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Activity Based Costing

 Activity Based Costing/Management in Service Industry
Prepared By Dr. Mir F. Ali

Activity Based Costing (ABC) was originally designed for manufacturing environments to calculate the unit cost based on the costs of production activities. The objective behind this notion was to maximize the performance of associated resources, allowing a provision to stay competitive yet profitable.

ABC became the table talk for organizations that either failed miserably in their efforts to reengineer their business processes or that never considered Business Process Reengineering (BPR) as a tool to overcome their fiscal or operational difficulties. There are all kinds of symptoms that these organizations are building up all kind of unrealistic expectations for new ABC efforts. This is not inconsistent with the general trends seen with the emergence of any new tools, techniques or technologies. However, it is critical for these organizations to understand that ABC is neither a silver bullet nor panacea.

Contrary to the popular believe, ABC can't be fully applied to the service environments without making necessary adjustments. Also, it presents a real challenge and requires total organizational commitment to implement ABC in a nonprofit service oriented environment, where people are struggling with the transition from budget to cost and organizational unit to activity.

ABC is best defined as a technique to quantitatively measure the cost and performance of activities, resources, and cost objects (output/service/client) based on cost drivers. ABC captures organizational costs for the factors - production and overhead - and applies them to each activity in a well-defined activity structure - Activity Dictionary.

Another way ABC can be defined is as a method to model the consumption of costs from resources through activities to services, channels (Methods of delivery) or other cost objects such as customers and clients. It enables organizations to answer the question:

What is the cost of providing ServiceA to ClientB through ChannelC?

Activity Based Management (ABM) is a mechanism designed to manage and report the cost efficiency associated with business activities in an organization. It keeps track of activities and people (Resources) involved in the process to produce products or deliver services, and allows organizations to improve the cost performance.

The focus of ABM is on the activities being performed to help determine the best way to directly charge or allocate more realistic proportions of costs to various services. It provides an opportunity to optimize and redesign the associated activities in the interest of effectiveness and efficiency, answering the question:

What should be the cost of providing ServiceA to ClientB through ChannelC?

The difference between ABC and ABM is that ABC helps established the cost associated with the activities involved in producing a product or delivering a service whereas ABM provides an opportunity to question the validity, accuracy, acceptability, and Affordability of the cost. This enables managers to optimize the performance of the activities and explore other options - Alternate Service Delivery.  Please click here to see a diagram which compares the traditional vs ABC approach.

The question is why ABC? Traditional accounting practices favored quick fixes to reduce costs, either by reducing resources or by forcing suppliers and vendors to cut costs. On the other hand, ABC deals with internal issues of waste, continuous improvement, and the identification of true cost drivers, misallocated costs, and value-added components of traditional overhead.

The traditional product costing approach is based on the costs consumed by product or service whereas the ABC approach is based on the costs consumed by activities and activities are consumed by the product or service. What does that mean? It means that the costs associated with the activities can be reduced and the performance of these activities can be improved by minimizing the number of steps involved in performing these activities, by removing the information bottlenecks and by using appropriate information technologies to provide reliable, and relevant information to the respective managers, and by providing adequate training to personnel. Please click here to see a diagram which illustrates the difference between a traditional vs ABC chart of accounts.

The chart of accounts are traditionally designed to keep track of an accumulated amount for a specific type of expenses like salary, benefits, travel, equipment, material, rent, and utilities expenses. These figures only reflect what was spent on what and these costs have no relationship whatsoever with the activities. In the case of ABC, each indicated activity could have consumed costs of salary, benefits, travel, equipment, material, rent, and utilities.

It is widely recognized that ABC/M has the capability to provide the cost sensitivity needed for making effective decisions. It is also recognized that ABC/M works better in business like environments where:
  • Client-focused products/services are provided;
  • The cost driver is a major source of motivation;
  • The cost and value of the products/services are clearly defined;
  • Accountability framework is established;
  • Horizontal thinking is practiced;
  • Technologies are managed effectively; and
  • Benchmarking is performed regularly to improve performance on a continuous basis.

The success of any ABC/M initiative is dependent upon the approach adopted to implement this discipline. The following graph represents a systematic approach to developing, designing, and implementing an ABC/M mechanism.  Please click here to see a diagram.

