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INTRODUcTiON TO AcTiViTY-BaSED COST MaNaGEmENT

Achieving Insight of Costs and Protability in the Organization

CONTENTS 2 Basic ABC Principles Principle 1: Activities consume resources Principle 2: Activities have a cause Principle 3: Customers, products, or channels cause different levels of activity. 4 Worked Example 9 Time-Driven Activity-Based Costing 10 Worked Example 12 The Importance of ABC

INTRODUcTiON

In the modern business world, we are blessed with more management information than ever before. But how much of that information is really valuable or even useful? How much of the information that lands on our desks or arrives in our email in-boxes actually helps us make decisions that will improve our organizations? We dedicate a huge amount of work to supplying management teams with data, but how many decision-makers can answer the following questions about their organization? Which customers are the most protable? Which products are the least protable? Which are our best and worst sales or distribution channels? How much of our activity is wasted? Which activities can be reduced or eliminated without loss of service? Many managers think they know the answers to these questions, and will be prepared to offer a view based on gut instinct. But this instinctive view is frequently based on very little qualitative information. Activity-based costing (ABC) can provide answers to these questions in a way that managers can understand, and which is supported by a fair and justiable methodology. In this paper we will discuss the basic principles of ABC, and illustrate them using a simple worked example. This paper is part of a series of three developed to help you understand activity-based costing and activity-based cost management (ABM). In this, the rst of the series, you can nd out about the basic principles of this methodology, and understand why activity-based costing is more relevant now than ever. The other two papers in the series cover Activity-Based Costing Implementation Issues and Practical Applications of Activity-Based Costing.

Author: Richard Barrett Contributors:  Chris Grundy, Jennifer Meegan, MaryLouise Meckler, Jing Zhao Audience: CFOs, nancial controllers, nancial managers, and cost accountants

BaSic ABC PRiNcipLES

ABC is often assumed to be complex, and consequently may seem rather impenetrable. This is something of a misconception, though. Although the various allocations of cost can be hard to unravel, this is usually handled by software tools, while the methodology itself actually stems from a few basic principles, which are really just common sense.

Principle 1: Activities consume resources.

The more an activity is performed, the more resources will be consumed by it.

Principle 2: Activities have a cause.

All activities are performed for a reason or cause. In the most efcient organizations, activities are mainly attributable to external objectscustomers, products, or distribution channels. Usually, though, some activities will have an internal cause. For instance, internal support activities, such as those carried out in personnel or IT functions, are generally caused by demand from other departments.

Principle 3: Customers, products, or channels cause different levels of activity.

Traditional costing methods, such as standard or absorption costing, allocate base costs directly to products, customers, or distribution channels. These methods ignore the principle that resources are actually consumed by activities, and not by the products, customers, and channels. Activity-based costing allocates costs to customers, products, and channels in line with the proportion of activities they actually consume. This paper uses a number of terms commonly used in ABC. Please refer to Figure 1 for an explanation of these terms.
Term
Resource Resource Driver Process Activity Task Activity Driver Cost Object

Definition
A resource used by the business in carrying out its business A measurable quantity used to allocate resources to activities A series of connected activities required to achieve an outcome A series of related tasks carried out repeatedly An element of work, a series of which make up an activity An event or factor that causes an activity to be performed The entities that are to be costed

Examples
Staff costs, property costs, capital, running costs Headcount, time spent, floor area, number of machine hours Handle customer orders Dispatch goods to customer Record customer order in database Invoices sent to customers Customers, products

Figure 1: Denition of ABC Terms.

