Continuous Improvement:

An Activity-Based
Model
B Y S U R E N D R A P. A G R A W A L , P H . D . , C M A , C P A ; Z A B I H O L L A H R E Z A E E ,
P H . D . , C M A , C PA , C I A ; A N D H O N G S . PA K , P H . D . , C PA

CONTINUOUS IMPROVEMENT MUST START AT THE ACTIVITY LEVEL. A FIELD STUDY OF

CONTINUOUS IMPROVEMENT ACTIVITIES AT THE AUTO LOAN DEPARTMENT OF A

COMMERCIAL BANK ILLUSTRATES HOW SUCH A PROGRAM CAN BE EMPLOYED TO

INCREASE A COMPANY’S COMPETITIVENESS AND SHAREHOLDER VALUE.

n a global business environment with advanced improvement in each category based on observations

I manufacturing innovation, continuous improvement

becomes crucial in gaining a competitive advantage.
Continuous improvement is the organizational
process that helps the company position itself
against its competitors in the pursuit of competitive
advantage. Continuous improvement strategies can be
used to develop competitive plans and focus on activi-
from a field study of continuous improvement activities
of the auto loan department of a commercial bank.

ties that create shareholder value.
Companies use many different ways to improve their
profitability, such as expansion of production and sales,
increase in quality, reduction in costs, and shortening of
cycle time. A business uses numerous processes consist-
ing of activities carried out by various units that com-
prise its organization. Therefore, an important aspect of
any method for continuous improvement is that it must
work at the activity level. We present here a model that
divides activities into four categories: essential and
value-added, essential and nonvalue-added, nonessen-
tial and value-added, and nonessential and nonvalue-
added. Then we discuss the strategy for continuous
C L A S S I F I C AT I O N OF AC T I V I T I E S
Antonio Davila and Marc Wouters argued that a signifi-
cant portion of product costs is determined during prod-
uct development and suggested that management pay
particular attention to continuous improvement, includ-
ing technological innovation, product performance, and
time-to-market, during the product development
stage.1 Alan Reinstein and Mohammed Bayou proposed
a continuum of 13 different product costing systems
that facilitates the adoption of continuous improvement
strategies.2 Robin Cooper and Robert Kaplan presented
a model that classifies activities into either value-added
or nonvalue-added activities.3 This model suggests that
business activities consume the organization’s resources,
and, thus, identification and analysis of these activities
are a prerequisite to improving operational efficiency.
This one-dimensional classification of activities to

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 14 SPRING 2006, VOL. 7, NO. 3

