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Strength in numbers: ABC integrated

with activity-based planning and
budgeting can create major benefits for a
whole organization. (Management
Trends).
By Dube, Daniel
Publication: CMA Management
Date: Sunday, September 1 2002

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 (www.synerma.com).
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© Copyright © 2002 Society of Management Accountants of Canada

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