Business Objects. Introduction to Activity-Based Cost Management

From General Ledger Resource Costs

Product, Service or Channel Specific Costs

Activity Specific Costs

Non-specific Costs

Allocation Methods

Resource Driver
Activity Costs Analysis

Customer and Product Costs

Activity Drivers

Unabsorbed Costs

Figure 2: ABC Allocation Model

In Figure 2, the shaded boxes illustrate how some of the resource costs are allocated to activities. The costs associated with each activity can then be apportioned to customers and products based on what proportion of the appropriate driver volumes that they use. For some activities, dening a sensible causal link to customers and products is not obvious, or may indeed not be a sensible thing to do at all. For example, most of the activities carried out by an organizations CEO would probably not be attributable to particular products or customers. The right hand branch of Figure 2 shows non-specic costs which cannot be attributed to an activity and have no relationship with customers or products. Expenditure on corporate image, for example, would fall into this category. Sometimes there will be resources that are directly attributable to products, customers, or channels, but for which it makes little sense to attribute to activities. For instance, the cost of advertising space for a particular product can obviously be attributed directly to that product, and would not be associated with any particular activity. The left hand branch of Figure 2 shows costs that cannot be attributed to an activity.

Business Objects. Introduction to Activity-Based Cost Management

WORKED EXampLE

This section contains a step-by-step illustration of a very simple ABC modeling exercise, which illustrates many of the aspects of the methodology. We will be using a credit control function as our example, for three main reasons: Most organizations operate such a function, so it should be reasonably familiar Credit control is often the responsibility of an accountant Most managers know that this functions costs are caused by sales activity, although they are not always in a position to make the connection between the costs and specic customers Our starting assumptions are as follows: 1. Property costs have already been charged to credit control on the basis of space occupied. 2. The cost and number of calls can be identied from the telephone system. 3. There are six members of staff, all of whom work full-time. The following tables contain the base data that we will use in the calculation.
Resource Staff Costs 1 Manager @ $25,000 5 Staff @ $15,000 Property Costs (50m2) Telephone (7,500 mins) Total
Figure 3a: Resources

$ 100,000

25,000 15,000 140,000

Business Objects. Introduction to Activity-Based Cost Management

Activity Print & Mail Invoices Chase Customers on Telephone Issue Credit Note Allocate Receipts Plan, Organize & Monitor Staff Total Staff Percent
Figure 3b: Activities and Time Allocation

% Time 30 100 400 50 20 600

From Figure 3b, you will see that we have identied ve activities. First of all, we need to calculate the cost of each of these activities. A simple assumption might be that the total cost of the resources is $140,000 and should, therefore, be allocated to all the activities. On this simplistic basis, the cost of print & mail invoices, for instance, would be $7,000 (140,000 x 30% 600%).

This assumption isnt necessarily a good one, though. Its ne for the staff costs, and arguably for the property costs, where we might take the view that the staff occupy the space in something like equal proportions and therefore all activities should bear a proportion of the cost related to time spent on each related activity. However, this approach allocates telephone cost to each of the ve activities when in fact only two activities, chase customers on telephone and issue credit notes, would actually consume those costs. A more realistic solution would allocate the telephone costs to only those two activities. Obtaining driver volumes for this split would probably require the staff to estimate the proportion of calls associated with each of the two activities, because its unlikely this proportion would have been captured historically (though the organization might want to start collecting this data from now on). Suppose the split has been estimated at 75%/25%, so 5,625 minutes are spent on the phone carrying out the chase customers on telephone activity, and 1,875 minutes are spent on the activity issue credit notes. Now we have the staff costs and property costs (total cost $125,000) to be allocated across all ve activities according to time spent, and the telephone costs ($15,000) to be allocated across just two activities in the ratio of 75/25.

Business Objects. Introduction to Activity-Based Cost Management

On this basis, activity costs would be as follows:

Activities Print & Mail Invoices Chase Customer on Telephone Resource Driver: % Time 30 100 5,625 Resource Driver: No. Calls Calculation 125,000 x 30 600 125,000 x 100 = 20,833 600 = 20,833 15,000 x 5,625 = 11,250 7,500 = 11,250 Total Issue Credit Notes 400 1,875 125,000 x 400 600 = 83,333 15,000 x 1,875 7,500 = 3,750 Total Allocate Receipts Plan, Organize & Monitor Staff Total 50 20 600 7,500 125,000 x 50 600 125,000 x 20 600 87,083 10,417 4,167 140,000 32,083 Cost $

