, rather the investment decision to have theoption to employ a capability.

In general terms, there are three type of training: initial cadre training (i.e., baselinetraining, common training), readiness training, and operation-specific training. Sinceinitial cadre training is non-capability specific and operation-specific training is de-pendent upon capability employment, readiness training (i.e., training for specificcapabilities) is the type of training that is most appropriate to attribute a forcestructure’s EAC to capabilities. Thus, a force structure’s capacity cost rate andcapabilities’ capacity usage are defined as follows.

• Force structure capacity cost rate

� Cost of capacity: A force structure’s cost of capacity is its EAC, includinghistorical cost, betterments, operating costs, etc., less the EAC of readinesstraining that the force structure performs. The readiness training costsshould be directly assigned to the appropriate capabilities being trainedfor. This is measured in dollars.

� Practical capacity of resources: Force structures are planned based onan annual usage (e.g., yearly flying rate for aircraft, sea-days for ships).For example, suppose a force structure’s yearly planned practical capacityis represented by the sum of the areas of the rectangles in Figure 3, wherethe area of each individual rectangle represents a proportion of the totalcapacity and the rectangle’s colour represents it purpose (i.e., red is training,yellow is operations, blue is other). The proportion of capacity used forreadiness training is the practical capacity of interest. This is measured inhours.

Initial cadretraining

Readinesstraining

Operation-specifictraining

Operations

Other

Figure 3: Example breakdown of a force structure’s planned practical capacity.


• Capability capacity usage: A capability’s capacity usage of a force structure’sreadiness training capacity is the number of readiness training hours performedin a given year for the capability. These training hours may be split into differentreadiness levels (e.g., low, medium, high).

Given these definitions, and the required data, the yearly cost to be able to providea capability can be calculated. The next section presents several examples of howthese calculations are performed, taking into account the practical issues discussed inSection 2.

4 Examples

In this section we present five examples that demonstrate how TDABC is used tocalculate a capability’s cost. The examples range from basic, which do not requirehandling of any practical issues discussed in Section 2, to more complex that takeinto account several practical issues. In addition, the examples presented use generic,rather than specific, force structures, so that the examples are applicable to the widestaudience.

4.1 Basic force structure

Suppose a force structure f that has 15 units, a per-unit total planned capacity of 500 hper year (total force structure capacity 7,500 h per year), and a total readiness trainingcapacity of 2,000 h per year. Suppose the EAC of the fleet is $150 M (i.e., life-cyclecost of $4.5 billion over 30 years), excluding readiness training costs. The capacitycost rate, using a departmental view, is:

Capacity cost rate =$150 M2, 000 h

= $75, 000/h . (6)

Suppose f produces two capabilities, labelled Capability 1 and 2, that have costs c1and c2 respectively. The force structure f conducts 750 h per year (h1) of readinesstraining (r1) for Capability 1 and conducts 1250 h per year (h2) of readiness training(r2) for Capability 2. The annual cost of readiness training r1 is $0.5 M and r2 is$5 M. The cost of each capability is given as:

c1 = $0.5 M + h1 ·$75, 000

h

c2 = $5 M + h2 ·$75, 000

h,

(7)


Suppose if only the combination of components required by Capability 1 were acquired,the force structure’s capacity cost rate would be $50,000. Likewise, if the combinationof components required by Capability 2 were acquired, suppose the capacity cost ratewould be $75,000 (as in the previous example). The relationship between capacitycost rate and capacity usage in this situation is shown in Figure 6.

0 500 1,000 1,500 2,0000

2

4

6

8

·104

r1

∑i r2,i

Unused

Capacity usage (h)

Cap

acity

cost

rate

($pe

rh)

Figure 6: Example 3 – Relationship between capacity cost rate and capacity usagewhen there is demand for different resources.

The demand for different resources in the above figure i s s imilar to the concept of peak-load capacity described in Section 2.3.3.2; that is, given the force structure f has been acquired to provide Capability 1 and 2, the capacity cost rate associated with Capability 2 should account for the unused capacity associated with Capa-bility 1. The capacity cost rates for f1 and f2 are then as follows.

