Activity-based costing

Author(s): John L. Eggers and Charles E. Bangert Jr.

Source: Journal (American Water Works Association), Vol. 90, No. 6, Management ABCs (JUNE
1998), pp. 63-69
Published by: American Water Works Association
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MANAGEMENT

ABCs

AtfMytod

costing
Activity-based

accounting

provides a true measure

of services and goods

and helps target business processes that need improvement.

John L. Eggers and
Charles E. Bangert Jr.
veryenterprisein today'sbusiness environmentpublicor private,facescontinuing
and unrelentingpressureto become "worldclass" or
"bestofbreed*or some otherepitomeof excellence.
Justas thereare businessesthatfailto accommodate
or respondto thispressure,thereare manyothersthat
will riseto the competitivechallenge.It doesn't matterwhetheran organizationmanufactures
hardgoods
or provides a service; organizations must become
more efficient
in orderto survive.
Waterutilitymanagersare likelyto agreethatprovidingthe highestqualityproductand serviceat the
lowest possible price has
always been important.
Those same utilitymanagers,however,may also
agreethatmanagingcosts
has neverbeen more difficultthan it is today.
Search for
efficiency leads
to change
Municipal governments, like the private
sector,are feelingextreme
Forexecutivesummary,
see page 172.
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What's in store for the

water utilityindustry? It is
highly unlikely (and physically impossible) that water
utilities will enjoy "equal
access competition"through
theestablishment
ofa regional
or national "water grid,"as
has been proposed for the
purchaseofpower withinthe
electricutilityindustry.Just
as unlikelyis theprospectofa
sitcomstartrumpeting
cityor
metropoliswateron national
television, in the way that
celebritiessell long-distance
telephone service.
What will happen, however,is that more politicians
and more utilitygoverning
budgetpressuresas theyprovide theircitizenswith bodies will take a fresh,businesslikeapproachto pronecessaryservices.Rates are risingto pay forregula- vidingtraditionalgovernmentservicessuch as water
torycompliance,infrastructure
repair,and a host of and wastewater.The driveto improvecost-effectiveotherneeds, and consumersare not happy about it. ness will likelylead many utilitiesto in-house cost
Unhappycitizenscan lead to crankymayorsand city reductionsor some formof public-or private-sector
council members.Withinthe water supplyindustry, outsourcing.
consumer concernsabout water quality are on the
Many management techniques are available.
rise. Some of these concernsare real, and othersare A whole host of managementtechniquesare widely
used by competitiveindustriesto decreaseoperations
not,but all mustbe addressed.
These conditionshave gottenthe attentionofnot costsand to increaseproductivity
and customerseronlywaterutilitymanagersbut also the politiciansat vice. Such management tools as total quality mancityhall. Such developments are the drivingforce agement, business process reengineering,continubehindthe cost-control
movementso prevalenttoday ous process improvement, and competitive
in the water utilityindustry.
ifproperlydevelbenchmarkingcan be veryeffective
Water industrylooks to privatization. In the oped, implemented,and managed.
midstof these developments(and perhaps partlyin
These processimprovementtechniquesgenerally
responseto them), therehas been a recentsurge of have one common element: forthe techniques to
interestby the privatesectorin owning, or at least workeffectively,
an organizationmustbe able to first
operating,municipal systems.The private sector's identifyand then measure the costand performance
involvementin theownershipor operationofpublicly ofthe numerousactivitiesthatmake up itscore busiowned utilitiescan take many forms,describedby ness processes.
such concepts as outsourcing,public-privatepartnerships, managed competition, "marketization," Getting a handle on costs
"businessization,"and plain old privatization.What- is as simple as ABC
ever formit takes and however it is termed,the priMost organizationscan readilyname those activvate sector'sparticipationin the operationofmunic- itiesthatcomprisetheircorebusinessprocesses.Meaipal waterand wastewaterutilitiesis becomingmore suringthe cost and performanceofthese activitiesis
prevalentas a way ofprovidingincreasedservicesat not so simple,however.
a reduced cost.
Activity-basedcosting (ABC) is a contemporary
Monopolies go "free market." Over the past management tool that effectivelyintegratesmeadecade, a number of US industrieshave undergone surementofprocessactivities,cost,and performance.
transformations.
significant
Regulated,monopolistic A proven operational method, ABC measures the
- such as the airline,long- cost and performanceof process-relatedactivitiesas
or oligopolisticenterprises
- have applied to cost objects or services.In the water utildistancetelephone,and gas utilityindustries
in
become, essence,freeenterprisemarkets.The elec- ityindustry,forexample, the primarycost object or
tricutilityindustry,
too, is in the processofa massive serviceis providingcustomerswith a safe,adequate
All
of
these industrieshave one thing supplyof water.
restructuring.
in common. They have used some formof activityIn managementaccountingterms,ABC (1) meabased accountingand activity-basedmanagementto sures the cost of activities,(2) providestrue costsof
become more competitive,in termsofboth cost and goods and servicesproduced,and (3) tellsa manager
customerservice.
where to look to improve business processes and
Modelofutility
andservices
resources,
activities,

