Not much is written about Activity Based Costing (ABC) these days. It was big in the 1980’s, but other things like the Balanced Scorecard seem to have taken the lime-light. My guess is that ABC was seen as a detailed oriented initiative that would consume vast corporate resources with no substantial payback and besides; the normal accounting systems would allow for various cost allocations – so why bother? ABC can be much more than a cost allocation methodology.

As a very quick reminder, Activity-Based Costing is a methodology that:

  1. Identifies the processes and activities within an organization,
  2. Assembles and pools the costs to support the processes and activities, and then
  3. Assigns the cost of each activity to products and services according to the actual consumption of activity resources by each product and service.

If the objective is just to use a costing system to track and allocate indirect costs to products and services, then objections to undertaking large initiative is well justified. However there are spin-off benefits to an ABC initiative that could substantially change the way you think about your business and could have huge implications on the future profitability of your company.

I conducted an activity based costing exercise once and it fundamentally changed the way we did business. You wouldn’t believe what understanding your business can really mean until you dig into the bowels of your organization and ask some very simple questions. And it really does not take that much effort.

Here’s how I did it, but first a bit of context

I was a Director of Manufacturing Engineering at the time. I was just a youngster in the middle of completing my CMA (Certified Management Accounting). Our manufacturing plant was divided up into 5 major areas – Engineering (me), Production, Quality, Materials & Production Management and Purchasing. Each of these areas had about 5 managers within making a total of 27 different groups/departments defined as cost centres (CC). Each of these cost centres had anywhere from 3 – 25 employees. We were a good solid team with strong lateral communications and most of all we had trust in each other. We didn’t always agree with each other, but the dialog that ensued made for solid decisions – we never suffer from group-think.

We were looking to launch some new products and were trying to determine whether we should build the new products “in-house” or “outsource” the manufacturing capability. The cost structure of the products was about 10% labour, 40% overhead and 50% materials. Overhead was allocated based upon labour rates and material costs. It was my assertion that our current standard costing structure would not suffice for the purpose of the analysis because it would tend to over-cost the product. We used standard labour rates and material costs were pretty well determined. Armed with a Bill of Materials for the product, and the processing times to assemble, test, pack and ship the products we could cost this product by applying our ‘standard’ rates. I though these standard rates were not relevant to the analysis we needed to conduct.

I didn’t have any hard facts to back up what I was saying. So being the technologist that I am and the management accountant that I wanted to be, I thought I had better get some data to lend credibility to what I was saying. So I got approval to conduct an activity based costing exercise with a view to establish separate “standard cost” for these new products.

I first assembled a cross functional team. Due to the scope of the initiative, it was determined that I only needed 11 of the 27 Cost Centres (groups) to participate in my exercise. The intent of the project was not to make it a huge initiative; we needed to keep employee and operational disruption to a minimum therefore we needed to fit this initiative within the current work load. I then proceeded to create a questionnaire to capture some data. We created this questionnaire by interviewing department heads on the things they did on a daily basis, the things they did on an interrupt basis and then things they did on a project basis. We took project work out of scope as these items were planned well in advance and had a start and a stop well defined.

With questionnaires in hand we sampled about 15%-25% of the staff in each of the groups to develop functional activities list within each department. We gathered information on activities they did as part of their job and the activities they did as part of interrupts on a daily basis. What was important to gather was the single event that triggered an activity. It could be an email, a piece of paper arriving in their in-basket, a phone call, etc. We also asked what they did once the task was completed – did they file it, pass it on to someone etc.?

With all these internal processes captured, we arranged for a war room to be made available to us for a period of 2-3 months so that we could post all of our process maps we made during the interview process. We matched inputs and outputs of the various groups. As we stitched these together we began developing and recognizing the cross functional processes that we worked with on a daily basis. We identified about 41 cross functional processes. It was important to identify the start and stops to each process.  We identified measurable outputs for each of the 41 cross functional processes. Each group had measurable inputs and outputs for their role in the cross functional process as well. We had departments that had a little as 3 processes, and as many as 13 processes that were worked on. Then, for 1 month we collected data. How many of each of the processes did they engage in on a daily basis, and how long did each one take. We wanted to complete one planning-operation cycle. With all of this information we were able to determine (and in most cases validate) what business processes were utilized within the operations and create output and input measures for each activity

Because we worked with Cost Centres, tracking pooled costs was easy. We knew the number of employees in each group and could determine a direct cost for each activity output within each cost centre. We knew the frequency of activities and the duration of activities or as some would say – the “level of effort” required for each activity. With costs in hand, the number of activity outputs and durations etc., we were able to calculate the cost of activities and their outputs.