value-added and nonvalue-added categories may not be
adequate and effective in improving operational
efficiency.
Business strategies are determined on the basis of
integrating activities in the value chain in different
units of the organization. Continuous improvement
strategies focus on activities essential in increasing the
value of a product or service. Competitive advantage
can be achieved when an organization increases the val-
ue of a product or service through continuous improve-
ments. Activities may be considered to have two
dimensions: Does an activity add value? Is it essential?
On the basis of these dimensions, activities are classi-
fied into four categories:
A. Value-adding and essential
B. Value-adding but nonessential
C. Nonvalue-adding but essential
D. Nonvalue-adding and nonessential
A business entity may carry out the classification of
activities in this manner at different levels, such as the
organization, division, unit, factory, department, process,
worker team, or even individual employee levels. This
basic model of activity classification is presented in
Figure 1.
A N A LY S I S OF AC T I V I T I E S
Analyzing activities is a way of identifying and concep-
tualizing the activities that are needed to create value in
Figure 1: ACTIVITY CLASSIFICATION
VALUE-ADDING ACTIVITIES
ESSENTIAL ACTIVITIES
A C
NONESSENTIAL ACTIVITIES
B D
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 15
products and services. An organization can be viewed as
a collection of discrete yet interdependent activities.
Some of these activities are essential and are the source
of value creation. A general analysis of each class of
activities for the purpose of continuous improvement is
presented below.
A . VA L U E - A D D I N G AND ESSENTIAL
AC T I V I T I E S
This area is of the greatest significance for each organi-
zational unit. Not all such activities are carried out with-
in the organization, however. The unit has to decide
which activities it must carry out by itself and develop
this area as its core competency. The objective should
be to acquire more and better expertise and other
resources in a continuing manner. This step may
involve developing new and improved products and
processes that will increase overall profits, and/or by
improving quality, cutting cycle time, or reducing costs.
The unit also must use cost/benefit analysis to evaluate
on a continuing basis which activities it should out-
source, including any opportunity costs of conducting
an activity internally that are not within its area of core
competency.
The primary focus in the case of activities falling in
this category is strategic. The strategy mentioned here is
the strategy of the unit under analysis. Thus, an activity
that requires strategic attention at the unit level may not
NONVALUE-ADDING ACTIVITIES
SPRING 2006, VOL. 7, NO. 3
require a strategic decision at the organizational level.
B . VA L U E - A D D I N G BUT NONESSENTIAL
AC T I V I T I E S
These activities are currently value-adding, but they
may be eliminated without losing the value-added fea-
ture of the output by such means as re-engineering and
product or process redesign. Identifying opportunities
for accomplishing this step requires continuous effort,
and the policy of each organizational unit should be to
look for such opportunities actively. In many situations,
the implementation of such an opportunity may require
approval at a higher level, such as in the form of a capi-
tal budget. The primary focus in the case of activities
falling in this category is technical.
C . N O N VA L U E - A D D I N G BUT ESSENTIAL
AC T I V I T I E S
These activities do not add value, but they are essential
and must be carried out to complete a process under
the currently existing conditions. A large number of
such activities are conducted by every organization,
both for internal and external purposes. A large part of
the time and effort of most managers is spent in keep-
ing control of these activities, which are often out-
sourced. The goal of each unit should be to minimize
such activities, both those carried out internally and
those outsourced. In the case of such activities, the clas-
sification depends upon the unit that is under analysis.
The primary focus in the case of activities falling in this
category is managerial.
D. N O N VA L U E - A D D I N G AND NONESSENTIAL
AC T I V I T I E S
Obviously, these activities must be eliminated as quick-
ly as possible, but identification of such activities is not
easy, primarily because the people who carry them out
would insist that they are either value-adding or essen-
tial, which is generally true from their point of view.
Each unit should actively look for such activities from
an overall view of the unit. Furthermore, units at the
higher levels of the organization also should analyze
activities carried out at the lower-level units from its
own perspective to consider if any of them fall in this
category. How high the analysis should go in the hierar-
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
chical structure for this purpose will be a matter of
judgment depending upon the cost of such activities.
The foregoing analysis of classifications of activities
applies to business activities in general. It should be
further refined when considered in the context of activ-
ities in different functional areas.
FUNCTIONAL AREAS OF A BUSINESS
For the purpose of classifying activities based on the
two dimensions for a particular business, a distinction
must be made between activities comprising its value
chain and those that relate to its planning and control
functions. A conceptual model of the business organiza-
tion depicting this distinction is shown in Figure 2.
AC T I V I T I E S IN THE VA L U E C H A I N
There are distinct inputs and outputs for each process
or subprocess in the value chain of a manufacturing
company. Furthermore, there is a customer who uses
the output. For most of the processes, the customer is
internal, and only the last process will have an external
customer. The process introduces a change in the input
that makes it useful to the customer. This change is the
value added by the process. There may be some activi-
ties that do not add value. An example of the activities
in a manufacturing process and their classification is
shown in the diagram below.
Input (X) ➮ Workstation 1 (Processing) ➮ Inspection ➮
Moving ➮ Waiting ➮ Workstation 2 ➮
Workstation 3 ➮ Output (X + a + b + c)
In this diagram, Workstations 1, 2, and 3 add the fea-
tures a, b, and c, respectively, to the input X. The com-
pany’s continuous improvement process suggests
combining the activities of Workstations 2 and 3 in a
single activity. In this case, the improved process causes
the activity of Workstation 1 to fall in category A (Fig-
ure 1), while the activities of 2 and 3 fall in category B.
In the current environment, moving the material from
Workstation 1 to 2 is essential to complete the process
though it does not add value as such. Therefore, “mov-
ing” falls in category C. “Waiting” seems to be neither
essential for the completion of the process, nor does it
add value; therefore, it would fall in category D.
“Inspection” is considered essential to ensure that the
16 SPRING 2006, VOL. 7, NO. 3
 Figure 2: BUSINESS ORGANIZATION—A CONCEPTUAL MODEL