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Financial
versusactivity-based
at DanaCorporation
accounting
accounting

reducecosts,and enhancethe
employeeperformance,
qualityofproductsproducedand servicesperformed.
Experts look at ABC. In his book BeyondReengi1Michael Hammerconsiderscompaniesfrom
neering,
a processperspective.He proposesfourprinciplesthat
formthe foundationforcontinualbusinesssuccess.
1. The missionof a business is to create value for
itscustomers.
2. It is a company'sprocessesthatcreatevalue for
itscustomers.
3. Business success comes fromsuperiorprocess
performance.
4. Superior process performanceis achieved by
havinga superiorprocessdesign,the rightpeople to
performit, and the rightenvironmentforthem to
work in.
Process is crucial to success in business. Activities- the components of processes that consume
- can be measuredand valued in bothfinanresources
cial and nonfinancialterms.Because cost is the great
normalizer,use of accurate cost-accountingtools is
imperativeto the design,implementation,and controlof superiorprocesses.
Turney2uses an analogy that compares the producingorganizationto a ship afloaton a smooth sea
of conventional cost misinformation.The mariner
managers are blissfullyunaware of hidden "rocks
and shoals of poor quality,highcost,lack of responsiveness . . . and neglectedcustomers. . . the things

thatsinkthe shipsofenterprisein today'scompetitive

world." Sinking is bad enough, but "nearby,lurk
sharks of all kinds . . . competitorslooking forthe
opportunityto biteoffpartsofyourbusiness. . . hostile asset strippers. . . hungryconglomerates."
In the introductionto his book on implementing
and sustainingan effective
ABC system,Cokins3states
"ABC is becoming increasinglymore importantfor
bothidentifying
and meaimprovement
opportunities
suringthe realizedbenefitsofperformanceinitiatives
on an after-the-fact
basis. Today'straditionalcosting
show
practices
very littleabout the costs of crossfunctionalbusiness processes and even less about
where the non-value-addedcostsare. Further,when
asked to detailtheiractual cost savingsor cost avoidance realized froma project,managers cannot adequately do so."
Termsdefined. Beforemovingto a detailedexplanation of ABC, the authorsintroducea hierarchyof
termsrelatedto activitiesand processes.4
Functionrefersto the aggregationof activities
that are related by a common purpose, e.g., engineeringor distribution.
Businessprocessis the network of related and
independent activitieslinked by the outputs they
exchange. In a water-relatedexample, mains installation requires engineeringdesign,procurementof
materials,installationofthe mains,settingofmeters,
and accountingforthe work performed.