Capacity cost rate f1 =$50, 000/h · 750 h

750 h= $50, 000/h

Capacity cost rate f2 =$75, 000/h · 1250 h+ $25, 000/h · 750 h

1250 h= $90, 000 h .

(9)

Given these capacity cost rates, and assuming the same annual readiness trainingcosts as in the previous example, the cost of Capability 1 and 2 are calculated as


follows and are shown in Figure 7.

from 1000 h to 500 h, and the difference will be used to perform readiness trainingfor Capability 3. The cost of conducting 500 h of high-level readiness training forCapability 2 is $2.5 M and the cost of conducting readiness training for Capability 3is $4 M.

Similar to the previous example, suppose if only the combinations of components toprovide the capabilities were acquired, then the capacity cost rates would be:

• If only the combination of components required to provide Capability 1 wereacquired, the capacity cost rate for f1 would be $50,000 per h.

• If only the combination of components required to provide Capability 2 wereacquired, the capacity cost rate for f2 would be $75,000 per h (e.g., Capability 2requires specialized radar and munitions not required by Capability 1).

• If only the combination of components required to provide Capability 3 wereacquired, the capacity cost rate f3 would be $80,000 per h (e.g., Capability 3 re-quires the specialized radar and munitions, plus additional software not requiredby Capability 1 or 2).

Similar to Figure 6, the relationship between the capacity cost rates and capacityusage is shown in Figure 8.

0 500 1,000 1,500 2,0000

0.2

0.4

0.6

0.8

1·105

r1

∑i r2,i

r3

Unused

Capacity usage (h)

Cap

acity

cost

rate

($pe

rh)

Figure 8: Example 4 – relationship between capacity cost rate and capacity usagewhen there is demand for multiple different resources.

As in the previous example, the unused force structure capacity associated withCapability 1 and 2 should be accounted for. Three approaches are possible: first,


assign the unused capacity to the capability with the next highest capacity cost rate(i.e., unused capacity in Capability 1 is assigned to Capability 2, unused capacityin Capability 2 is assigned to Capability 3); second, assign a portion of the unusedcapacity to the capability with the next highest capacity cost rate, where the portionis determined by the capacity usage; third, all unused capacity is assigned to theCapability with no unused capacity. The second option is preferred since a portionof the unused capacity in Capability 1 is used in Capability 2 and Capability 3 andlikewise a portion in Capability 2 is used in Capability 3. The capacity cost rates forf1, f2, and f3 are then as follows.


750 h= $50, 000/h


750 h

+$25, 000/h · 750 h+ 750 h

750 h+500 h

500 h= $90, 000/h


500 h

+$25, 000/h · 750 h+ 500 h

750 h+500 h

500 h

+$5, 000/h · 1, 500 h

500 h= $110, 000/h .

(11)

The cost of capabilities are calculated as follows and are shown in Figure 9.

c1 = $0.5 M + h1 ·$50, 000

h

c2 =2∑

i=1

(βi + h2,i ·

$90, 000

h

)

c3 = $4 M+ h3 ·$110, 000

h.

(12)

The cost of Capability 1 is unchanged as compared to the previous example; however,the cost of Capability 2 has decreased from $112.5 M to $72 M and the cost ofCapability 3 is $59 M. The total cost of the three capabilities is $169 M, of which$160 M is the force structures’ EAC (less readiness training) and $9 M is readinesstraining. The increase in the former, from $150 M to $160 M, is due to the additionalkit required to provide Capability 3.


training for two capabilities with a total training time per year of 500 h and a total costper year of $10 M. Furthermore, suppose if the readiness training for each capabilitywas conducted separately then they would require 600 h and 250 h respectively. Thereadiness training hours can be attributed to the capabilities as follows:

Capabiity 1 readiness training hours =600

600 + 250× 500 = 353 h (13)

Capabiity 2 readiness training hours =250

600 + 250× 500 = 147 h . (14)

The cost of the readiness training for each capability can be attributed in a similarmanner, however the 500 h in the above equations is replaced with $10 M. It is theseattributed readiness training hours and costs that should be used to calculate eachcapability’s cost.