To produce products and services, a bill of activities is required. The basic equation is materials + direct people costs + overhead = product costs. Material costs are pretty easy to determine; just look at your invoices. Direct people costs are easy; just look at your payroll. Overhead costs will be allocated based upon the activities that they produce in support of the product build. A bill of activity might look like, take order, schedule order, issue order to work shop, produce the goods or service (your direct costs), inventory goods (can’t inventory services), deliver the goods or service, support products until installed and paid for. For service organizations, the capacity to produce service is a form of inventory since costs are incurred to maintain capabilities. These costs can be pooled and allocated based on services delivered. If you guessed that low volume of delivery will produce high unit costs, you are correct; this is why capacity management for service organizations is so important – just as important as finished goods inventory is to manufacturers.

Back to the exercise at hand; once we pooled and allocated all the costs it was determined that I was both right and wrong. Well not really wrong,  just– kinda-sorta-wrong. We determined that our loaded labour rate for the new line would have been about 25% too high. Given the time to build the product, this would have translated into about a 15-20% cost penalty to the product especially when compared to off-shore manufacturers. On the other hand, our material costs (including applied overhead) was under-costed. What we found interesting was that these costs would not have gone away if we manufactured off-shore. This was due to the fact that we ‘custom-designed’ many components and this drove a lot of special processes and activities from a management and tracking perspective.

So the overall outcome of the exercise was to ensure appropriate material cost management and handling were equally applied to both internal and external quotes and we saved labour costs (including manufacturing overhead) on the new line. Our plant won the bid to manufacture the new product line and I was asked to spearhead the introduction of the new product into operations. This created new jobs in Canada, a fact I am still very proud about today. This was one of the high-lights of my career.

So other than learning what our true costs (and hence profitability) were; what other things did we learn from this? And, what can you learn from an Activity Based Costing exercise?

 

  1. True Cost Reductions or Cost Avoidance. Understanding and managing what people do and how they do it is fundamental requirement to reducing costs. Products, service, customers consume activities, activities consume resources and resources consume costs. Eliminating people without understanding the underlying causes to activities and subsequent products, services and customers could yield disastrous results.
  2. Standardize for Savings. Non-standardization does drive costs. We found significant costs were incurred to support customizations. These customizations could have been better dealt with by using off-the-shelf components. At the company I was at, there was a drive to stop designing mechanical items that could be better delivered by off-the-self components with minor modifications made in-house.
  3. Bench Marking. Comparing theoretical best case costs with your actual activity based costs is an excellent start to base lining your operations for improvement. In some cases, this can become your competitive advantage. This could also prove to be better than benchmarking since you know your operations better than your competitors. Benchmarking can get you information as to how well you are doing relative to others, but knowing and improving your operations will get you beyond the bench mark. It’s better to look ahead in the race, versus comparing yourself to the others beside you and ahead of you in the race.
  4. Design Smart the First Time. When you start out to design or build something; do so with the end state in mind. The decisions you make today may have irreversible and unintended consequences on downstream operations or operations that have yet to be created.
  5. Improve Organizational Design & Effectiveness. Understanding activities versus the functions that are required will allow a smaller company to grow more effectively and efficiently than a larger company. By grouping common activities one can hire for the activities that are required. At the company I worked for, when we introduced that new product line, we adopted a focused factory strategy. I was put in charge of creating a new ‘start-up’ line for that new product that was discussed at the beginning of this article. Achieving cost and quality targets was essential to the success to the operation. By focusing on activities versus functions I was able to create a very lean organization that kept overhead costs very low. For example I was able to combine a technical debug position on the line with a support engineering role. I only needed 1 person versus 2. I used the same process for assessing my master scheduling, production planning and production management activities. The plan was that sufficient volumes would justify increases in headcount – not functional roles.

We would be interested in hearing from others about what you have read here; so please comment below. If you have any questions, contact us at info@rkfischer.com