PLANNING MANAGERIAL CONTROL

STRUCTURE GOALS AND

(NATURE, SIZE, LOCATION, PERFORMANCE
TECHNOLOGY, ETC.) EVALUATION

DEVELOPMENT
ORGANIZATION
(R&D, MARKETING)
(PROCESS DESIGN AND LONG TERM
PRODUCT DESIGN)

SUPPORT
(HR, DP, ACCT, ACTIVITIES SHORT TERM
ADMIN, ETC.)

CURRENT

INPUTS OUTPUTS

MATERIALS/COMPONENTS INTERNAL PROCESSES PRODUCT

SERVICE PROCUREMENT MANUFACTURING SELLING DELIVERING SERVICE

LABOR INFORMATION

INFORMATION
SUPPLY/VALUE CHAIN

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 17 SPRING 2006, VOL. 7, NO. 3

output is of the required quality and thus falls in cate-
gory C. The company can improve the process in many
ways, such as the following:
◆ Eliminate “waiting” by a more proper scheduling
of jobs;
◆ Minimize “moving” by placing Workstations 1
and 2 close to each other;
◆ Replace Workstations 2 and 3 with a new activity,
if it is found to be feasible and cost effective;
◆ Make further improvements in the features a, b,
or c that will make the output more attractive to
the customer, subject to its being cost effective;
and
◆ Use an effective quality control system that
reduces defects.
Making similar improvements will continue even
after the foregoing changes have been made. This is
why we call it a continuous improvement model.
HIERARCHY OF AC T I V I T I E S
As mentioned earlier, the actual definition of “value-
adding” and “essential” will differ when viewed from
the perspective of different levels of the organizational
hierarchy. For example, the foregoing analysis was car-
ried out at the process level. If it is viewed from a high-
er level, the customer may be external and the entire
factory may be considered as one process. From that
vantage point, a “value-adding” activity would be one
for which the customer is prepared to pay. Suppose it is
found that the external customer does not care for an
added feature and is reluctant to pay for it. In such a
case, the activity at Workstation 1 may belong in cate-
gory D and, therefore, be a candidate for elimination.
At yet a higher level of the organization, “value-adding”
may be defined in terms of an increase in the value of
the company through the profitability of its products.
Suppose at this level it is determined that this particular
product is not likely to be profitable in the long run. In
such a scenario, the entire production process for the
product may be considered to be nonvalue-adding.
S E R V I C E AC T I V I T I E S
Planning, control, and similar other activities generally
have no concrete inputs and/or outputs. Most of the
input and output is in the form of information that may
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
be communicated to recipients orally, electronically, or
by means of documents on paper, computer disks, etc.
Each function has an identifiable goal, and the activities
constituting that function should be defined as “value-
adding” and/or “essential” with respect to such goal.
Some examples of the classification of such activities
are given below.
Value-adding and Essential
Collection and analysis of information; development
and exchange of ideas; making decisions; resolving
problems; preparation of documents; communica-
tion of information.
Value-adding but Nonessential
Manually performed activities that can be
computerized.
Nonvalue-adding but Essential
Keeping files for future reference.
Nonvalue-adding and Nonessential
Sending copies of documents to people who do not
use them; playing games on personal computers.
A C T I V I T Y- B A S E D M O D E L OF
CO N T I N U O U S I M P R OV E M E N T
Activity-based costing, activity-based budgeting, and
activity-based management have become popular in
recent years. The use of an activity-based model can
facilitate decision making in operations by focusing on
activities that are essential and create value. Continuous
improvement may take various forms, such as in rela-
tion to production and sales, cost, quality, or time.
Activities falling in different categories require signifi-
cantly different strategies for improvement. Further-
more, while some of these strategies may be developed
at the unit level, some others have to be developed at a
higher level of the organization.
Within the classification of activities presented here,
the strategies mentioned earlier suggest moving the
activities from one classification to another. Such move-
ment may take the following directions, with the ulti-
mate aim of eliminating activities that fall in category
D. The movement among the classes of activities is dis-
cussed below and illustrated in Figure 3.
Enhancing activities in category A. A company must
continue to enhance its activities constituting its core
18 SPRING 2006, VOL. 7, NO. 3
 Figure 3: ACTIVITY-BASED MODEL OF
CONTINUOUS IMPROVEMENT
VALUE-ADDING ACTIVITIES
STRATEGIC FOCUS
ESSENTIAL ACTIVITIES
A C
ENHANCE
STRATEGIC FOCUS
NONESSENTIAL ACTIVITIES
B D
SEEK AND IMPLEMENT
competency. This process involves carrying out addi-
tional activities and making changes in existing activi-
ties that may be called for with the improvements in
technology, management techniques, worker capabili-
ties, and so forth.
Moving activities from category A to category B.
Activities that are currently value-adding and essential
will be analyzed to determine if any of them may be
reduced by means of redesigning the product or the
process. For example, it may be possible to avoid the
activity of welding two fabricated metal pieces together