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 Activity
refersto a process element that consumes substantialresources to produce an output.
More specifically,
it is the mechanismby which work
resources(e.g., labor and equipment) are converted
intoan output (eitheran intermediateor a finaloutput). Examples of an activityare estimatingthe cost
of a distributiondepartmentwork order or metersettingby distributiondepartmentemployees.
Tasksare the combinationsof work elements
or operationsthat make up an activity.Withinthe
distributiondepartmentactivityof settinga meter,
one ofthe tasksis collectingthe necessaryhardware
fromthe storagelocation.
Operations
are the smallestunitsofworkused for
planningor controlpurposes.An operationrequired
forthe task of collectinghardwareformeter-setting
is checkingthe bill of materialsforthe job.
ABC applied. In application,ABC is management
accountingor internalaccountingperformedto serve
classicmanagementneeds such as planningand controlling.Financial accountingis definedas accounting thatservesexternaldecision-makers(regulators,
stockholders),whereas cost accountingserves both
externalentities(incomemeasurementand inventory
valuation in accordance with generally accepted
accountingprinciples)and internaldecision-makers
(all levels of management).5
Althoughprocesscostingis not a new technique,
its most recentreincarnationas ABC was drivenby
the changes in modern industrialtechnology that
have resulted in higher indirector overhead costs
in relationto directcost. Put anotherway,the direct
cost componentofa good or servicebecame less and
less significant,
while totalcostwas drivenmore and
more by indirect costs (costs of support management,automation technology,and externalregulatoryfactors).When an organizationenjoysa monopoly position, added cost may not pose a problem.
Today'smarket,however,is highlycompetitiveand
demands that all players- even monopolies- be as
efficientas possible (i.e., incurringthe minimum
necessary cost to satisfythe customer betterthan
anotherprovider).
Classiccost accountinggenerallyrequiresthatall
indirectcosts be spread over some directcost basis.
For example,the serviceindustry'sdirectlaboror the
manufacturing
industry'sdirectmaterialsare used as
thebasisforallocatingindirectcosts.In thepastwhen
directcosts constitutedthe major part of total cost,
such allocation methods induced negligibleerrors.
Nowadays,improperallocationcan and does undercosthigh-volumeproductsand overcostlow-volume
output.A well-designedABC accountingsystemallocatesbothdirectand indirectcostsbased on theactual
consumptionofthose costsby the product,not some
theoretical
basisofconsumptionthatprovidesa mathematicallyaccuratebut incorrectend cost.
The service industryissues that apply to utility
providerscenteron work performedin the organization'score processes.Core processesare definedas
those processes crucial to customersatisfactionand

continuedsurvivalofthe organizationitself.Forwater
utilities,core processesinclude such key elementsas
customer service; water collection,treatment,and
distribution;systemoperation,maintenance,repair,
and major component replacement; and revenue
billingand collection.Each oftheseprocessesis composed of numerous activities,operations,and tasks
that are performedby functionalelements within
the organization.
ABC views activities as process components.
ABC's basic premise is that costs of organizational
resources- an organization'sfactorsofproductionare assignedto an activitybased on the activity'suse
of these resources;costs are then finallyassigned to
cost objectsbased on the object's use of activities.
As an example, distribution
departmentactivities
in a typicalwaterutilitycan be modeled in thismanner. Figure 1 shows a model of a utility'sresources,
activities,and services.In this model, the distributiondepartment's
resourcesincludelabor,equipment,
and materials.Threeofthe department'smanyactivities- pick materials, travel to job site, and install
materials- are componentwork elementsthatconsume departmentalresources. Managers, supervisors,and otheremployeesorganizeand do the activities to generate the end services- in this example,
main extensionand meter-setting.
The most importantaspect ofthe ABC concept is
thatthe end product,i.e., the serviceproduced,is a
resultof combinedactivitiesthathave a known cost.
Once the activitiesand their costs are known, the
groundwork is in place for management to mold
activities
intoan effective,
efficient
productionprocess.
How ABC works
First,ABC measures the cost of activities.Identifyingthe resources that are used in each activity
(e.g., costed labor,equipment, and materials) helps
determinethe cost of each activity.As an example,
the activity of reading meters may require labor
(salary and fringebenefits for the meter reader),
equipment (lease or depreciationcosts of the meter
reader'stransportvehicle and any recordingdevices
used), and materials(cost of vehicle fuelsand other
expendable items).
Truecostsofgoods and servicesproducedare then
ascertainedby determining
the consumptionofactivities (previouslycosted) thatare collectivelyused in
processesthatgeneratetheseproducts.Thistracingor
assignmentof cost is based on whatever drivesthe
activity,e.g., customer requests, purchase orders,
workorders,or complaints.Once theproductcostsare
determined,then management can act to improve
processes and attain betterperformance,enhanced
quality,and reduced costs. The better,cheaper, or
fasterthe output,the higherthe operation'sefficiency
and effectiveness.
The net effectof this formof cost accountingis
not to place emphasison the typeofcost (e.g., dollar
use) as in classicfinancialaccountingbut to focuson
the actual activities for which the dollars are ex-