6,250

Figure 4: Credit Control Function Activity Costs

The next stage is to allocate activity costs to customers and products. Well take the activity chase customers on telephone as an example. We need to decide what activity driver to use. In other words, what is the most direct cause of the activity? Possible candidates might be the number of overdue invoices, or the number of overdue accounts. The latter assumes each overdue account receives the same length of telephone call, while the former assumes the number of overdue invoices lengthens the call proportionately. Furthermore, in practice neither driver may be easily available and a best t driver, such as the average value of overdue accounts, might be necessary.

Business Objects. Introduction to Activity-Based Cost Management

Cost Objects Customer A Customer B Customer C

Volume 200 500 0

Figure 5: Activity Driver "Late Paid Invoices"

Figure 5 (above) shows activity driver volumes for customers A, B, and C. Since any relationship between late paid invoices and the products being invoiced would be unlikely, there is no breakdown by product. Using the number of late paid invoices as the activity driver for the activity chase customers on telephone, we would calculate the following customer costs:
Customer Customer A Customer B Customer C
Figure 6: Customer Costs

Calculation 32,083 x 200 700 32,083 x 500 700 32,083 x 0 700

Cost $ 9,167 22,916 0

Traditional costing methodology might allocate $10,694 to each customer ($32,083 3). However ABC gives us a fairer result. The larger proportion of the activity cost is incurred by customer B who is a slow payer. Customer C, who pays promptly by direct credit and is the cause of none of this activity, is attributed with none of the cost. ABC highlights that Customer B is costing our organization more than our other customers, and this knowledge allows management to take appropriate action, whether that be working with Customer B to improve his payment schedule or compensating in some other way. Now let us examine the activity issue credit notes. Lets assume each credit note is issued as a result of a customer return, so a suitable activity driver would be number of return notes. (The number of credit notes might be an alternative choice, but we want to drive the costs to products, and the returns data by product is more easily available. This kind of consideration is made a lot in real-world ABC implementations).

Business Objects. Introduction to Activity-Based Cost Management

The driver volumes for the number of return notes driver are shown in Figure 7.
Cost Objects Customer A Product I Product II Customer B Product I Product II Customer C Product II Volume 700 20 1,600 50 30

Figure 7: Activity Driver "Number of Return Notes"

Note: Number of return notes is referred to as a multidimensional cost driver, because there is a real relationship between the driver and more than one cost object dimensionin this case, customer and product. The allocation of costs with a multidimensional driver is shown in Figure 8 below.
Activity: Issue Credit Note Activity Driver: No. of Return Notes Activity Cost = $87,083 Product I 700 1600 II 20 50 0 30 Customer C / Product I = $87,083 x 30 / 2,400 = $1,089
Figure 8: Customer Costs Multidimensional Driver

A Customer B C

Depending on the activity, as you can see, costs can be allocated to different combinations of cost object dimensions. Some activities will be allocated to just products, with no customer-or channel-based element. Others may be allocated to just customers or just channels. Some may be allocated to products and customers and channels. Some may be allocated to products and customers, but not to channels, and so on. The important thing is to determine what drives the cost of each activity, and then to select an appropriate cost driver. Remember a fundamental consideration is that the data should be available from some source within the organization. Vitally, the whole ABC approach focuses on the way resources are consumed rather than the traditional nancial presentation of the way resources are spent. It is this that permits ABC to be used to manage costs.