if the process is redesigned to fabricate them as a single
piece. Thus, this activity will be reclassified as value-
adding but nonessential.
Moving activities from category B to category D.
Once the redesigning of the product or the process is
carried out, the activities previously carried out will
become nonessential and will be reclassified as prime
candidates for elimination.
Moving activities from category A to category C.
Value-adding and essential activities will be continually
examined to see if they really add value; if any of them
is found to be nonvalue-adding, it would be reclassified
as nonvalue-adding but essential.
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 19
NONVALUE-ADDING ACTIVITIES
MANAGERIAL FOCUS
MINIMIZE
ELIMINATE
Moving activities from the category C to category D.
Activities that are nonvalue-adding but essential will be
continually examined to find ways to render them to be
nonessential. Thus, attempts will be made to reclassify
them as nonvalue-adding and nonessential.
Eliminating activities that fall in category D. As previ-
ously mentioned, these activities should be eliminated
as quickly as possible. As soon as an activity is moved
from category B or C to this category, it becomes a
prime candidate for immediate elimination.
This model shows a continuous flow of activities
within a unit as well as into and out of that unit. In fact,
this is a never-ending process with no pre-specified
goal. With the developments in technology and man-
agement, there will be a continuous need to keep
enhancing the core competency of the company, to
keep analyzing activities, moving as many of them as
possible to category D, and eliminating them as quickly
as possible.
T H E F I E L D S T U DY
The banking industry has faced intensive competition
not only from its own industry but also from other
financial service companies because of substantial
SPRING 2006, VOL. 7, NO. 3
deregulation and other regulatory changes. As competi-
tion becomes more intensive, the efficiency of a bank’s
operation becomes more critical for its survival. Two
sets of data were collected from the auto loan depart-
ment of a commercial bank over two periods. One set
is the data before the implementation of a new tech-
nology (i.e., an automated telephone system) in the
department and the other set is the data after the
implementation in the same department. A set of activ-
ities in the department was collected for the four-day
period of July 6-9, 1999. The other set of activities was
collected for the four-day period of January 9-12, 2001.
The bank implemented a new telephone system
between these two study periods.
A survey form was designed to collect data for partici-
pants’ activities during the study periods. Participants
were asked to report their activities in detail as much as
possible along with time they spent. Further, they were
asked to judge whether activities they conducted fall in
the categories of “value-added” and “essential.” The
definitions and examples of the terms were given in a
survey instruction sheet, and forms were delivered to
study participants. The data obtained from the surveys
are summarized on the basis of the broadly defined
activities: (1) originating auto loans, (2) documenting
loan applications, (2) reporting auto loans, (4) providing
customer services, (5) collecting the delinquent auto
loan receivables, and (6) funding money.
The auto loan department’s activities are analyzed on
the basis of our two-dimensional classification model,
i.e., value-added and essential, value-added but
nonessential, nonvalue-added but essential, and nonvalue-
added and nonessential. Then an analysis was conduct-
ed to determine how the adoption of an automated
telephone system changed the loan officers’ activities.
We focused on whether nonvalue-added and nonessen-
tial activities were reduced because of the new system
while more value-added and essential activities were
created. For example, the loan originating activities are
considered to be value-added and essential activities
because those activities are essential to commercial
banking, and the outputs of the activities, auto loans,
are the products that the customers expect from the
commercial bank. The documenting, reporting, and
funding activities are the necessary procedures to com-
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
plete loan origination processes and to comply with the
bank’s loan procedure policy under the currently exist-
ing operational condition. The outputs of those activi-
ties, however, are not related to the customers’
satisfaction. Thus, the activities are classified as “essen-
tial but nonvalue-adding” activities.
In theory, the activities of customer service may be
classified to be either “value-adding” or “nonvalue-
adding” activities. If the activities lead to the satisfac-
tion of the customers by introducing the products of the
commercial bank or resolving questions in regard to the
products of the bank that the customers have, they are
considered to be “value-adding.” If the activities do not
create any customer satisfaction, they are considered to
be “nonvalue-adding” activities. Furthermore, the
activities may be classified to be either “essential” or
“nonessential.” If the customer service activities are a
part of the currently existing auto loan procedures, the
activities are classified to be “essential”; otherwise, they
