In Earlier articles John McKenzie, FSN contributing editor has highlighted the shortcomings of traditional measures of cost allocation and how these can give a false impression of product and service profitability or the true worth of sales delivery and distribution channels. In this article John extends the thinking to the budgeting process. He explains how an Activity Based Budget (ABB), based on the true drivers of cost in the organisation combined with levels of activity can quickly highlight the deficiencies of a traditional budget based on a chart of accounts and arbitrary cost centres.
In order to understand the value of activity based budgeting, it is worth considering a couple of basic truths which stare us in the face yet we have somehow either ignored or forgotten. Firstly, the overwhelming majority of organizations have been developed on functional lines with a typically hierarchical structure. Accountants have reinforced this view of life through the chart of accounts with its line item recording of costs and the budgetary process and reporting mechanisms which align these costs into cost centres that mirror the corporate functional structure. Yet do we stop and consider what a function represents?
A function is nothing more than a management construction whereby we organise employees of a similar skill set into groups to undertake tasks of a particular character. This makes for ease of management with regard to pay, discipline and assessment but in no way reflects the way work actually happens. People do not work in functions , they are merely managed within them. People work in processes or workflows that enable certain deliverables to be achieved and these processes are inevitably multi-functional.
Consider the diagram above. We have aligned our traditional cost and budgetary view on a vertical alignment whereas work is undertaken (and hence cost incurred) along a horizontal axis and in so doing we have not only lost sight of the true picture of cost performance but we have arguably achieved only the illusion of control! Now turning to the diagram below we can see a typical process of order fulfilment – a workflow that begins with the acceptance of a customers order and ends with the order satisfied and payment in the bank.
This workflow is repetitive, taking place each time an order has to be processed and we can see multiple functions executing the process. Our traditional cost alignment takes a snapshot of vertical slices along the way, each slice managed by a cost centre manager whose responsibilities and objectives lie within the function. Two questions must be asked. 1) Who has overall responsibility for the effectiveness and efficiency of this process, and 2) how do we know it its working as well as it should? To the first we can only say no-one and to the second, we don't!
A second basic truth we should face is that our accounting and reporting processes concentrate almost exclusively on financial measures such as the balance sheet, profit and loss account, traditional budgetary analysis by cost centre and line item of costs with an associated rate and volume variance analysis etc. Yet what do these really tell us from a management perspective? Financial measures, by their nature are outcomes..... the end of a chain of events for a given period of time. They give management little or no insight as to how those outcomes were driven or achieved and consequently only a limited understanding of how to do better.
Activity Based Budgeting addresses these basic truths. As we have seen in earlier articles, with ABC/M, we cost each of the activities undertaken by the enterprise and identify the drivers involved. For example, let's say we have assessed the cost of "chasing customers for late payment" as £350,000 and that the driver for this activity is the number of unpaid invoices we had to chase and these totalled 3500. Then our driver volume is 3500 and the driver unit cost is £100 (£350,000/3500). With ABB resources are linked to the level of activity undertaken and the efficiency with which it is performed. ABB uses the driver volume of major activity drivers as the basis of forecast activity levels and efficiency improvement is measured and forecast as a reduction in the Unit Driver Costs . Furthermore, ABB captures multiple functional inputs to both individual activities and to a workflow.
In the above case we have 3 functions contributing inputs to various activities in a process and in the case of one activity (say, chasing customers for late payment) all three are contributing. At the top level of an ABB we would find something like this....
Taking the driver "# of Overdue Invoices" which drives customer debt chasing, the £350,000 incurred will have come from different functions. £200,000 may have come from A/c Receivable along with £60,000 from sales where sales staffs have had to get involved in debt recovery along with £40,000 from Legal where matters have reached this stage. We see an adverse variance of £11.14 on the driver unit cost. Clearly this type of variance has much more meaning that those within a traditional budget where, for example, sales might be criticised for being £60,000 over budget and a volume variance highlights simply that there is one head over budgeted levels. With ABB, we highlight that sales is having to waste resources on debt chasing and that the excess head is required to fill the gap caused by loss of productive selling time within the sales team who still have sales targets to meet. Rather than being critical of sales, perhaps we should turn to credit control and screening as the possible root cause.
We also can now gain a true picture of efficiency of the use of resources and how well they are being managed. Consider the scenario below for the accounts receivable function.
On a traditional budgetary basis, we would have considered that A/c Receivable had performed well against budget coming in 10% below planned expenses. Declining work volumes would not be recognised as we do not know the activities undertaken, the activity costs or the causal drivers. With ABB however, we can see that driver volumes have fallen against forecasts which would result in declining workloads. The actual volumes for each driver have been factored in to give a view of what actual resources were required during the budgetary period. As opposed to the traditional view which suggested a 10% favourable performance, ABB is indicating quite the reverse – a 10% adverse variance. This example has obviously been kept simple for illustrative purposes and costs assumed to be fully variable. But in reality, the same patterns emerge time and time again where companies have switched to ABB and made comparisons on a traditional basis.
The preparation of an ABB is in most respects no more arduous than any other – indeed, many proponents of ABB say that their budgetary process is much shorter and less consumptive of resources as it is much easier to get it "right first time" without multiple iterations. Forecasting requires more thought as an ABB cannot be prepared based on high level business assumptions of volume etc. Forecasting has to be performed at the driver level but this is a good thing as it ties the budget much more closely to the business plans requiring an explanation, for example, of just where and how that magical "10% increased volume forecast" for next year is coming from...... how many customers, how many orders, how many invoices, how many debts to chase, how many deliveries, etc etc. The imposed rigour this imparts to the process improves forecast accuracy and the transparency of how costs are built up and justified leads to less opportunity for management to "sandbag" their costs.
In the next article, we explore the application of ABC/M to process re-engineering and the quest to add and create value.
