Cost management: As easy as ABC

Today, Oct 2000 by Pieper, Chris

Activity Cost

Management offers an interesting concept : save money not by spending less, but by doing less of the wrong things.

Activity-Based Costing (ABC) was developed as a practical solution for problems associated with traditional cost management systems. In the early 1980s, many companies began to realize that their traditional accounting systems were generating inaccurate costing information. Traditional cost accounting systems that were designed to address the issues of inventory valuation for external audiences had two deficiencies:

1. the inability to accurately determine actual total product and service costs

2. the inability to provide useful information to management for purposes of making operating decisions

As a result, managers of companies selling multiple products and services were making decisions about pricing, product mix and technology based on inaccurate cost information.

Alternatively, ABC focuses on the activities associated with operating the business. Traditional cost systems do not touch the subject, except in reports that isolate salaries, benefits, etc. If a manager were asked to cut costs, he or she would cut headcount, believing that it was the largest cost contributor. But today, people are not the major cost contributors; activities that people do contribute more. How often have we heard the lament, "We've cut our staff 20% but the work is still here"? ABC allows managers to attribute costs to activities and products much more accurately than conventional accounting methods. ABC is more than an accounting tool. This tool gives you a view of what you have done financially, and they are fundamental to shareholding disclosure and statutory reporting. But it is as important to have the ability to translate this cost information to the language of operational units and the business. With ABC, you get a strong internal view of your products/services and customers. Armed with this information, you are ready to make financial, operational and strategic decisions, such as outsourcing and pricing.

ABC identifies the activities that are responsible for costs. Activity costs are passed on to products or services only if the product or service uses the activity (i.e. activities consume resources, and products/services consume activities). As the number of activity measures increase, ABC is better able to capture the underlying economics of the company's operations, and the reported activity/product/service costs come to light. In addition, ABC analyzes all activities that exist to support production and deliver goods and services. Business is Multidimensional

ABC contends that many important cost categories vary not with short-term changes in output, but with changes in the design, mix and range of a company's products, services and customers. Once product costs are identified, users begin to see the value of understanding the activities and their associated costs. The primary use of ABC shifts from that of an accounting tool to that of a management decision support system for operational streamlining; we call this "Business Intelligence."

Information Technology gathers and manages this ABC information, combining not just cost but non-financial information and performance measures. We call this enterprise-wide technology "Activity-Based Information Systems."

Expanding Market Opportunities and Application

The proliferation of ABC has accelerated as companies begin to apply activity-based results in a variety of new areas and utilize ABC as the financial information source to better manage their enterprises. This results in an increasing demand for access to ABC data, thus creating significant new market opportunities. These software applications and services have been applied to three major markets:

Service Industry: Insurance, Utilities, Government, Financial Institutions

Manufacturing Industry: Automotive manufacturers, Machine parts

Process Manufacturing Industry: Grocery, Food & Beverage, Semiconductors

Major initiatives have used ABC as a best practice within industries. The Process Improvement initiatives have pushed ABC for years. The more recent Efficient Consumer Response (ECR) initiative is a $30 billion cost controlling initiative in a $500 billion market for the food & beverage industry. They have picked ABC as a key success factor and ABC Technologies Inc. as a driving force. The semiconductor industry, with its insatiable requirement to remain competitive, has also picked ABC. SEMATECH, the US-based consortium of leading semiconductor manufacturers, has standardized on ABC as a best practice.

As more managers become aware of the activity and information that is available, additional applications for ABC open-up. For example, business re-engineering efforts have long focused on reducing speed and increasing quality, using contemporary measures of performance. Yet, which do you re-engineer? How do you decide to re-engineer anything? ABC provides the lens that focuses your reengineering efforts and also provides a contemporary measure of cost.