Increasing competition, both globally and locally, make it clear that businesses know accurately and understand the source of process, product and service costs within their organization. Activity Based Costing (ABC), with its focus on deconstructing overhead pools and assigning costs to products and services in a more meaningful manner, has been a giant leap forward from traditional costing models where a high percentage of cost is arbitrarily allocated to products.
However, ABC models often look at cost from a financial point of view, making sure only that all costs are assigned to some product accounting “box” without a thorough understanding of the business process that underlies and defines the resource utilization that creates the cost. This paper will describe a methodology that combines business process analysis with ABC to create a tool that translates Activity Based Costing into Activity Based Management (ABM), a methodology for running, improving and measuring a business.
The objectives of this paper are:
- Briefly review the deficiencies of traditional cost systems and benefits of ABC.
- Describe The Model Approach, a method that combines business process analysis and ABC to create a useful tool to manage the business.
- Describe a case study that illustrates the process and its benefits.
Traditional Cost Systems
Traditional costing systems (TCS) focus on direct material and labor costs, while summarizing all other costs to one or more overhead pools that are then arbitrarily allocated to products, typically as a percentage of direct labor or machine hours. Although adequate to value inventory for financial statement purposes, it has severe shortcomings as a management tool:
- Widely differentiated products utilize resources in substantially different proportions, a fact unrecognized by TCS.
- Overhead now constitutes the largest share of cost, often greater than 50% and is typically applied to products as percentage of the smallest cost (direct labor), leading to serious distortion of product cost.
- Sales, distribution and other “below the line” costs have increased dramatically and are not attached to individual products or customers at all, meaning that the system gives no information about value chain costs to the customer.
- Improvements in data collection methodology have been used primarily to improve the precision of the numbers without addressing the accuracy of cost application.
These shortcomings result in a system that:
- Provides virtually no meaningful analysis of the effectiveness of overhead resource utilization.
- Generates three and four digit overhead rates making no attempt to trace actual resource utilization to products.
- Overcosts standard, high volume products and undercosts custom, low volume products, leading to incorrect pricing and product mix decisions.
- Creates a bias toward direct labor reduction as a cost reduction methodology rather than overall productivity improvement.
- Provides no information useful in either identifying productivity improvement opportunities or determining if productivity improvement efforts have yielded significant results. Indeed, often TCS indicates higher cost in the presence of known productivity improvement and vice versa.
Activity Based Costing
ABC took the overhead pool and deconstructed it into multiple cost pools, assigning the costs in each pool using a “driver”, that is, a surrogate that approximates the way in which a resource is consumed by an activity. For example, the creation of a purchase order is a surrogate “driver” for the activity of acquiring material. Every time a purchase order is written, it represents the use of a resource by the product involved and an element of cost is transferred (or “driven”) from the resource to the product. This approach to ABC is called cost decomposition. This method has some advantages over TCS:
- It provides a more accurate model of how costs are absorbed by activities and products.
- It creates improved information for cost based pricing, product mix and make/buy decisions.
- It insures that all costs are absorbed by products and, thus, can still be used for inventory valuation for financial statement purposes.
Although better than TCS, as a tool for managing the business cost decomposition ABC still has some shortcomings:
- It is still a financial view of cost and takes into account little or no operational information.
- Detailed analysis of accounts is required resulting is a time consuming analytical process.
- It is static — substantial changes in product mix or process volume require a reanalysis and rebuilding of the model.
- It provides no understanding of how key business processes affect cost.
Activity Based Management
ABM is not just a replacement for cost of sales and inventory valuation on the financial statements. Indeed, financial statement cost valuation is often not related to ABM systems. ABM is a new level of information combining financial and operational information in a way that both can be used for improved decision making. It is a management information tool not a financial statement valuation method. To fulfill this purpose requires that the information system take into account both the operational processes of the organization and the resources costs as represented in the financial system. These then must be combined in such a way that they 1) reflect how the organizational process consumes resources and flows costs and 2) capture in total the costs in the financial system to insure the financial integrity of the model.
The Model Approach1
A better approach for this purpose than cost deconstruction is to combine business process analysis and ABC to create a cost model that dynamically reflects the underlying business process. The process starts with an operational flow model of the business process and then attaches costs to the resources. Costs accumulate in relation to the flow of activities. Costs are applied directly to the resources that consume these costs, therefore the costs do not need to be decomposed. Costs flow through activities to cost objects (products, services, etc.).