Suppose that a force structure’s capacity is used simultaneously for operations andreadiness training. For example, a ship on its way to an operation may conduct itsrequired readiness training prior to arrival. In this case, the cost of readiness trainingused in the capability cost calculations is the cost if the operations did not occur.

5 Discussion

In this section we present a discussion of implementation issues, data requirements,and how the output of this approach may be used within capability-based planning toinform resource allocation decisions.

5.1 Accuracy, not precision

The objective of the approach described in this report is to calculate a capability’sstrategic cost—that is, the calculated cost must be accurate, but does not have tobe precise. It is sufficient, for the purposes of strategic decision-making, to know acapability’s cost to the first digit, to be close on the second, and follow with zerosthereafter. As a result, ‘lite’ measurement techniques, as opposed to those commonlyused in industrial engineering (Konz 2007), may be used to estimate the time requiredto perform activities. These ‘lite’ techniques include:

• direct observation;

• accumulating the time required to perform an activity several times and thencalculate the average time;


• interviewing or surveying employees;

• utilize existing process maps; and

• leverage time estimates from other areas within the organization or similarorganizations.

5.2 Simplified approach

Kaplan and Anderson (2007) suggest that a simplified approach to attributing aforce structure’s cost to capabilities is to base the attributions on the proportion ofactual time used to conduct readiness training for the capabilities. This simplificationskips the estimation of practical capacity and cost rates. A capability’s cost is thencalculated as,

Capability cost =∑

Forcestructures

Training timeTotal time

· Force structure EAC (15)

where training time is the time that a given force structure trains for the capabilityof interest, total time is the cumulative training time the force structure performstraining for all capabilities, and the force structure’s EAC includes readiness trainingcosts.

Kaplan and Anderson (2007) identified three reasons why this approach may be used.In terms of capability costing, they are as follows.

1. Once the force structure’s EAC and estimates of how much time was used totrain for the activities are known, the capability costs can be computed withoutestimating the practical capacity or capacity cost rate of each force structure.

2. Decision-makers, in particular those in financial positions, may value having allcosts assigned to capabilities.

3. Since there is no unused capacity costs, there are no questions about how to assignthem.

Although this approach is simpler, it does have three drawbacks. First, since it skipsthe estimation of practical capacity, it does not signal when the CAF are under or overcapacity. Second, capability costs will be inflated if the CAF have unused capacity.Third, readiness training costs are not directly assigned to the capabilities’ costs, andthus may be attributed incorrectly. Thus, there is a trade-off to be made—betweensimplicity and accuracy.


5.3 Time equations

Variability in how an activity is performed leads to variability in the activity’s resourcedemands. Although describing activities at this more granular level increases thecomplexity of the model, it is important because, otherwise, the model will fail tocapture the differences between different variations in an activity.

When developing time equations, Kaplan and Anderson (2007) suggest the followingsequence:

1. Start where the most time is spent and cost is incurred, since accurate modellingof these processes will have the largest potential impact on the organization. Forexample, the most timely and costly process in Table 2 is ‘Activity A ComplexFormat’.

2. Define the scope of the activity. Be clear about where an activity is initiated andconcludes. For example, the main component of ‘Activity A Complex Format’may be converting information into a simple format, but the activity may alsoinclude transferring information from its owner and validating the information afterconversion.

3. For each activity, identify the most significant factor that affect resource con-sumption. For example, for the ‘Activity A Complex Format’ activity the mostsignificant factor may be the size of the information.

4. If possible, use existing data rather than installing new data-collection technologies.However, if key activities that consume a large percentage of total cost have datagaps, then it may be justified to invest in new data-collection systems.

5. Start simple and add more accuracy if required.

6. Engage operational personnel to help build and validate the model. The model isonly as good as the organization perceives it to be.

5.4 Data requirements

A large amount of data is required to fully implement this approach for all operationalcapabilities in the DND/CAF. Currently, elements of the required data may not existwithin the DND/CAF or if they do exist they may be incomplete, inconsistent, orinaccurate. Thus, prior to implementing this approach the quality of the data usedmust be assessed.

Although it is beyond the scope of this report to identify the complete list of sources(i.e., databases, strategic plans, etc.) that may be used when implementing thisapproach, each required data sets can be described in high-level terms. These data


sets may be clustered into two groups, force structure related and capability related,and described as follows.