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^m||

Schematic
ofutility
andfactorsmeasuredbyABC
representation

pended.Figure2, takenfromFortune
magazine,shows
the changes that occurredwhen auto parts manufacturerDana Corporation installed activity-based
accountingsystemsat itsplant in Plymouth,Minn.6
Costs forthe materials control departmentare
viewed accordingto traditionalaccountingmethods
and ABC. At thebottomline,thereis no difference
in
the amount ofmoneyexpended when viewed either
accountbytraditional
accountingor byactivity-based
ing. With ABC, however, management can clearly
trackwhere dollars are going in the supply-chain
process and take action to make the process more
efficient.
Performanceand output are measures of efficiency. Change forexcellence centers on gains in
efficiency,
usually definedas an increase in output
fora giveninputor,more simply,gettingmore bang
forthe buck.
In ABC methodology,the objectiveis greaterefficiencyfora given process. Attainingmore efficient
and definingcomprocessesbeginswithidentifying
ponentactivitiesand measuringtheirconsumptionof
resources in terms of cost per dollar. Making the
process and its elemental activitiesmore efficient
should lead to one of threeresults:
output remains constant (value unchanged)
with less inputresources,
value increases with no change in input, or,
optimally,
outputvalue increaseswithless inputresources.
An accepted truismin management holds that
what getschecked getsdone. This applies to process

performancemeasures;managementneeds to ensure
that the measures apply to processes across functional "stovepipes,"i.e., organizationalunits. Costsper-unitoutput,e.g., dollarsper milliongallons,illustratethispoint. Data on costsper customertypecan
All the
provideexcellentinsightintoratesufficiency.
tasks,operations,and activitiesin the water supply
organizationare combinedin the processof producing waterofdesiredqualityat the rightplace and the
righttime.
Performancemeasures take many forms. Other
typesof performancemeasures that may be appropriate include the following:workload, output-tocost ratios,transactionratios,errorrates,consumption rates,inventoryfillrates,timelinessmeasures,
completionand backorderrates,quality,responsiveness rates,and user satisfactionrates.
Business model approach recommended
A business model of an organization must be
developed froma specificperspective.The best perspectiveforany organization,froma largemunicipal
water utilityto a 50-person advertisingagency, is
that of the customer the organization serves- the
user or buyerof goods and services.
Identifycustomers and the products they consume. Who are the customersofa typicalwaterutility? Obviously,individual consumers of water are
key customers.Water sustainslife,of course, but it
serves other needs as well. Businesses comprise
anothersegmentofthe utility'scustomerbase; many
industrialprocessesrequirelargevolumes ofwaterto

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Cross-functional
modelofprocessesandactivities

produceproductsfortheircustomers.Stillothercustomersmay be less apparent, but they are no less

demanding; these include stockholders,regulatory
agencies,and local governmentswho need mandated
reports,meeting participation,and other requirementsof governance.
Once all stakeholdershave been identified,the
next step is to identifythe utilityproductsthese customers consume. The commodity of water is just
one of many productsgeneratedby a water utility.
Other products range fromannual financialstatementsto customerservicerequestprocessingto environmentreports.
At thispoint,the modelingeffort
requiresa bitof
strategicgamesmanship. Product generation performancemeasures need to be structuredto evoke
desired results from customer-orientedprocesses
ratherthan functionalstovepipes. As an example,
average unit costs of service work orderprocessing
(startto completion across the utility'sfunctional
organizationalelements) is more meaningfulthan
the simplecost of customerservicedepartmentprocessing.Additionally,performancemeasures should
be attuned to some attributeof customerdemand.
One such example is the unitcost formilliongallons

ofwaterdeliveredper day; the performancemeasure

is easily understood by producersand consumers.
Now that services have been defined,the next
step is identificationand definitionof activities.As
statedearlier,activitiesare processelementsthatconsume substantialresourcesto produce an output. It
is at this stage that the process model generation
needs both a strategicand tacticalview.The activities
should be manageriallyuseful for senior managei.e.,
ment,yetrecognizableto the processperformers,
first-line
managersand employees.
The ABC model builder must firstapply cost
attributesto the activitiesby assigningresourcevalues (costs of labor, equipment, materials,or other
resources) to each activity and, second, identify
driversor cost-tracingmechanisms forthe activity.
The drivers serve as the link between the costed
activityand the activity-consumingproduct. For
example, the indirect costs of administeringpersonnel may use number of employees as an activitydriver.
Costs also have a time parameter sometimes
referredto as a period cost. Depending on the needs
of the model builderto satisfymanagementrequirementswithinspecifictime constraints,activitycosts