are classified as “nonessential.”
The information gathered by this study indicates that
most customer services provided by the loan officers are
avoidable and not directly related to the operational
condition of the department. The head of the depart-
ment expressed the opinion that the customer-related
activities are purely nonproductive and even hamper
other essential activities. He wanted those activities to
be eliminated. From the practical standpoint, this study
classifies the activities as “nonvalue-adding” and
“nonessential” activities.
The activities related to the delinquent loan collec-
tion may be considered to be either “value-adding” or
“nonvalue-adding” activities. If the user is the outside
customer of the bank, the activities are classified to be
“nonvalue-adding” because the outputs of the bank’s
collection activities do not satisfy the customer. If the
user is defined as “top management” or “shareholders”
of the bank, then the activities are classified as “value-
adding” activities because the activities produce more
earnings and, ultimately, cash for the bank. Further-
more, the activities may be classified to be either
“essential” or “nonessential” activities depending on
whether the activities are part of the currently existing
operations. For example, the bank’s target customers
are those whose financial credits are below average.
20 SPRING 2006, VOL. 7, NO. 3
 COMPARISON OF BEFORE
Table 1: ment’s adoption of a new telephone system increased
AND AFTER IMPLEMENTATION value-added and essential activities from 12.94% to
16.58%, while it decreased value-added but nonessen-
OF TELEPHONE SYSTEMS tial activities from 10.34% to 3.52%. Nonvalue-added
activities were increased from 76.72% to 79.9% due to
the adoption of a new telephone system. The results
TIM E S P ENT
Difference
also show that about 13% to 17% of total time surveyed
AC T I V I T I E S Before After (After—Before) is considered to be value-added and essential activities,
I. Value-Added and Essential about 40% to 53% to be essential but nonvalue-added
Originating Loans 12.94% 16.58% 3.64% activities, and about 12% nonessential and nonvalue-
II Value-Added but Nonessential added activities.
Collecting 10.34% 3.52% -6.82%
III. Essential but Nonvalue-added
Documenting 26.90% 38.70% 11.80% A FRAMEWORK FOR CONTINUOUS
Reporting 9.48% 6.63% -2.85% I M P R OV E M E N T
Mailing 2.46% 7.55% 5.09%
To compete successfully in the global market, organi-
Funding 1.25% 0.27% -0.98%
zations must continuously improve operational perfor-
IV. Nonessential and Nonvalue-added
Customer Service 11.00% 12.19% 1.19% mance of their products and services. Our research
study suggests that activities analysis and continuous
improvements can be powerful tools in developing
sound business strategy. Identifying, classifying, and
The bank may assume the high risk of loan defaults, analyzing activities is a process of searching for contin-
and, therefore, collection is the anticipated activity and uous improvements. This framework links activities to
an essential part of the bank’s operations. On the other business strategies of increasing value of products and
hand, if the bank does not anticipate a high default risk, services that may be used by companies to embark
the collection activity may be considered to be upon a journey of continuous improvement. It classi-
nonessential in its operation. fies activities into four categories on the basis of two
The results of this study (see Table 1) show that the dimensions: value-adding vs. nonvalue-adding, and
officers’ time spent for customer services slightly essential vs. nonessential, making a distinction among
increased rather than decreased from 11% before the different functional areas of business and different levels
change to 12.19% after the change. Further, the offi- of organizational hierarchy. It discusses strategies that
cers’ time spent for originating loans and collecting may be followed for a continuous improvement in
default loans decreased from about 23% to 20%. Inter- each category. Such improvement will comprise
views with the loan officers who participated in this sur- enhancing value-adding/essential activities, taking
vey study indicated that the bank’s customers felt steps to move as many activities as possible to the
uncomfortable with the automated telephone systems nonvalue-adding/nonessential category, and eliminat-
because they had been used to talking personally to the ing all activities in that category. The results of the
loan officers. Further, these interviews indicated that field study suggest that the bank’s strategies for con-
the loan officers had to spend more time to deal with tinuous improvement of activities are essential and our
the customers’ complaints due to the change. The two-dimensional model works well in identifying and
results suggest that technology may reduce and elimi- assessing value-added, nonvalue-added, essential,
nate some activities but, at the same time, it may create and nonessential activities in the loan department.
other nonessential and “nonvalue-adding” activities We hope that business executives and other
(e.g., the officers’ time spent on the customers’ com- researchers will evaluate and further refine this
plaints due to the bank’s system changes). The results framework from the viewpoint of its feasibility for
of our field study indicate that the auto loan depart- adoption into practice. ■

