WHITE PAPER

Author: Richard Barrett

Contributors: Chris Grundy, Jennifer Meegan, MaryLouise Meckler, Jing Zhao

Audience: CFOs, financial controllers, financial managers, and cost accountants

IntroduCtIonIn 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 profitable?

Which products are the least profitable?

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 justifiable 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 first of the series, you can find 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.

IntroduCtIon to ACtIvIty-BAsed Cost MAnAgeMent Achieving Insight of Costs and Profitability 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 Example12 The Importance of ABC

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 efficient 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.

BAsIC ABC PrInCIPles

Figure 1: Definition of ABC Terms.

Business objects. Introduction to Activity-Based Cost Management

Term Definition Examples

Resource A resource used by the business in carrying out its business

Staff costs, property costs, capital, running costs

Resource Driver

A measurable quantity used to allocate resources to activities

Headcount, time spent, floor area, number of machine hours

Process A series of connected activities required to achieve an outcome

Handle customer orders

Activity A series of related tasks carried out repeatedly

Dispatch goods to customer

Task An element of work, a series of which make up an activity

Record customer order in database

Activity Driver An event or factor that causes an activity to be performed

Invoices sent to customers

Cost Object The entities that are to be costed Customers, products

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, defining 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-specific 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.

Resource Costs

Activity Specific Costs

Activity Costs Analysis

Product, Service or Channel Specific Costs

Customer and Product Costs

Non-specific Costs

Unabsorbed Costs

Allocation Methods

Resource Driver

Activity Drivers

From General Ledger

Business objects. Introduction to Activity-Based Cost Management

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 specific 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 identified 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.

Figure 3a: Resources

Worked exAMPle

Resource $

Staff Costs 100,000

1 Manager @ $25,000 5 Staff @ $15,000

Property Costs (50m2) 25,000

Telephone (7,500 mins) 15,000

Total 140,000

Business objects. Introduction to Activity-Based Cost Management

From Figure 3b, you will see that we have identified five 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 fine 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 five 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 five activities according to time spent, and the telephone costs ($15,000) to be allocated across just two activities in the ratio of 75/25.

Activity % Time

Print & Mail Invoices

Chase Customers on Telephone

Issue Credit Note

Allocate Receipts

Plan, Organize & Monitor Staff

Total Staff Percent

30

100

400

50

20

600

Figure 3b: Activities and Time Allocation

Business objects. Introduction to Activity-Based Cost Management

On this basis, activity costs would be as follows:

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 fit driver, such as the average value of overdue accounts, might be necessary.

Figure 4: Credit Control Function Activity Costs

Business objects. Introduction to Activity-Based Cost Management

Activities Resource Driver: % Time

Resource Driver: No. Calls

Calculation Cost $

Print & Mail Invoices

Issue Credit Notes

Allocate Receipts

Plan, Organize& Monitor Staff

Total

30 125,000 x 30 600

125,000 x 400 60015,000 x 1,875 7,500 Total

125,000 x 50 600

125,000 x 20 600

1,875400

50

20

600 7,500

Chase Customeron Telephone

100 5,625 125,000 x 100 60015,000 x 5,625 7,500 Total

= 20,833

= 11,250

= 83,333

= 3,750

= 20,833

= 11,250

6,250

32,083

87,083

10,417

4,167

140,000

Figure 5: Activity Driver "Late Paid Invoices"

Figure 6: Customer Costs

Business objects. Introduction to Activity-Based Cost Management

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:

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).

Customer B

Customer C

Customer A 200

500

0

Cost Objects Volume

Customer B

Customer C

Customer A 32,083 x 200 700

32,083 x 500 700

32,083 x 0 700

9,167

22,916

0

Customer Calculation Cost $

Figure 7: Activity Driver "Number of Return Notes"

Figure 8: Customer Costs Multidimensional Driver

Business objects. Introduction to Activity-Based Cost Management

The driver volumes for the number of return notes driver are shown in Figure 7.

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.

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 financial presentation of the way resources are spent. It is this that permits ABC to be used to manage costs.

Cost Objects Volume

Customer B

Customer C

Customer A Product I 700

20

1,600

50

30

Product II

Product I

Product II

Product II

Product

I II

700

1600

20

50

0

Cus

tom

er

30

A

B

C

Customer C / Product I = $87,083 x 30 / 2,400= $1,089

Activity: Issue Credit NoteActivity Driver: No. of Return NotesActivity Cost = $87,083

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 definition, 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 specific 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.

Figure 9a: Resources

Figure 9b: Activities and Time Allocation

Business objects. Introduction to Activity-Based Cost Management 10

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.

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.

Resource $ Time Cost Per Hour

Staff Costs1 Manager @ $25,000

5 Staff @ $15,000

Property Costs (50m2)

Telephone (7,500 mins)

Total

25,000

25,000

15,000

140,000

10,000-

10,000 14.00

100,000

75,000

Activity Duration Time

Unit # Units Total Hours Cost Per Hour $

Activity Cost $

Print & Mail Invoices

8 hours Day 200 1,600 14.00 22,400

Issue Credit Notes

Allocate Receipts

Plan, Organize & Monitor Staff

Spare Capacity

Call

Note

Day

40 mins

60 mins

8 hours

1,875

200

Chase Customers onTelephone 5,625 14.00

14.00

14.00

14.00

14.00

3,750

1,875

1,600

1,175

10,000

52,500

26,250

22,400

16,450

140,000

Excluded (Done by Manager)

One of the obvious benefits 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 11

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.

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

% o

f Cos

t Bas

e

120

100

80

60

40

20

030 Years Ago Now

OverheadDirect LabourDirect CoseTechnology

Figure 10: The Inexorable Growth in Overheads

Business objects. Introduction to Activity-Based Cost Management 1

the IMPortAnCe of ABC

Notes

Business objects. Introduction to Activity-Based Cost Management 1

Notes

Business objects. Introduction to Activity-Based Cost Management 1

Notes

Business objects. Introduction to Activity-Based Cost Management 1

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