Activity Based Costing

INTRODUCTION
What is ABM?
(Wikipedia Encyclopedia)
Activity-based management (ABM) is a method of identifying and evaluating activities that a business performs using activity-based costing to carry out a value chain analysis or a reengineering initiative to improve strategic and operational decisions in an organization. Activity-based costing establishes relationships between overhead costs and activities so that overhead costs can be more precisely allocated to products, services, or customer segments. Activity-based management focuses on managing activities to reduce costs and improve customer value. (Kaplan, 1998) Divide ABM into operational and strategic: Operational ABM is about doing things right, using ABC information to improve efficiency. Those activities which add value to the product can be identified and improved. Activities that dont add value are the ones that need to be reduced to cut costs without reducing product value. Strategic ABM is about doing the right things, using ABC information to decide which products to develop and which activities to use. This can also be used for customer profitability analysis, identifying which customers are the most profitable and focusing on them more.
Components of Activity Based Costing (Miller, 1996)

There are five basic components to the activity-based cost assignment methodology: resources, resource drivers, activities, activity drivers, and cost objects. Resources: Resources are what organizations spend their money on the categories of costs that are recorded in the general ledger. Additional examples of resources include travel, rent, depreciation, utilities, insurance, and supplies. Resource Drivers: Resource driver is defined as a measure of the quantity of resources consumed by an activity. Activities: An activity is defined as a process, function, task, or step that occurs over time and generates results that the company uses to produce and sell its products and services. An activity consumes resources as it transforms its inputs into outputs, and therefore incurs a 'cost' every time it occurs. Activities consume resources and Products consume activities ABC two stage tracing methodology
Stage 1 - Resources traced to activities Stage 2 - Activity cost traced to product The cost of activities is determined by tracing resources to activities using the resource drivers. Activity Drivers: Activity Driver is defined as a measure of the frequency and intensity of the demands placed on activities by cost objects. Cost Object: Cost objects can be any customer, product, service, contract, project, or other work unit for which a separate cost measurement is desired.
Cost assignment under ABC (Miller, 1996)
ACTIVITIES RESOURCES RESOURCE DRIVERS ACTIVITY DRIVERS COST OBJECTS
ABM and a growing business

ABM has many goals depending upon the type of business it is intended for. The goal of Activity based costing/management in a growing business is to improve profit and productivity by increasing sales more than the increase in costs. The focus is on eliminating or reducing non-value added activities so that resources can be redeployed to value added activities. The objective is to minimize adding people or equipment and to get information that helps decide if future growth activities are adequately funded or not. The benefits of ABM can only be measured by the decisions that are taken or improvements made using knowledge provided by ABC. If the information provided is not used, all efforts to implement ABM are wasted. The value and benefit of ABM can be difficult to quantify. Because ABM information drives and supports all improvement initiatives, its role in improvement can be difficult to quantify. All the initiatives that are taken as a result of information provided by ABM can be thought of as the real cause of improvement instead. For example if a certain activity was improved using benchmarking, benchmarking would be thought of as the real cause of improvement rather than ABM that actually initiated the improvement. It measures the results of improvements in monetary terms and attached a value to it. Money is the bottom line of every business.
What does a fully implemented ABM information system look like?

In fully implemented ABM information system business process and activities are defined and organization wide system for collection of activity based information on periodic basis is in place. Systems to collect activity data and budget activity data are in place. Timely information on activities is available to help make decisions and track operational performance. And most importantly activity information for important activities is documented in an activity based dictionary.
How much detail is enough?

The amount of detailed about any activity required for ABM reporting depends on the use of the information. In general, more detail is required for process improvement applications than for product costing applications.
Time frame & effort required for ABM installation

In a very large organization, a complete ABM installation requires 3 to 5 years to complete whereas in a small company it might only take 5 to 6 months. Total effort required for complete installation is dependent on many factors of which two most important factors are the size of the organization, starting point and the detail and precision of information required.
Large organizations require more time for ABM implementation and organization which have defined business processes take lesser time and effort. Regardless of all these factors the general steps for ABM implementation are same.
Steps for ABM Implementation

The approach used by most companies as described in Implementing Activity Based Management in daily operations by John A. Miller is the use of a pilot or initial implementation approach which uses a cross-functional team of five-to-six people working in a time frame of three to six months to implement ABM principles, techniques and methods for some part of the organization. The team is composed of internal people (dedicating 25 to 100% of their time), external consultants or both. Data is gathered through interviews and crunched off line in commercial ABM software or home grown spreadsheets. If the initial implementation is successful, it is carried out in other areas of the organization as well. John A. Miller has given a Four-step ABM Implementation Model in his book Implementing Activity Based Management in daily operations.
FOUR-STEP ABM IMPLEMENTATION MODEL 1. Planning

Planning includes a detailed plan including timeline, responsibilities and members of team, methods used to collect data. It has significant bearing on the outcome.
2. Activity Analysis
It is the most significant portion of the ABM implementation. It includes specifying activities and processes, identifying cost drivers, documenting outputs and output measures, analyzing activities from a value-added perspective and developing performance measures. Activity analysis can take 50% to 55% of implementation resources.
3. Activity/Product Costing
It includes tracing of resources to activities and defining the base assumptions. More than 25 to 30% of the resources should not be used on this step. Software is usually used to perform this step.
4. Document Results
It includes documenting the results, recommendations and conclusions.
Data Gathering and Analysis

Data gathering and analysis represents about one-third to one-half of the effort involved in each of the four steps.
Data gathering is required to complete the product/activity costing step. Information is collected about consumption of resources and activities.
ACTIVITY ANALYSIS
Activity analysis is defined by Miller as Identification and description of activities in an organization. Activity Analysis must contain the following: Activities within a business process How many people perform each activity How much time they spend performing the activity What resources are required to perform that activity What operational data best reflects the performance of activities What value has the activity for the organization Activity analysis is done by following these steps: 1. Define business processes 2. Specify key & significant activities 3. Define activity outputs/measures 4. Identify customer/user of activity 5. Perform value-added analysis 6. Identify cost drivers 7. Determine activity performance measures & goals 8. Gather activity data for costing
Identifying Activities
Criteria for selecting/stating activities (Miller, 1996)
As a general rule, criteria for selection of activities are key, significant and relevant for decision making. Key and significant means those 20% of total activities that represent 80% of the costs. The primary criteria for stating an activity is a verb and a noun. There are a number of specific criteria to be considered when defining an activity as key and significant. 1. 2. 3. 4. Where the company interacts with the customers. Activities that are high cost. Activities that are core or sustaining. Activities that support objectives. 5. Activities with potential for competitive advantage

Activity Based Costing

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INTRODUCTION

Components of Activity Based Costing (Miller, 1996)

Cost assignment under ABC (Miller, 1996)

ACTIVITIES RESOURCES RESOURCE DRIVERS ACTIVITY DRIVERS COST OBJECTS

ABM and a growing business

What does a fully implemented ABM information system look like?

How much detail is enough?

Time frame & effort required for ABM installation

Steps for ABM Implementation

FOUR-STEP ABM IMPLEMENTATION MODEL 1. Planning

Data Gathering and Analysis

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