21st Century Economics

This report introduces, in a simplified manner, the concepts of Activity Based Costing (ABC) as an introduction to the analysis applied to the Process Model and the development of the strategic plan for departmental analysis of the organization.. The department used in this example was the IT department.

Description of ABC

Activity Based Costing (ABC) is a technique that measures the cost and performance of activities and the products or services generated from those activities (Cost Objects). The resources, which are commonly reflected by the general ledger, financial statement, or object class codes are traced to activities based on primary and secondary methods of consumption. Activities are traced to cost objects, which are the functional outputs of the business processes based on their use.
The task of differentiating the organization’s activities as either value added or non-value added is perhaps the most important theme in ABC. Non-Value Added activities become candidates for elimination or reduction whereas Value Added activities become targets for improvement.

Traditional cost accounting systems do not provide adequate information to identify the causes of cost. In situations where costs are deemed by management to be too high, managers tend to rely on across-the-board overhead cuts to control spending in the absence of proper information. Thus, when funds decline or disappear, organizations usually respond by “tightening the belt” in the wrong way at the wrong point in the enterprise.

Common approaches include:

Universal reductions in the budgets of all departments;
Freeze on wage increases;
Freeze on overhead activities;
Early retirement;
Freeze on training and nonessential travel;
Freeze on hiring; and
Freeze on investments.

Such well-intentioned efforts generate a self-feeding cycle of competitive decay. They do not address the demand for overhead resources - the activities that keep people busy. There is a natural tendency for managers to cut expenditure on activities critical to the mission of the organization both in the present and in the future. Deterioration in the quality of service and pressures on an overburdened staff prompt renewed spending and overhead creeps up. The problem is that the fundamental causes of cost were not corrected.

The most common and least understood factor that touches off such a cycle is management operating with the wrong type of data - data geared to accounting rather than management.

How ABC was applied in this case

A baseline represents the inventory of business policies, practices, methods, measures, costs, and their relationships at a particular location at a particular point in time. The baseline also comprises a set of business processes that provides the context to an organization’s work. Activity Based Costing (ABC), often in conjunction with BPR modeling, pulls together all of these factors to enable decisions concerning the advisability, value, and difficulty of implementing various improvement alternatives.

ABC recognizes the causal relationships of cost drivers to activities. Cost drivers are the factors that cause work to be performed and in turn cause costs to be incurred (i.e. resources to be consumed).

The activity based management approach to cost management breaks down an organization into activities. An activity describes what an enterprise does - the way time is spent and the outputs of the process. The principal function of an activity is to convert resources (materials, labor, and technology) into outputs. Activity accounting identifies activities performed in an organization and determines their cost and performance (time and quality).

For purposes of developing an ABC model for the departments, a simple and effective activity based management system incorporating the following steps can be used:

1) Determine enterprise activities.

To identify the activities performed in the IT process a series of surveys and focus group sessions were held with each member of the IT department.

2) Determine activity cost and performance.

Performance is measured as the cost per output, time to perform the activity, and the quality of the output. As part of the interviewing conducted in Step 1, data was collected from each interviewee regarding:
number of transactions for each service area;
duration for performing each activity one time; and
information pertaining to the salary of each individual performing each activity.

Based on the interview results and detailed budget reports, all costs are able to be directly traced to specific activities, except for, miscellaneous expenses and computer supplies. These two categories were allocated to all activities.

3) Determine the output of the activity.

An activity measure (output) is the factor by which the cost of the process varies most directly. For each of the activities identified in the model an output was identified and quantified. These outputs provided the basis for tracing the activity costs to the cost objects.

4) Trace activity cost to cost objects.

Activity costs are traced to cost objects such as products and/or services generated by performing the activities. The best approach to take for identifying the appropriate cost objects is to view the services or products from the perspective of the end user or customer. This is the approach that was used for this cost analysis. The end result of this step is the determination of the costs of various time and attendance methods in the aggregate and on a per transaction basis.

5) Determine corporate short-range and long-term goals (critical success factors).

This requires an understanding of the current cost structure, which indicates how effectively operating activities deliver value to the customer. An assessment is then made based on these critical success factors as to which activities are non-value added and which are value added. Non-value added activities are those activities not providing value to the customer or to the business. These activities are candidates for elimination. Value added activities are by definition critical to the success of the enterprise’s mission.

6) Evaluate activity effectiveness and efficiency.

Knowing the critical success factors enables an organization to examine what it is now doing and the relationship of that action to achieving those goals. Everything a company does - or avoids doing - is measured against the short and long-term goals. This provides a useful formula on which to base a decision whether to continue performing or to restructure an activity. Also, cost control is improved by ascertaining if there are superior methods of performing an activity, identifying wasteful activities, and determining the cause of the cost.