Printer Friendly

Strength in numbers: ABC integrated with activity-based planning and budgeting can create major benefits for a whole organization. (Management Trends).

Activity-based costing (ABC) has been around for a long time. Originally conceived in the 1980s as a better way to allocate indirect costs in manufacturing companies, it has evolved in a variety of ways. Today, plain vanilla ABC still has a lot to offer, but it's demonstrating its value in leading-edge organizations as one element in broader management systems.

How plain-vanilla ABC pays off

Implementing a basic ABC system, even with none of the enhancements described later in this article, can still yield major benefits for an organization. They include the following:

Pricing. More accurate product costing can lead to more competitive pricing, especially for those high-volume products that were soaking up too much overhead cost with traditional costing.

Product profitability. At the same time, you can identify the 20% of your products and services that provide 80% of your profits as well as the products that are dragging down your profits by losing money. Some companies have found this effective for as much as 40% of their product line.

Client profitability. The same kind of analysis can be applied to your customer base. The 80/20 rule applies to customer profitability as well. Identifying the winners and losers here can help you make sure your profitable customers stay satisfied. It can also help you decide what to do with unprofitable customers -- eliminate them or change how you deal with them.

Process cost. The first report on costs per activity that comes out of an ABC system almost always elicits comments like, "I didn't know it cost us that much to do that!" The manager who says this is making an intuitive judgment that the value added by the activity is out of line with what it costs. Of course, there are more formal approaches to value analysis, but the bottom line will be a number of cost-reduction initiatives.

Poor Quality. Knowing costs per activity also allows us to come up with the cost of poor quality. These are the costs that arise when our quality standards aren't met and include inspection, re-work, billing and payable errors, handling complaints and warranty costs. Making these costs visible is the first step towards attacking them and bringing them down.

BPR. A related benefit comes from using activity costs in a continuous improvement project or in the introduction of business process changes (for example, automating clerical activities). In fact, one cause of the failure of many business process redesign (BPR) projects is undoubtedly the lack of activity and process cost information.

Benchmarking. Where the same activities are performed in multiple departments, regions or divisions of the organization, these activity costs can be benchmarked against each other to identify best practices and make them standard practices. This internal benchmarking can also be extended outside the company, by using benchmarking services. Again, the result can be significant cost reductions.

In the course of an ABC implementation, some of these benefits can be quick hits. For example, the activity modeling process often turns up duplication of activities between departments.

Moving it up a notch: activity-based planning and budgeting

Many organizations have found that, in addition to the impressive list of benefits that can be obtained with ABC, the activity model can provide a dynamic new approach to planning and budgeting. Once the activity model with its relationships between resources, activities and cost objects is set up, the process can be turned around. Instead of allocating the actual cost of resources to activities and then to cost objects, the process can start by looking at each of the cost objects (products and/or services).

In the first wave of ABC implementations, organizations reversed the flow to estimate their budget requirements by simply taking the unit costs as calculated by the ABC application and adjusting the driver quantities to reflect the forecasted business volumes. This approach was often referred to as the hack calculation method. Although it served its purpose, practitioners soon realized its limits. This method assumed that the current business processes were efficient and cost effective, and that the resource capacity was fully used without under or over use. If these assumptions were wrong, the back calculation would only build into the budget the inefficiencies and the unused capacity.

One of the failings of ABC in the past has been its restrictive use in costing. What the vendors and the practitioners failed to do was to develop its use as an active management tool. Software vendors have since responded to this and are developing software that can do both ABC and ABP/B.

For each cost object, we ask the question, "What activities have to be performed to make one of these?" Once we have identified the activities, the next step is to determine the required resources to conduct each of these activities once. We call this the unit level of effort when it addresses human resources, or the consumption rate in all other cases. In a sense, we are writing the recipe for each type of output -- but at the activity level. In a manufacturing environment, this probably already exists for the direct costs in the form of bills for material, but activity-based budgeting extends this concept beyond the factory floor to the support areas like finance, personnel and informatics.

Once all of the recipes are in place, the key personnel of the organization are brought together so that the expected business volumes for each cost object for the planning period can be forecast. This demand forecast for each output is multiplied by the unit levels of effort for each product or service to give the total resource requirements, both in quantities and in dollars.

ABC is a process of pushing actual resource costs to activities and then from activities to cost objects. In activity-based planning and budgeting (ABP/B), the budgeted cost of resources are pulled back through the model by using the forecasted demand for the cost objects and the recipes to calculate the total amount of work to be done at the level of each activity. ABC practitioners often talk about push models and pull models.

Capacity decisions

ABP/B is a powerful tool for budgeting, because a number of "what if" scenarios can be run to evaluate the impact that different levels of demand will have on materials, salary costs and overhead. The information it produces provides extremely good insights when making capacity-constraint decisions. Besides simulating the impact on direct resources, a well-designed model linking all components of the organization will allow the management team to recognize the effect of their decisions throughout the organization.

ABP/B can extend the concept of capacity management from the factory floor to the support areas and to the service sector in general. When the salary cost of providing a service is seen as an essentially fixed cost, the ABB model can be used to compare the current level of staffing to the resources required to meet the demand forecast. This can show where excess capacity exists and where additional resources are needed.

Performance targets

Putting together these calculations allows a critical view of how the products and services are produced so that processes can be improved and attainable performance targets set rather than just relying on historical data.

