Strength in numbers: ABC integrated with activity-based planning and budgeting can create major benefits for a whole organization

CMA Management, Sept, 2002 by Michael Tinkler, Daniel Dube

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.