Expert Opinion

Activity Based Costing (ABC) and Activity Based Management (ABM) are utilised to gain a fuller understanding of the real cost dynamics and cost structures involved in business operations. ABM together with ABC principles can enable managers to better understand (a) both product and customer profitability, (b) the cost of business processes, and (c) how to improve them.

Joyce Chutchian-Ferranti (1999), writing for Computerworld, has defined ABC as  "A costing model that identifies the cost pools (or activity centres) in an organisation, and assigns costs to products and services based on the number of events or transactions involved in the provision of that product or service". Products or services themselves do not generate costs; rather it is the activities associated with the planning, procuring, and producing of those products that generate costs. Ellen Franklin, Regional Portfolio Analyst with the National Bank based in Evansville Indiana, and Mehmet Kocakulah, Professor of Accounting, at the University of Southern Indiana (2002) wrote that ABC was formed over the last 20 years and is used as a management tool to assess the costs of various repeated activities carried out on behalf of a customer with the purpose of passing those costs on to the customer as appropriate. 

The aim of ABC methodologies is basically to provide a clearer picture of the factors associated with providing services compared to simply taking the aggregated totals of costs derived from traditional costing sources. Through the structured analysis of the activities involved in the provision of products or services ABC can enable organisations to find new efficiencies and to consolidate tasks. It should be noted that ABC methodologies use estimated costs and assume a constant capacity usage, for this reason the derived costs will not be exact. Mabberley (1998) is cited as stating, "ABC is most useful in illustrating the link between costs and the factors that incur those costs. This provides a better understanding of why those costs are generated."

Leslie Kren, Associate Professor of Accounting at the University of Wisconsin-Milwaukee, and Thomas Tyson, Professor of Accounting at St. John Fisher College, Rochester (2004), write that ABC is a systematic method of assigning the cost of activities to products, services, customers, or any other cost object. 

ABM uses ABC information to control the cost of activities using the fundamental assumption that activities consume costs. ABM has been defined as a systematic method of planning, managing, controlling, and improving the labour and overhead costs of organisational processes. ABM focuses on understanding, managing, and improving processes and activities to support cost reductions.

ABM systems are a very effective means for improving company performance on many fronts. An organisation can realise the power of ABM when the right individuals access the right information in the best format for improving performance. Brad Anderson and Mick Twomey of Pendiant Consulting, Charles Davis an Ernst & Young Teaching Fellow, and Elizabeth Davis from Baylor University, Waco, Texas (Anderson et al, 2004), interviewed people from several organisations to learn how they had implemented and kept their ABM systems running. The following comments are a distillation of the lessons learned:

• Initiation -since human beings are creatures of habit it is important that the staff involved in any ABM implementation programme is given good reasons to change. It has been recognised that successful performance management implementations make a clear connection with the operating side of businesses, and are more than simply a means of recording a score. They represent the real heart of the organisation. They highlight how managers can meet their specific cost and productivity objectives, helping them and their departments to achieve their bonuses and goals.

• Project identification and scope - as ABM becomes part of an organisation's operational culture, systems should be devised to identify appropriate projects for continual improvement purposes. It is recommended that smaller pilot projects should be attempted first to obtain quick and encouraging wins. These will also serve as a training and development platform.

• Team selection - full-time dedicated resources are recommended to ensure that work gets done as quickly, and as competently, as possible.  As a means of ensuring that the ABM system is designed to meet operational objectives it is wise to have operations personnel working as full-time members of the implementation team.  By participating in the development of the system, operational employees will pick up essential knowledge that will assist in the future maintenance of the system. External consultants can also add (a) invaluable experience, (b) additional staff power, and (c) enabling tools and techniques that could greatly reduce the implementation time line and improve the quality of the initial model. An essential point to note is that the chosen implementation team will ultimately be responsible for developing a tool that could change the way the organisation views its total operations.

• Ongoing maintenance - excessive maintenance requirements have been known to destroy the effectiveness of ABM implementations which are by nature heavily data dependent. Some ABC data can be automatically retrieved, however much of the information needs to be entered manually. Successful ABM systems must maintain a balance between the value being generated by the system and the level of ongoing maintenance effort required.

• Communications - it is wise to establish a strong communication program, particularly during the first year after the ABM implementation. Management should regularly engage in reviewing and understanding the periodic results of the systems with operational managers. An agreed common language is recommended to minimise miscommunications.

In summary, the keys to the successful implementation of ABM systems are seen as being the development programmes that are:

Mitchell Max, Managing Partner of The Performax Group (2004), writes that studies continue to show that banks which manage the profitability of customer relationships outperform banks that manage without that data. Experience has demonstrated that non-profitability-based segmentation (e.g., based on revenue, balances or number of products) can encourage behaviour that rewards retention of "high touch", and generally less profitable, customers.  Best practice organisations explicitly measure and manage the true profitability of each customer relationship. This has been achieved by using the following:

• Activity Based Pricing (ABP);

• Linking ABC information into Performance Management scorecards and processes;

• Providing information supporting cost improvement needs and facilitating ongoing accountability for management, and information concerning the profitability of customer relationships.

The gathering of appropriate cost driver information has been simplified with the availability of Enterprise Resource Planning (ERP) solutions. Sidney Baxendale a Professor of Accountancy at the University of Louisville, and Farah Jama a Solution Manager at SAP America , Inc., Chicago (2003), state that one of the big challenges associated with the implementation of ABC systems is the location of the most appropriate activity cost-driver to use when attributing activity costs to  a product or other object. Furthermore the non-financial measures that are typically used as activity cost-drivers are rarely found within accounting systems. Measures such as the number of sales orders, the number of material moves, or the number of engineering change notices per type of product are more likely found elsewhere. With the advent of ERP systems the availability and reliability of activity cost-driver information has been significantly increased. The integration of production planning, materials management, and cost and management accounting within ERP systems has dramatically aided the reliability of cost driver information. This in turn has enabled ABC to be used to increase the accuracy of product-cost information and permitted the development of activity-based budgets.

 
Figure 1: diagram adapted from Needy et al, 2003,

The following four phases, as outlined in Fig 1, were found to be common to the small business  investigated:

Phase 1 - Cost System Evaluation:

• Assess company commitment to ABC;
• Assess current costing systems;
• Develop a process plan;
• Identify potential data sources;
• Analyse financial statements;
• Document customer profiles or segments;
• Discover fixed costs to variable costs ratios.

Phase 3 - ABC Implementation:

• Evaluate system implementation alternatives;
• Implement the system.

Phase 4 - System Evaluation and Validation:

• Evaluate the system and its effect on strategic decision-making;
• Evaluate resulting profitability;
• Validate that system is working as intended;
• Make improvements to the system as required.