• Force structure related� Set of force structures: A set of force structures, such as those identified

by the Strategic Costing Model (Chouinard and Wood 2007, Solomon et al.2008) or those identified by CBP. These are the CAF resources that providethe capabilities.

� Force structure EAC: The total EAC of each force structure, as com-puted by the Strategic Costing Model, less the EAC of the readiness trainingthe force structure conducts.

� Force structure practical capacity: The force structure planned capac-ity to conducting readiness training. This information may be extractedfrom the force structures’ strategic planning documents.

� Force structure readiness: The set of readiness levels that each forcestructure provides for each capability. In addition, the planned numberof hours of training for each readiness level and the associated cost. Thisinformation may be extracted from sources such as strategic planningdocuments and the Force Posture & Readiness Directive (e.g., Force Posture& Readiness Directive, Annex C, Appendix 2). In addition, it is anticipatedthat an output from the the Defence Renewal Initiatives (Department ofNational Defence and Canadian Armed Forces 2013) will be the developmentof a Force Posture & Readiness cost model. Although the model has yetto be developed, it output may be used to estimate the cost of readinesstraining activities.

• Capability related� Capability taxonomy: A taxonomy of capabilities, such as those iden-

tified in CBP. The tier within the taxonomy to be costed should be thatwhich is analyzed in CBP for importance and affluence/deficiency.

� Capability-to-force structure mapping: A mapping of which forcestructures provide which capabilities. This information is captured withinthe CBP process.

5.5 Usage in capability-based planning

CBP creates a large amount of data that is often difficult for decision-makers tocomprehend. However, existing statistical techniques may be used to summarizethe data to help decision-makers overcome this issue. For example, Rempel (2014)describes how dimensionality reduction and partition clustering can be applied to CBPdata to create visualizations that convey how important capabilities are in planning


scenarios and how much operational capacity the planned force structures have toprovide the capabilities. An example visualization is shown in Figure 10, where eachblue circle represents a capability. Capabilities in the lower left are those that havelow operational capacity and a low importance, whereas those in the upper right havea high operational capacity and a high importance across the planning scenarios.

Divestment

Divestment Investment

Low to high importanceLow

tohi

ghpl

anne

dop

erat

iona

lcap

acity

Figure 10: Capability costing usage within capability-based planning.

The output of the capability costing method described in this report can be combinedwith information in the above figure. For example, Figure 11 shows the same informa-tion as Figure 10, and in addition uses the area of the circles to encode the capabilities’cost such that higher cost capabilities have larger circles. The example shows thatthe capabilities on the left (low importance and low/medium operational capacity)have a relative high cost as compared to the other capabilities. These capabilitiesmay be candidates for divestment and have their resources diverted to higher prioritycapabilities (e.g., those on the right side of the figure with high importance and lowto medium operational capacity). Thus, combining this information together enablesdecision-makers to make evidence-based resource allocation decisions at the capabilitylevel.

6 Summary

In this scientific report we presented a novel approach, based on TDABC to calculatethe cost of a capability. The approach attributes a force structure’s cost to thecapabilities it provides based on the amount of readiness training the force structureconducts for the capabilities. The cost of a capability is then the sum of the attributedcosts plus the cost of its associated readiness training. We presented five examplesthat highlight unique aspects of force structures, and showed how these aspects may


Divestment

Divestment Investment

Low to high importanceLow

tohi

ghpl

anne

dop

erat

iona

lcap

acity

Figure 11: Capability importance and operational capacity.

be accounted for within the approach. Lastly, we discussed several implementationissues, data requirements, and how the output of this approach may be combined withinformation from CBP to create simple visualizations to support resource allocationdecisions.

The approach presented may be considered as in the concept development phaseand is currently not used within the DND/CAF. Given this approaches potential toenhance evidence-based decision-making within the DND/CAF, the following researchactivities are recommended.

