Introducing Activity Based Costing (ABC) and Activity Based Management (ABM)
23rd July 2007 Activity Based Costing (ABC) and Activity Based Management (ABM) have been with us for some 15 years and yet, even now, few organisations in the UK (probably only between 10 and 12%) have taken the plunge and embraced these as their primary costing, measurement, budgetary and management control tools. Yet, amongst those who have adopted ABC/M, there is a high degree of satisfaction in terms of the benefits that such an approach has brought. In the first of a series of seven articles, John McKenzie, FSN contributing editor examines the basics of ABC/M in terms of its principles, its underlying logic and why it has significant advantages over traditional accounting processes.
The majority of businesses today rely upon traditional line item posting and tracking of costs, usually at a cost centre level in their accounting and budgetary processes. Whilst this allows them to understand the nature of costs being incurred and where organisationally they lie, no useful insight is given as to how or why those costs are consumed. Today's management accounting focus is mainly on traditional financial measurement structures, mirroring statutory reporting requirements, the Balance Sheet and P & L along with ratio and variance analysis and of course, budget cost performance. These ignore the causes of consumption of resources and cost performance. None of these measures in themselves drive cost.... They are merely outcomes after the event. Furthermore, whilst existing accounting processes allow a reasonable understanding of consumption of direct costs, such as direct factory or service delivery labour and raw materials, little understanding is achieved about the consumption of “overhead” or below the line costs. Beyond knowing the nature of the costs by line item and in which department they lie, the view of overhead has little or no linkage through to the products, services or customers which drive them.
If we go back to the roots of our accounting structures we find that they come from a bygone age. The balance sheet can be traced back to the late 1600's and the P&L account as we know it passed into statutory force in the early 1900's. Even line item cost center budgeting can be traced back as far as around 1920. The significance of this is that our accounting structures and thinking date back to times when the world had little or nothing to do with providing services – it was predominantly a manufacturing world and today's accounting processes were developed to operate in this environment. Functions such as Sales, Marketing, Supply Chain Managment, Finance and Customer Support and Service were, if not non-existent then very limited in scope. Costs were predominantly above the line , direct costs typically accounting for around 90% and relatively easy to understand and apportion. Below the line or overhead costs comprised a mere 10% or so and as such, the limited understanding of how these were driven did not significantly impact management's understanding of profitability or decision making capability.
Today however we have a reversal of the position. As businesses move more and more away from a manufacturing base (indeed, it is estimated that services, if we include those provided by manufacturing businesses as part of their revenue stream, account for just under 80% of UK GDP) the balance of cost is shifting heavily towards below the line, indirect cost. It is not at all unusual to find below the line costs accounting for 70, 80 or even 90% of the cost base. In this environment, management are ill served in their understanding of profitability, cost control, budgeting and forecasting by existing management accounting views.
Most organisations still use standard and absorption costing techniques for their product or service costing. Whilst being simple to understand, apply and operate, with the exception of factory or operational direct costs, they fail to apportion or allocate other business costs on a realistic basis - costs such as manufacturing indirect, sales and marketing, customer service, R&D, purchasing, supply, IT support and personnel. Standard cost techniques apportion these on an arbitrary basis - direct labour hours, square metres, number of units produced or sold, number of customers, etc. In a non-manufacturing or service business, the problem is understandably even more acute with very little cost being allocated on a true basis.
ABC takes a rational approach to product, service and customer costing, identifying what major activities are performed in each function across the business. An assessment is made of how much company resource is actually consumed by each activity, resource meaning anything that is a cost to the business, i.e., employee time, assets, money, etc. These are allocated to activities using appropriate methods dependent on the type of resource to be allocated, e.g.
Cost Type
Allocation method to activity
Employee Costs
%age of time spent on each activity
Occupancy Costs
M 2 occupied by employees performing activity
I.T. Network Costs
Number of P.C.'s by department, Network Volume
and so on…………the aim being to establish a true cost for each activity, based on the consumption of all resources.
The next step establishes what causes or drives each activity and the relationship between the driver and a product, service or customer, if such a relationship exists. Below is an example of activities and their drivers.
Activity
Driver (# = number of)
Enter customer order to computer
# order lines by customer
Process returned damaged goods
# returns by product
Set up machine to produce
# set-ups by product
Deal with customer product enquiry
# enquiries by product/customer
Chase customer for late payment
# unpaid invoices by customer
Taking this last example, we all know that some customers have a better payment history than others. Let's say my ABC assessed cost to chase customer payments is £750000 a year and I have 100000 customers. On an absorption cost basis, I would probably treat the whole of accounts receivable as either an unallocated cost, to be paid for out of contribution, or I would spread it across all customers equally, i.e. £7.50 per customer.
ABC dictates that only customers who pay late cause the costs of “chasing customers for late payment”. If 90% of my customers pay on time, then the remaining 10% should receive this cost, i.e. £75.00 per customer. Furthermore, when I look at the number of times I chase a late payment for each of this 10%, I will probably find that there are repetitive offenders whose costs of chasing are £'00's per annum. This affects the way I view the overall profitability and desirability of specific customer relationships …… a view that would not be obtained through standard or absorption costing. The diagram below illustrates the flow of cost on an activity basis.
As can be seen, we have to consider other costs beyond those consumed by activities related to customers, products, services and distribution channels. Some cost will be consumed by activity relating to internal service provision.....IT, HR and Finance, for example, will undertake activity for internal “customers” for which there are identifiable internal drivers. These drivers may be used to re-allocate those costs across to the “front-line” activities that consume them. For example, an IT help desk would have activity relating to handling help desk calls. The drivers of these could be # of calls by user, call duration by user, etc. Other activity may be “sustaining” in character, having no driver at all that links to customers (whether internal or external), products or services. For example, activities relating to the production of annual statutory accounts could not be rationally allocated on a driver. These sustaining activities remain unallocated and are held away from the allocable costs. Finally, there are costs which do not relate to consumption by an activity. Some costs may be directly attributable to a customer, product or service. Raw materials would be a prime example. Lastly, there are costs of a “one-off” nature that cannot be allocated. Examples of these would be charitable or political donations that organisations often make. Following an activity based logic, we can recreate the P&L on a far more informative basis.
Benefits of ABC/M
Many companies using ABC have found that their view of the business is turned upside down and many previously held beliefs are shattered. Numerous cases exist where highly prized customers (usually prized because of high gross margins or revenue) are found to be amongst the most unprofitable following an ABC analysis, because the true costs of all the hoops we jump through for them are determined. The same applies to products. Some thought to be highly profitable turn out to be the complete opposite when all the hidden costs (warranty, returns processing, set-up time and frequency, handling and storage difficulties, obsolescence or deterioration, customer complaint, etc., etc.) are allocated. Similarly, the insights gained from understanding activities and drivers within the business reveal areas of inefficiency and waste where little or no value is created, more appropriate metrics on which to base business planning and forecasting, smarter and more accurate ways to construct a budget and powerful metrics on which to base performance measurement structures such as Balanced Scorecards.
All of these issues will be explored in subsequent articles in this series. However, in the next we explore ways and means in which ABC/M can be implemented without tears and at the minimum of cost and effort.