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can be determinedformonthly,quarterly,or other

timesegments.
The finalcomponentofthisapproach to building
the organization'sABC model is linkingthe activity
to the functionalcomponent. Activitymatrixesare
built foreach organizationalelement cost centeror
center.This serves to tie activityperresponsibility
formance(and custodyforactivitystructure,design,
and redesign) to the functionalelement managers.
This is nothingmore than an instance of the classic
management loop- planning, direction,feedback,
and control.
ABC requires activity-based management. All
the componentsforABC are in place; all thatremains
is for management to shiftto a process-centered
methodofmanagement.Activity-based
management
happens when managerial decisions are based on
feedbackfromthe ABC matrixshown in Figure 3.
Now that product-generatingwork is measured in
costtermsand tiedto the functionalelementsofthe
utility,efficiency
improvementscan be planned and
and theireffects
can be measuredas feedback
directed,
forfurtheraction.
ABC reaps benefits, avoids blind action
ABC provides managers with previously unavailable informationthat can be used to more effectivelymanage operations. The costs of work
processes are collected in such a manner that
process owners can become responsible for the
costs of the process. ABC shiftsthe organizational
focus to business processes and their value and
Once cost becomes the means of meaproductivity.
surement, a common basis of reference is established forall management areas to use in improving the organization.
Figure4 shows some typicalactivitiesthata water
utilityorganization may performin response to a
customer'srequestforservice.The stepsin theprocess
have been defined,but how can a manager be sure
that this is the best way to provide better,faster,
cheaperservice?No managercan know forsure until
the processparametershave been measured and the
effectsof changes can be tracked.Currentmanagementliteratureis litteredwithexamples of downsizand resizingthat could all be classiing,rightsizing,
fied as "dumbsizing." Most of the fault can be
attributedto management actions that were taken
withouta means of measuring theireffecton customer-oriented
productionprocesses.
More to the point, ABC serves as the basis for
activity-basedmanagement- the management of
organizationalworkthroughmanagementofprocess
cost.ABC can help utilitymanagers
contain rate increasesby enhancing efficiency
in organizationalprocesses,
stave offcompetitorsthroughbetterin-house
performance,and
improvecustomerperceptionsof cost,quality,
and timelinesswith cleaner, leaner processes that
yieldbetterresults,fasterand more economically.

Conclusion
Today'scompetitivebusiness climaterequiresthe
water industryto become more cost-effective
while
delivering high-quality products and services. To
achieve this,water utilitymanagers,just like their
counterpartswithinthe privatesector,mustbe concernedwithwhat efficiency
is and how to measureit.
As management maven Peter Drucker writes,"We
need to measure, not count."7
A provenmanagementtool,ABC enablesan organizationto quantifycostand performancein termsof
the process activitiesthatmake up its core business.
This provides a true measure of how much goods
and servicesproduced actuallycost. Withthisinformation,managementcan pinpointareas where costs
can be reducedand businessprocessesand employee
performancecan be improved.
ABC and itscorollary,
activity-based
management,
give managersan accurate pictureof organizational
and help themavoid hit-and-missattempts
efficiency
to improveperformance.For watersupplymanagers
look at ABC, thereferences
requiringa moredefinitive
cited in this articlehave been selected to provide a
solid introductionto activity-basedaccounting and
activity-basedmanagement.
References
1. Hammer,M. BeyondReengineering.
HarperCollins,
New York (1996).
2. Tzurney,P.B.B. CommonCents:TheABC PerformanceBreakthrough.
Cost Technology,Hillsboro,
Ore. (1991).
3. Covins, G. Activity-Based
CostManagement:
MakingIt Work.IrwinProfessionalPubl.,BurrRidge,
111.(1996).
4. Brimson,J.A. Activity
: AnActivity-Based
Accounting
John
&
Approach.
Costing
Wiley Sons, New York
(1991).
5. Horngren, C.T. & Foster, G. CostAccounting:
A
ManagerialEmphasis.Prentice-Hall, Englewood
Cliffs,N.J. (7th ed., 1991).
6. Par,T.P.A New Tool forManagingCost.Fortune
(June 13, 1993).
7. Drucker, P.F. Editorial.WallStreetJournal(Apr.
13, 1993).
About the authors: JohnL. Eggers
is a seniorcostanalystwithManagementAnalysisInc., 8150 Leesburg
Pike,Suite1100,Vienna,VA22182.
He hasmorethan20 yearsoflineand
inoperation
and logisstaff
experience
ticprocess
andsince1993
improvement
has specialized
in activity-based
coststudieswithemphasis
onpublicworks
ingand productivity
organizations.
Eggersholdsa BS inchemistry
fromDavidson
Davidson,
N.C.,an MS in organicchemistry
College,
from
Clemson
Clemson,
S.C.,andan MS inmanagement
University,
information
systems
fromGeorgeWashington
University,
D.C. CharlesE. Bangertisa principal
in Orr&
Washington,
BossInc.,13600Otterson
Ct., Livonia,MI 48150.

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