Realizing the fact that the most budgets/expenditures are based on the organizational structures, this methodology is designed to take this into consideration as the starting point for the expenditure (Costs), which is already incurred, in the previous fiscal year. The total costs (A combination of direct and indirect costs) have to be mapped to each major organizational unit within an organization with the responsibility to produce cost objects.

Activities: Activities performed in each organizational unit need to be defined. Activity is defined as a unit of work performed within an organization. A description of the work being performed in the organization to produce product/service that consumes resources. For instance:

  • Develop Strategic Direction;
  • Provide Professional Advice;
  • Prepare Business Plan;
  • Conduct Marketing Surveys;
  • Manage Financial Services; etc.

Cost objects: Cost object (s) for each major activity need to be defined. Cost object is the reason for performing an activity. Products, and services are reasons for performing activities. For instance:

  • Strategic Direction;
  • Advice;
  • Business Plan;
  • Financial Statement;
  • Invoices; etc.

Client: Internal/external Client (s) for each cost object should be defined. Client is a person or organization who receives the service/product, which is delivered/produced as result of performing the respective activities. For instance:

  • Reports are produced for Financial Department (Internal);
  • Products are distributed to customers (External); and
  • Consulting services are offered to clients (External).

Activity Costs: Activity costs are calculated based on the utilization of resources. Resources are defined as economic elements applied or used in the performance of activities. For instance:

  • Salaries and Employment Benefits;
  • Travel; Professional Services;
  • Materials and Supplies;
  • Capital Acquisition/Depreciation;
  • Occupancy Costs; Utilities; etc.

Cost driver: Cost drivers have to be determined for each cost object. Cost driver is defined as a factor that causes a change in the performance of an activity and, in doing so, affects the resources required by that activity. For instances:

  • Strategic directions are developed and communicated twice a year;
  • Advice is provided twenty times a year;
  • Business plan is prepared once a year;
  • 400 invoices are produced every year; etc.

Unit Cost: Unit cost has to be calculated for each cost object. This calculation is based on “Activity Costs divided by Cost Driver”. For instance:

  • If the costs of developing and communicating Strategic Direction (Cost Object) is calculated to be $50,000 and the cost driver is twice in a year, then the unit costs will be: $50,000/2 = $25,000;
  • If the costs for providing Advice (Cost Object) is calculated to be $80,000 and the cost driver is twenty times, then the unit coast will be: $80,000/20 = $4,000;
  • If the costs of developing Business plan (Cost Object) is calculated to be $50,000 and the cost driver is once in a year, then the unit cost will be: $50,000/1 = $50,000

At the completion of this exercise, an ABC Model will be developed, reflecting the current:
Costs of the activities; Costs of the cost objects; Costs of providing service/product to a specific client/customer; etc.

The current cost structure provides an opportunity to appreciate how cost is contributed. However, it is critical to understand that the functional and organizational ineffectiveness, inefficiency, incompetence, and mismanagement are the major contributors to these costs. It has to be recognized that these factors have a direct negative impact on the bottom line.

This is the time for making some crucial management decisions to determine the corporate level of tolerance for accepting and implementing change. Similarly, the following questions have to be answered:

  • What should be the costs of the activities, cost objects, and services?
  • What kind of investment can be made in the new technologies and training? and
  • Should the focus be to enhance the capabilities to handle additional work and generate more revenue or do more with less by reducing the workforce?

Answers to these questions will help to set guidelines for reducing the overall costs of the services by optimizing the performance of the information, technology, and human resources. This will require:

  • Each business process should be reviewed and analyzed to explore the potential for improvement;
  • The vertical analysis must be conducted to minimized the number of steps/tasks by deleting and combining them;
  • The horizontal analysis must be conducted to remove the information bottlenecks by introducing the right technologies; and
  • Each business process must be analyzed to determine the skills requirements and recommendations must be made to provide training for bridging the gap.

This exercise will help to establish the business rationale for the change and at the same time this will enable refinement of the current model to meet the desired level of improvement. Following the successful refinement of the model, a roadmap should be developed to highlight the sequence of changes and the implementation of these changes in a systematic fashion should ensure the expected milestones/expectations are met.

The critical factor for the success of any ABC initiative is the senior management commitment for implementing the recommended major changes with an intention to continue searching for better and consistent ways to perform business activities/processes to support the corporate objectives.

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