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 21 SPRING 2006, VOL. 7, NO. 3

Surendra P. Agrawal, Ph.D., CMA, CPA, FCA, is professor
of accountancy, Fogelman College of Business and Econom-
ics, The University of Memphis, Memphis, Tenn. He can be
reached at sagrawal@memphis.edu.

Zabihollah Rezaee, Ph.D, CMA, CPA, CIA, CGFM, CFE,

is Thompson-Hill Chair of Excellence & Professor of
Accountancy, Fogelman College of Business and Economics.
E-mail: zrezaee@memphis.edu

Hong S. Pak, Ph.D., CPA, is professor of accountancy, Col-

lege of Business Administration, California State Polytechnic
University, Pomona, Calif. He can be reached at
hspak@csupomona.edu

1 Antonio Davila and Marc Wouters, “Designing Cost-Competitive

Technology Products through Cost Management,” Accounting
Horizons, March 8, 2004, pp. 13-26.
2 Alan Reinstein and Mohammed E. Bayou, “Product Costing
Continuum for Management Decisions,” Managerial Auditing
Journal, September 1997, pp. 490-497.
3 Robin Cooper and Robert S. Kaplan, Cost and Effect: Using Inte-
grated Cost Systems to Drive Profitability and Performance, Harvard
Business School Press, Boston, 1997.

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 22 SPRING 2006, VOL. 7, NO. 3

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.