In traditional accounting a business reports the use of resources and may split these simply into direct costs and overheads. However, in the overhead departments there exists a large diversity of costs. The conventional categorisation of such activities obscures the rich diversity of tasks being undertaken in a business to serve many purposes. In the third of his series of articles for FSN, Brian Plowman, Develin & Partners suggests a fresh approach to looking at costs in a business, with a view to much better informed management decision making.
In his next article for FSN, Brian Plowman takes a look at the dilemma posed by operating in functional hierarchies when business processes work across the organisation.
In the accounts these costs are lumped together as business overheads and shown under Cost Centres (ie departments & functions) and expensed under headings such as ‘salaries’, ‘consumables’, utilities’ and so forth. However, ABM categorises these costs in a quite different manner.
The conventional and simple categorisation of such activities obscures the rich diversity of tasks being undertaken in a business to serve many purposes. Where a company allocates all its costs to products and customers (full absorption costing) it loses the real relationship between cost drivers and those costs that are influenced by the drivers. It also loses the visibility of the difference between the current business that is generating income and the real contribution that can be used to develop the future business. Full absorption costing destroys the ability to make meaningful relative judgements of product and customer profitability.
In ABM, the diverse costs and activities are categorised so that management can understand what is happening inside the business and how the costs are driven. There are certain key activities that are being performed that are defined as Frontline. A frontline activity is one that has something to do with producing the primary product or service and any activities that interface with customers. Frontline activities have a direct cause-and-effect relationship to products and customers through cost drivers. This relationship may be a simple one based on, say, production hours to produce a product or number of invoices processed for each customer. They are current costs paid for by the revenue from current products and services for current customers. If more volume of the cost driver is forecast then more resource will be required. However, changing the methods used can change the unit cost of doing the work.
There are other costs and activities that exist because the organisation is a legal entity and must fulfil specific tasks. The annual audit and financial reporting would fall into this category. Such costs are largely independent of the product or service being provided. They are the costs of being in business. They are referred to as Legal Entity costs. These costs and activities have no direct relationship to current or future products and services. The level of costs is unlikely to change with throughput volumes or number of customers. However, the actual costs can change if the method changes or a service is obtained at a lower rate. For example, the auditors can be changed to reduce the level of fees charged.
In most organisations, doing nothing to develop future products and services will guarantee the demise of the business. Organisations need to have funds to pay for the current costs of the people doing, say, new product development, but the benefits are expected to be derived in the future. The current product throughputs or current customers do not directly influence these activities. These activities are called Sustaining and they are essentially an investment to achieve a return in the future. An organisation has a choice over the level of Sustaining costs it wants to have. A reduction in Sustaining costs would transfer directly to the bottom line, but it would risk the future of the business. Companies invest in Sustaining costs so they make a higher return in the future. It could be argued that Sustaining costs should be made specifically visible to shareholders as they are investments in the business made out of retained profits that could have been distributed.
The final category is called Internal Service. Typically, training, recruitment, current use of IT networks and the like are an internal service to all the other departments in the organisation. There are no direct relationships to current products and customers other than through the frontline activities that are supported. The key here is to understand and then assign the internal service costs and activities based on the demand for them from all the other areas of the business that are supported.
Given the four categories of costs and activities the costs can be structured in an ABM model in a way that is far more meaningful way than using conventional accounting categories and thus aid decision-making.
Having analysed the activities in an organisation, the first task is to re-assign the Internal Service costs and activities to those of Frontline, Legal Entity and Infrastructure. This uplifts the Frontline costs and links the cost drivers to the Internal Service costs. One can imagine a need for more frontline staff in say the invoicing department requiring an increase in the training department to train more invoice clerks. The link may be the number of people trained per annum, which would be the cost driver volume.
The uplifted frontline activities are assigned to the products and customers. The ABM Contributions are the revenue less the uplifted Frontline costs, either at customer or product level. It is at this point that it is meaningful to compare ABM Contributions for each product and for each customer. This is what Product and Customer Profitability means in ABM.
The total ABM Customer Contribution has to pay for the Legal Entity costs. After that, any amount that is left has to pay for any Sustaining costs and activities the company has determined it needs to secure its future. Increasing Sustaining costs reduces profit to shareholders. That the shareholders believe that leaving the money in the business to grow the future is better than extracting large dividends is the acid test of management’s decision to spend on Sustaining activities.
The four ABM categories of cost are not shown in the accounts. However, these categories better identify the nature of the decisions that management is called upon to make. It also focuses Management on two clear objectives. Firstly, to ensure that cost effective methods are used to produce current products to current customers at a price that generates the maximum positive ABM Product and Customer Contributions. Secondly, to ensure that the ABM Contributions are used effectively to generate new products and services to new markets such that the return on the investment in Sustaining costs is greater than that which would be achieved by shareholders investing elsewhere.