Target costing

There are other valuable spinoffs from ABP/B. For instance, when a new product is being developed, the budgeted activity costs can be used as part of a target costing exercise, where a market-determined selling price and a desired profit margin are used to determine a target cost. Knowing costs by activity can be an invaluable tool in bringing planned costs in line with this target cost.

Value chain

Supply chain management and value chain analysis are gaining increasing popularity in the industry sectors that require to-the-market logistics including warehousing and distribution operations. The cost information contained in the ABP/B applications has proven to be invaluable when implementing value chain analysis.

Dynamic ABM

But the most important reason for doing ABP/B is to be able to identify the variances between planned and actual results. Being able to analyse variances at the activity level and take corrective action takes us from a costing system to a system of operational management as shown in the illustration on this page.

As we acquire more experience in activity-based planning and budgeting, organizations are realizing the full power and flexibility of dynamic activity-based management (ABM).

Although this concept is not new to the manufacturing sectors, it is in a service environment. The use of dynamic ABM in service sector operational management will instil in the organization a continuous improvement philosophy and culture. But to get full value from ABC and ABP/B, we need to go to yet another level.

Taking it to the max: performance measurement and the Balanced Scorecard

Measuring performance is an essential part of sound management. Comparing actual to budgeted costs for activities is a key performance measure that ABC and ABP/B can provide. But many of the cost drivers used above to do cost allocations are also useful in calculating other performance measures. For example, the number of service calls, the number of complaints or the number of billing errors could be used as drivers for certain activities. They could also be key metrics in a performance measurement system.

The latest trend in performance measurement is the balanced scorecard (Kaplan and Norton, 1996). Over half of Fortune 1000 companies have already adopted this powerful tool or are in the process of doing so. Whether you are implementing strategic or operational balanced scorecards, they become the rallying point for senior management to get insight on how well the operations are managed, the strategic initiatives implemented and to what point your strategy map is successful. Managing without a balanced scorecard is like flying a plane without an instrument panel.

Balanced scorecards provide a balanced approach to performance measurement, as well as an integrated framework for strategic planning, implementation and performance measurement. They are usually organized around four perspectives: financial, customer, internal business processes, and learning and growth.

ABM feeds the balanced scorecard in many ways. First, it feeds information to its quadrants on how well the organization is doing. Although its major contribution is to the internal business process perspective, it also feeds other concerns.

Financial. The more accurate product and service costing provided by ABC can contribute to the development of new pricing strategies. It can also assist in reducing unit costs, as well as reducing operating expenses.

Customer. ABC can provide important information on customer profitability. This helps keep customer-focused organizations from becoming customer obsessed. ABC can also be used in conjunction with customers who are distributors to identify their most profitable suppliers, especially when the supplier company expects they will show up favourably in this analysis.

Internal business process. ABC facilitates the measurement of process costs. Quality, cycle time measurements and process costs are the three parameters organizations must manage when initiating continuous improvement or business process redesign.

Learning and growth. Accurate and timely cost information on customers, processes and the financial consequences of their decisions are important contributing factors to employee motivation, involvement and effectiveness.

Another way ABM helps in the balanced scorecard is that, when a red signal flashes on a balanced scorecard metric, ABM information can be used to drill down into the information to identify and correct the problem. Without a balanced scorecard, senior management swims in a sea of data or manoeuvres blindly.

Putting it all together

Like a lot of other approaches to costing, ABC started in the manufacturing sector. We have talked about both product and service costs in this article, because more and more service sector organizations are finding that they too can profit from this powerful tool. The application of the concepts may be a little less straightforward than in a manufacturing environment, but the benefits can be just as great, if not greater.

This is also true for the public sector, where cost reduction is an important goal. Unfortunately, many past cost-cutting efforts have used a sword rather than the scalpel that ABC can provide. Also, a number of government organizations are moving to results-based management and the balanced scorecard, and ABC-ABP/B can make an important contribution to these efforts.

The diagram to the left recaps most of what has been discussed here. As you can see, within an integrated management framework, the balanced scorecard is positioned at the strategic management level while the dynamic ABM information addresses operational management. Combined with the other techniques, the balanced scorecard and dynamic ABM provides not only the weapons system to be successful but also the guidance system to manoeuvre in the complex world of business.

Daniel Dubue, FCMA, M.Sc., is the CEO of Synerma Inc. and Michael Tinkler, FCMA. CA, CMC, is the vice-president of knowledge management at Synerma (
COPYRIGHT 2002 Society of Management Accountants of Canada
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2002 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:activity-based costing
Author:Tinkler, Michael; Dube, Daniel
Publication:CMA Management
Article Type:Statistical Data Included
Geographic Code:1CANA
Date:Sep 1, 2002
Previous Article:How to manage problem employees: an appreciation of workplace issues can help diffuse a volatile situation. (Career Intelligence).
Next Article:Restructuring for a new start: debtor in possession financing -- the Canadian spin on an American concept. (Business Strategies).

Related Articles
The ABCs of Competitive Government: The Indianapolis Experience.
Army's Directorate of Logistics Saves $6 Million with Activity Based Costing.
More Complex, More Robust: Activity-based costing systems are harnessing the internet and adding new functionality, giving companies more horsepower...
Performance Based Costing.
Critical issues to address before you embark on an ABC journey.
Aligning costs with revenues: at a time when revenues are unpredictable, closing the gap between operational planning and budgeting is imperative,...
Five keys to deploying activity-based costing.
Activity based costing in healthcare: a UK case study.
Time-Driven activity-based costing.

Terms of use | Privacy policy | Copyright © 2021 Farlex, Inc. | Feedback | For webmasters