Business Objects. Introduction to Activity-Based Cost Management

TimE-DRiVEN AcTiViTY-BaSED COSTiNG

The original exponent of ABC, Dr. Robert Kaplan, has also proposed an alternative approach to ABC and has suggested that it is simpler for estimating and maintaining an ABC model, and also more accurate. This approach suggests cost driver rates be based on the practical capacity of the resources supplied using transactional and duration drivers, and by estimating the quantity of time taken to perform an activity, uses this quantity in the analysis. Transactional cost drivers count the number of times an activity is performed. Examples include number of production runs, number of setups, number of shipments, number of purchase orders, and number of customer orders. By denition, a transactional driver is used whenever the activity takes about the same amount of time to complete. Duration drivers estimate the time required to perform the task or activity. Examples of duration drivers are setup hours, material-handling time, direct labor hours, and machine hours (relating to a specic activity). While duration drivers are generally more accurate than transaction drivers, they are also more expensive to measure, as the work involved is far more detailed and labor intensive. Whenever resource demands can be reasonably approximated against the number of times an activity is performed, cost system designers will typically use transaction drivers.

Business Objects. Introduction to Activity-Based Cost Management

WORKED EXampLE

Cost driver rates are calculated by dividing the activity expense by the quantity of the transaction cost driver. Lets rework the example of the credit control department using a time-based methodology. The resources remain the same although we do need to know how much time this resource is made available. We have assumed each person works 2,000 hours each year.
Resource Staff Costs 1 Manager @ $25,000 5 Staff @ $15,000 Property Costs (50m2) Telephone (7,500 mins) Total
Figure 9a: Resources

$ 100,000 25,000 75,000 25,000 15,000 140,000

Time

Cost Per Hour

10,000

10,000

14.00

Notice that as the manager simply manages and is not a productive resource, we have ignored their time in calculating a cost for each hour that the resource is available. This works out at $14.00 per hour.
Activity Duration Time 8 hours 40 mins 60 mins 8 hours Unit # Units Total Hours Cost Per Hour $ 14.00 14.00 14.00 14.00 Activity Cost $ 22,400 52,500 26,250 22,400

Print & Mail Invoices Chase Customers on Telephone Issue Credit Notes Allocate Receipts Plan, Organize & Monitor Staff Spare Capacity

Day Call Note Day

200 5,625 1,875 200

1,600 3,750 1,875 1,600

Excluded (Done by Manager) 1,175 10,000 14.00 14.00 16,450 140,000

Figure 9b: Activities and Time Allocation

Business Objects. Introduction to Activity-Based Cost Management

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One of the obvious benets of time-based costing is it automatically measures and costs excess capacitysomething managers are normally reluctant to identify if they are simply asked to quantify the proportion of time their staff spends on various activities. However, this may lead ABC to be perceived as little more than a variant of a time and motion study and lead to unanticipated resistance from both staff and their managers. For time-based costing to work, it is also important to have access to highly accurate and reliable duration times. In the example above, although the costs were carried through in the calculation, the activity plan, organize and monitor staff carried out by the departmental manager was excluded, as it is simply not a time related activity. Therefore, although a time-based approach may be appropriate for high volume and highly repetitious activities in responsibility centers with a high level of controllable cost, it is often inappropriate in others. In practice, models frequently incorporate driver-based costing and time-based costing, as well as hybrid allocations that incorporate aspects of both approaches.

Business Objects. Introduction to Activity-Based Cost Management

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THE ImpORTaNcE OF abc

ABC methodology has been around since early 1980s, but its only relatively recently begun to gain acceptance. This recent enthusiasm for the methodology is largely because the makeup of the cost base has changed over the last 30 years or so. There has been a proportionate decline in direct costs and an increase in overheads (notably technology, sales, marketing, and other support costs). At the same time the creation of products, whether traditional manufactured products or individual services, has become more and more sophisticated. The importance of customer-service functions has also increased, with a commensurate cost increase in those areas, as companies seek to maintain a competitive edge.
120 100 80 % of Cost Base 60 40 20 Now
Overhead Direct Labour Direct Cose Technology

0 30 Years Ago
Figure 10: The Inexorable Growth in Overheads

As a result of all this change, overheads form a much more signicant part of corporate expenditure and it is perhaps not surprising that ABC has been adopted as a more robust way of allocating cost.

Business Objects. Introduction to Activity-Based Cost Management

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Notes

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Notes

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