The advantages of The Model Approach over cost decomposition are many:
- Because the business process model is dynamic, simulation and “what if” analysis can be done to evaluate business decision alternatives.
- Productivity improvements, sensitivity analysis, process changes and investment justifications can all be evaluated via the model.
- The model integrates the business process and the cost system, promoting understanding of how process affects cost.
- It helps identify key performance measurement opportunities.
- It provides strategic financial and operational decision support.
Eight Steps to Activity Based Management
The Model Approach is a structured approach starting from the existing understanding of the business process and the existing cost system and concluding with ABM process improvement. It can be used for an entire business organization, a division or department or a function. In large organizations, it is often advisable to execute a pilot project first to develop skills, train team members and facilitators and obtain prompt results and payback. A typical pilot project can result in a validated model in 6-8 weeks. A brief description of the eight steps in The Model Approach follows:
Step One–Define the project scope. Examine the company wide business issues that face the company and select an area where improved information will yield significant results. Consider areas with high levels of product or service diversity and/or area with high, poorly understood indirect costs. Finally, make sure people in the area to be studied will be supportive.
Step Two–Identify activities, resources and output measures. Both activities and resources can be direct or indirect. Direct activities are those that are generated in response to product or service demand. Indirect activities are those that support product demand but are generated in response to other activities. Direct resources are consumed directly by activities, while some resources are consumed indirectly by other resources. In this model, only resources (e.g. labor, energy or occupancy) have costs, so they must be identified and linked to activities. An output measure must be identified for each resource and activity. Figure 2 illustrates the way in which demand generates activities which consume resources per the attached measures.
Step Three–Map the operational flow of the process to be analyzed. There are many graphical methodologies that are appropriate for this task. Whatever method is used, it must clearly show the resource supplies, activities and demands along with their units of output and their relationship to one another.
Step Four–Collect data and define rules of data relationships. There are four types of data and rules required: 1) demand volume per unit time, 2) conversion factors between a unit of output and the input required, 3) capacity limits (or infinite, if appropriate) per period on resources and 4) financial data specifying cost/revenue per unit for variable costs and total cost/time period for fixed costs.
Step Five–Build the computer model. Again, there are many generic modeling tools available. The one used on the case described below is NetProphet1, an ABM tool specifically designed for this purpose.
Step Six–Validate the model. This requires validation of both operational integrity and financial integrity. Operational results from the model should be compared to historical data to ensure it reflects the business accurately. It also should be reviewed for “reasonableness” by operations people. Once the model is operationally valid it must be validated financially against total historical costs and reconciled at the detail cost level against known expenses.
Note that the above six steps can typically be accomplished in six–eight weeks on a pilot project or small business unit or company. The following two steps are informational and process improvement uses of the model.
Step Seven–Interpret new information. A well designed model will yield a great deal of new and revised information as a result of linking the operational and financial views of the business into one powerful tool. High cost and unprofitable products and services can be identified. Potential capacity constraints and excesses can be pinpointed. Non value added activities can be targeted. On the financial side, costs of products, processes and any cost object (e.g. supplies or idle capacities) can be accurately identified. The final benefit is to identify process improvement opportunities using the new information available.
Step Eight–Perform activity based management. The model is useful in many ways in the management of a business. Among them are: 1) business process re-engineering, 2) strategic planning and decision making, 3) simulation of potential business threats and opportunities, 4) benchmarking and productivity improvement.
The Case Study
This case study is a simplified example of a real manufacturing company. In the simplified form the company manufactures three product lines in a single plant:
- Product line A is high volume, simple and produced in large batches.
- Product line B is medium volume and more complex.
- Product line C is low volume, small batch and highly complex.
