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During the 1980s, many businesses started to introduce activity-based costing (ABC) systems. The aim of these was to achieve a more accurate calculation of product costs. However, it soon became apparent that the information that had been produced for activity based costing had much wider use than just calculating the cost per unit of a product or service.

Activity-based management (ABM) can be defined as the entire set of actions that can be taken on a better informed basis using ABC information. The aim is to achieve the same level of output with lower costs.

Stages in ABM

The initial stages in ABM are the same as for ABC, so these should be familiar from earlier studies:

  1. Identify the activities that the organisation performs
  2. Calculate the cost of each activity
  3. Identify the activity cost driver for each activity. 

Identifying the activities

Organisations perform hundreds, if not thousands, of different activities. It would not be feasible, or even beneficial, to identify every activity that the organisation performs – so judgment will need to be used to identify the significant activities; perhaps based on the amount of time that is spent performing them or based on the expected cost.

Some organisations may try to define only high-level activities to keep the number of activities defined to less than 30, while other organisations may define much more detailed activity lists. These activities may be summarised in an activity dictionary.

The following list shows examples of some of the activities that may take place in a manufacturing organisation:

  • Schedule production jobs
  • Set up machines
  • Receive materials
  • Run machines
  • Support existing products
  • Introduce new products
  • Calculate the cost of the activities

All indirect costs must be apportioned to the particular activities that they relate to using an appropriate basis. Staff may be asked, for example, to estimate how much time they spend on each of the activities above so that factory staff costs can be apportioned to the relevant activities. Other costs such as rent and heating and lighting will also have to be apportioned. This is similar to the principle of allocating and apportioning costs to cost centres in traditional absorption costing.

As far as ABM is concerned, simply having the information about the cost of each activity may be all that is required. In the case of ABC however, it is then necessary to apportion the costs of each activity to the products using the cost driver information.

Identifying the cost driver

The cost driver is the factor that causes the cost of an activity to vary. In traditional costing, it was always assumed that the cost driver was volume of production, measured either in terms of the number of units, or a proxy, such as the number of labour hours or the number of machine hours. In ABM however, it is recognised that the cost of a particular activity may depend on something other than volume of output. In the case of sales order processing, the costdriver may be the number of orders processed; so whether a sales order contains five line items, or 10 line items, the amount of time to process it will be the same.

The cost drivers for the activities listed above may be as follows:

ActivityDriver
Schedule production jobsNumber of production runs
Set up machinesNumber of setups
Receive materialsNumber of receipts
Run machinesMachine hours
Support existing productsNumber of products
Introduce new products
Number of new products introduced


ABC then apportions the costs of each activity among the different products that use them, based on the use of the drivers by each product.

There are two main types of activity-based management:

  1. Operational activity based management (doing things right) – this relates to making the organisation more efficient by reducing the cost of the activities and eliminating those activities that do not add value.
  2. Strategic activity based management (doing the right thing) – which essentially involves deciding which products to make, and which customers to sell to, based on the more accurate analysis of product and customer profitability that activity based costing allows.

Operational ABM

One of the greatest advantages of ABM is that costs are categorised by activities rather than by traditional cost categories. A simplified analysis of expenses from a traditional costing system may look something like this:

Cost of salesX
Staff costsX
Rent of factory
X
MaintenanceX
DepreciationX
Total costsX


ABM analyses costs by activity. For example:

Direct materials costs
X
Direct labour costsX
Schedule production jobs
X
Set-up machinesX
Receive materialsX
Support existing productsX
Introduce new productsX
Total costsX


Having costs analysed by activity provides much more relevant information to managers. There may be activities that are being performed that do not add value, so these can be stopped. Management may also identify activities that cost more than expected, and can investigate these. Management might decide for example that the cost of setting up machines is too high. Using their knowledge of the drivers of that activity, management would realise that having longer production runs could reduce the cost of this activity as the number of set ups would be reduced.

Many writers discuss using ABM to eliminate non-value added activities. Cooper and Kaplan claim that it is not always clear whether an activity is value added or not. It might be argued for example that setting up the machines is a non-value added activity, as customers do not value it. However, without setting up machines, there can be no production. Instead, Kaplan and Cooper suggest discussing how efficient an activity currently is, and therefore how much opportunity there is for improvement.

Use of ABM with other performance improvement strategies

ABM does not have to be used in isolation, and can be used alongside performance management improvement strategies, such as Total Quality Management, Six Sigma and Business Process Reengineering, where the information provided can support the projects.

In Total Quality Management, costs are analysed into costs of conformance (appraisal and prevention costs) and costs of non conformance (internal and external failure costs). The aim of TQM is to reduce the costs of non-conformance. Activity-based management enables organisations to more accurately calculate these quality related costs and to monitor improvements.

Six Sigma, Business Process Improvements and Business Process Reengineering aim to achieve large one off (discontinuous) improvements in particular business processes relating to efficiency and better customer satisfaction. ABM can support these methodologies in several ways:

  1. Identifying processes that need improvement and establishing priorities
  2. Providing cost justification for proceeding with the project
  3. Monitoring the benefits of the projects.

