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Activity Based Costing (ABC): What is it and how can reengineering teams use it?
The latest buzz word and improvement mantra in the business world is activity based costing (ABC). This article will provide some insight into ABC and its relevance to reengineering.
ABC: What is it?
Activity based costing is an accounting methodology that assigns costs to activities rather than products or services. This enables resource and overhead costs to be more accurately assigned to the products and the services that consume them.
For example:
Traditional |
ABC |
| Salaries $100 | Clean door $40 |
| Equipment $80 | Paint door $75 |
| Supplies $20 | Inspect door $75 |
| Overhead $45 | Send door to assembly $55 |
| TOTAL $245 | TOTAL $245 |
ABC doesn’t eliminate or change costs, it provides data about how costs are actually consumed. In this example, if you wanted to reduce costs using traditional data you would have to decrease salaries, or decrease costs of supplies. You don’t know enough to change the equipment or overhead costs. Using ABC data you can see that it costs the same to paint and inspect the door. Could these steps be combined to lower cost?
Traditional accounting systems are inaccurate in the way that they allocate costs. Large batch or high volume products and services typically incur 50-200% LESS overhead than they are assigned. Small batch or low volume products and services typically incur 200-1000% MORE overhead than they are assigned. This means that products and services that are considered highly profitable may in fact be profit eaters. This inaccuracy is becoming more and more critical as companies move toward customer-defined products and services (which often means a batch size of one).
In order to correctly associate costs with products and services, ABC assigns cost to activities based on their use of resources. It then assigns cost to cost objects, such as products or customers, based on their use of activities. This information assists in making decisions about pricing, outsourcing, capital expenditures and operational efficiency.
Figure 1 shows the relationship between products / services (cost objects) and the resources that are consumed by the product or service.
Resources -> resource drivers -> activities -> activity drivers -> cost objects
Figure 1
Resources are people and machines.
The resource driver is the measure of the frequency and intensity of the demands placed on resources by activity
Activities are the processes performed by people and machines.
Activity drivers measure the frequency and intensity of the demands placed on activities by cost objects enabling costs to be assigned to cost objects.
Cost objects are the products, services produced.
Cost drivers are the factors that affect the cost of an activity, e.g. poor quality.
Examples:
Resources -> resource drivers -> activities -> activity drivers -> cost objects
Example1 R&D department à % of time -> Design -> # components -> product.
A cost driver would be the knowledge of the R&D department.
Example 2 Window washer -> # minutes > Wash window -> # windows -> clean car
A cost driver is the quality of cleanliness required by the company.
ABC: How can reengineering team use it?
Reengineering teams can use ABC to determine the cost and benefits associated with their reengineered processes and systems. This cost and benefit analysis will then become part of the overall business case for the project.
An ABC approach will account for:
- Activities / processes (comparing before and after the reengineering project)
- The frequency and cost of the activity/process (comparing before and after the reengineering project)
- The do-nothing scenario (what would happen if we do not do the project)
- Which processes provide value (i.e. are needed to attract and retain customers, result in operational savings)
An example of the steps needed to develop ABC data:
- Define the major business processes and key activities of the organization (Process Map).
- Trace operating costs and capital charges to key activities. Use existing accounting and financial data which includes labor and capital equipment expenses and any other resource that can be changed / eliminated. Some reports to analyze include: budget, general ledger, supplier invoices.
- Link activities to processes and identify the cost drivers. The best way to do this is to actively engage the doers of the process. Have the doers of the process identify where the costs come from – then seek out data from that source.
- Summarize the total costs for each process.
- Once processes are reengineered then the "new" costs must be tabulated.
For More Information
Additional information and examples on developing the costs and benefits of processes using activity based costing methods can be found in the Prosci's Business Case Toolkit, or feel free to contact us at (970) 203-9332.
About the Author - Nancy Maluso
serves as a consultant to businesses and reengineering teams. Her expertise focuses on
helping businesses create marketing, operational and business plans. In particular she has
assisted many BPR efforts in the development of sound business cases that have enabled her
clients to secure the necessary resources for their BPR projects.
Related Toolkits and Workshops
Business Case Template and Toolkit
Reengineering Best Practices