Over the years margins have dropped for Product line A due to increased competition. The revenue and expense summary for the last three years is shown In Table 1:
Ace Division Two Last Current
Revenue and Years Year Year
Expenses (000) Ago
Revenue $8010 $6460 $5110
Expenses $6538 $5591 $4527
Net Income $1472 $ 869 $ 583
Marketing believes that the company’s share of Product line A market will continue to shrink and that the company’s future rests on Product line C where margins appear to be higher. They believe that additional promotional effort should be put into Product line C in order to secure a stronger place in that market and Product line A should be de-emphasized. Accounting has calculated product line costs and profitability in a very traditional manner, with manufacturing overhead allocated based on direct labor and Selling & Admin. Costs apportioned based on revenue volume per product line. A product line cost summary for the current year is shown in Table 2:
Current Year Product Product Product
A B C
Volume (000) Pieces 1000 500 150
Sell Price/Piece $2.450 $3.550 $5.900
Total Cost/Piece $2.269 $3.163 $4.501
Income/Piece $0.181 $0.387 $1.399
Total Profit ($000) $181 $193 $209
Because of concern with the situation and the accuracy of the product line costs the company decided to analyze the business process and develop an Activity Based Costing system to determine product line costs more accurately. To accomplish this they used NetProphet software and The Model Approach. They built a macro level model for the entire business unit and used interviews, surveys and self report amongst direct line and supervision to identify activities, resources and output measures. They built the business process model first, then applied costs from the financial system. The resulting operational model is shown in Figure 3:
In the diagram, oval “boxes” represent variable resources, trapezoid boxes represent demands, rectangle boxes are used to represent fixed resources, processes or as a summary of activities/resources. The small arrow shaped boxes are connectors.
After the model was built and validated for operational and financial integrity, new product line costs were calculated. Table 3 compares the traditionally calculated costs with the activity based costs generated by the model. It also indicates the income/piece and total profit per product line as previously calculated and calculated by the model. Differences in the total profit are due to roundings.
Current Year Product A Product B Product C Total
Volume 1000 500 150 1650
Old Cost/Piece $ 2.27 $ 3.16 $ 4.50
New Cost/Piece $ 1.89 $ 2.85 $ 8.06
Old Income/Piece $ 0.18 $ 0.39 $ 1.40
New Income/Piece $ 0.56 $ 0.70 ($2.16)
Old Total Profit $ 181 $ 193 $ 209 $ 583
New Total Profit $ 560 $ 350 ($324) $ 586
It is clear that when costs are attached to the business process and costed in a manner more closely aligned with the way the business really operates, a substantially different set of conclusions results. The purposed strategy of the Marketing department to emphasize Product line C and neglect Product line A clearly is inappropriate. In fact, it would border on disaster.
These are the results that are predicted by ABC theory. Traditional volume based costing will tend to overcost high volume standard products (Product line A) and undercost low volume, custom, complex products (Product line C). The degree of over or under costing will depend on the differences in volume and complexity between standard and complex products, the greater the difference, the greater the distortion. Also, because of the differences in volume between high and low volume products, small decreases in predicted costs in high volume products can lead to large increases in low volume products. Thus, many of the products that traditional costing indicates are very profitable may be substantially less profitable or even money losers, while traditionally low margin standard products may actually be the basis of success for the business as was the case here.
Practicing Activity Based Management
Once the original costing problem was addressed, the company discovered they could use the business process model they had built for many other strategic planning and productivity improvement projects. Here are some of the other uses for the model:
- Sales projections can be entered into the model to determine projected profitability. Different pricing and product mixes can be tried to identify where marketing emphasis should be placed in order to maximize return.
- Because the model includes capacities, it can be used to identify the volume at which a current capacity will be exceeded. This can aid in long range planning to adjust capacities to insure that the business process has the capability to fulfill projected sales.
- Excess capacities can be identified and, where possible, reused or reassigned where they can be more usefully employed. If business organizations need to be “downsized” this can be done rationally based on resources that can be identified as excess, rather than the more traditional “reduce everything 10% across the board” technique.
- Productivity improvement opportunities can be analyzed based on their impact on costs in the business process. Process improvement resources can then be allocated to those improvements that will yield the greatest cost reduction.
Clearly, Activity Based Management using The Model Approach goes far beyond Activity Based Costing in its usefulness. ABC certainly gives a better distribution of costs that traditional methods, but it still presents a financial view of the organization. ABM and The Model Approach, utilizing a powerful computer modeling tool like NetProphet can provide a business decision making tool that can be used to manage and improve the business.
1. The Model Approach and NetProphet are registered trademarks of Sapling, Inc.
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