Exploratory trial: An exploratory trial should be conducted to demonstrate howthe approach in this report may be executed. First, it should be determined if therequired data exists within the DND/CAF and its quality. If the data exists, a smallnumber of capabilities from the current CBP capability taxonomy should be selectedand their costs computed. If the data does not exist or some of its components aremissing, subject matter experts within the force development community should beconsulted to develop a fictional, yet realistic, data set for a small number of capabilitiesand their costs should be computed using this fictional data.

Data collection: If the exploratory trial determines that the CBP process does notgenerate the required data (i.e., set of defined force structures, capability-to-forcestructure mapping, etc.) to calculate a capability’s cost, then the required changes tothe CBP process to provide the required data should be investigated. In addition, ifother required data, such as readiness training hours and cost, are identified to be notcurrently available, then it should be determined how this data can be measured orestimated. Lastly, since the capability taxonomy used in the CBP process has beensignificantly modified each time the process has been executed, it is recommended


that a single capability taxonomy be used across multiple cycles. This will enable acapability’s cost to be analyzed across time, as well as the CBP results themselves tobe compared across iterations.

Visual analytics: A decision-support system, based on visual analytics, shouldbe developed to help decision-makers gain insights into the linkages between forcestructures, capabilities, and the capabilities’ costs. For example, by combining visual-ization techniques such as treemaps, hierarchical edge bundling diagrams, and sankeydiagrams through multiple coordinated views, decision-maker will be able to efficientlyexplore these linkages and gain insight into capabilities that may require investment ordivestment. This system will enable decision-makers to better understand the impactof these decisions from a capability and force structure perspective.

The work associated with each of these recommendations is non-trivial. However,implementation of each is expected to significantly enhance CBP, defence invest-ment planning, and in general promote evidence-based decision-making across theDND/CAF.


References

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Dalci, I., Tanis, V., and Kosan, L. (2010), Customer profitability analysis withtime-driven activity-based costing: a case study in a hotel, International Journal ofContemporary Hospitality Management, 22(5), 609–637.

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List of abbreviations

CBP Capability-Based Planning

CAF Canadian Armed Forces

DND Department of National Defence

EAC Equivalent Annual Cost

SAR Search and Rescue

TDABC Time-Driven Activity-Based Costing


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A time-driven approach to capability costing

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We present a novel method for calculating the cost of a military operational capability. First, aforce structure’s cost is separated into two categories: (1) the equivalent annual cost of performingreadiness training for each capability it provides; and (2) the force structure’s remaining equivalentannual cost. The first category’s costs are directly assigned to their respective capabilities. Usingtime-driven activity-based costing, the second category’s costs are attributed to the capabilities itprovides based on how many hours the force structure spends conducting readiness training foreach capability. The cost of a capability is the sum of the equivalent annual costs of performingreadiness training and the attributed force structures’ costs. We present five examples thathighlight unique aspects of force structures, and show how these aspects are accounted for withinthe method. Lastly, we discuss several implementation issues, data requirements, and how theoutput of this approach may be used within capability-based planning to inform resource allocationdecisions.

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Time-driven activity-based costingCapability-based planningCapability costingStrategic planning

Nous présentons une méthode de calcul novatrice permettant de déterminer le coûtd’une capacité militaire. À laide de la comptabilité par activités en fonction du temps, lescoûts d’une structure de forces sont attribués aux capacités que celle-ci o˙re en fonctiondu nombre d’heures qu’elle investit dans l’instruction en disponibilité opérationnelle pourchaque capacité. Le coût d’une capacité est la somme des coûts attribués et de ceux del’instruction en disponibilité opérationnelle. Nous présentons cinq exemples qui mettent enévidence les aspects particuliers de certaines structures de forces et qui expliquentcomment en tenir compte dans la méthode de calcul. Finalement, nous soulevonsplusieurs questions relatives àà la mise en œuvre, précisons les besoins en matière dedonnées, et expliquons comment les résultats de cette approche peuvent éclairer lesdécisions quant à l’attribution de ressources dans le cadre de la planification axée surles capacités.

A time-driven approach to capability costingcradpdf.drdc-rddc.gc.ca/PDFS/unc201/p802618_A1b.pdf ·...

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Transcript of A time-driven approach to capability costingcradpdf.drdc-rddc.gc.ca/PDFS/unc201/p802618_A1b.pdf ·...