As far as establishing priorities is concerned, ABM enables management to identify which activities or processes it is spending the most on, and where the biggest financial savings can be made. It can also identify activities where management believe big improvements can be made. Typically these are the processes that are highly fragmented, and involve people from many different departments.

Many business improvement projects may require considerable capital expenditure, and it will be necessary therefore to do a cost benefit analysis to establish whether it is worthwhile going ahead. ABM can provide more accurate information about the potential savings from a particular project, therefore leading to a more accurate assessment.

After completion of a business process improvement project, many businesses do not measure the benefits achieved by the project, and in some cases fail to take full advantage of them. For example, the project may have reduced the amount of time spent on dealing with customer complaints, but have the excess staff members whose time has now been freed up been re-deployed in other departments?

ABM models also provide information about cost incurred on the various activities, so it is easier to monitor how much the costs of an activity have been cut by a particular project.

Example

A case described by Kaplan and Cooper related to a producer of technical manuals for the computer industry. The company had run out of storage space in their main factory in South Street, due to a large amount of slow moving inventory for their biggest customer, IBM. So additional storage space was rented in Elmore Street, several kilometres away from South Street. After production, the manuals for all other customers were transported to Elmore Street for storage. They would then be returned to South Street for despatch to the customer when required.  This was often only two or three weeks later.

The management knew that this movement of finished goods to and from Elmore Street was inefficient.  However, since the company used a traditional cost accounting system, the only visible cost relating to this was the cost of transport – this was $200,000 per year. A solution to redesign the storage process in the South Street factory for the fast moving goods, and to move the slow moving inventory to Elmore Street (or destroy it entirely) was estimated to cost $600,000. It did not seem worth investing in this, given that the annual saving would be only $200,000.

Activity based management was then introduced, and this identified that fact that the actual costs of operating the inefficient system were much higher than expected. The annual savings of the proposed solution analysed by activity were:

 $
Reduced rental expense
128,000
Reduced transport costs271,000
Reduced costs of moving WIP within factory38,000
Reduced costs of moving finished goods within factory
91,000
Reduced costs of finding materials
88,000
Equipment savings27,000
Reduced cost of managing WIP
44,000
Reduced cost of managing finished goods
68,000
Eliminated use of outside warehouses
53,000
Total annual savings808,000


This activity based information clearly gave management a much more accurate idea of the savings that could be made by going ahead with the proposed solution, and since the required investment was $600,000 it was clearly worthwhile.

Strategic ABM

The first application of strategic ABM is to help decide which products or services to make. The use of ABC enables the cost per unit of a product or service to be measured accurately and therefore the profit per unit can be predicted. Many organisations find that when they rank their products according to total profit, it is typical that 20% of their products generate 300% of the company’s profits.[1] This means that between them, the remaining 80% of products lose 200% of the company’s profits. The loss making products are normally those that are produced in low volumes, or require a high level of customisation.
While it may be tempting to suggest that all such loss making products should be stopped, there are two possible dangers to such a simplistic decision. First, if 80% of the products were stopped, demand for the remaining 20% might fall, as many customers prefer to buy all their requirements from one supplier. A second danger is that even if the business were to stop producing the loss making products, the costs associated with them would not all be saved.
A more realistic approach that can be used is to adjust the price of the loss-making products, or to employ tools such as target costing to reduce the cost.

A second application of ABM is customer profitability analysis where overheads are allocated to customers using activity based management processes to obtain a more accurate analysis of the profit or loss generated by each customer. In traditional costing it is assumed that if a customer generates positive contribution, then servicing that customer must increase the profits of the company. This ignores the fact that many 'fixed' overhead costs are customer specific – such as the time spent by customer service departments.

Using ABM, overhead costs are also apportioned to customers using appropriate cost drivers, giving a more accurate picture of how profitable each customer is. Such exercises have produced surprising results for many businesses, where the 'best' customers have often turned out to generate losses when ABM is employed.

Example  

In Hometown, there are several providers of electricity, and domestic consumers can easily switch from one provider to another.
One of the providers of electricity is First Electric. The company recently had an aggressive advertising campaign and increased its customer base from 30,000 users to 40,000. Management was surprised to discover that this led to a fall in profits.

The company introduced customer profitability analysis, using activity-based principles. The analysis identified the following activities, along with their cost per unit of driver.

ActivityDriverCost per unit of driver
Meter reading
Number of visits$20
Customer serviceNumber of calls
$30
InvoicingNumber of invoices$10
Customer complaintsNumber of complaints$25


The meter reading took place every three months, after which an invoice was issued.

For an 'easy' customer, the overhead cost per quarter was $30, the cost of reading the metre, and issuing the invoice. More difficult customers could cost much more. Many customers were out when the metre reader came, so a second visit was necessary. Sometimes the customer was not home second time either, so was requested to read their own metre and then call the customer service centre.

Using this information, First Electric was able to analyse accurately the profit per customer. The company was surprised to learn that it made a loss on 20% of its customers and only broke even on a further 30%.

In order to remedy the situation, the company made a number of changes. First, it reduced the number of meter readings to once per year, and issued invoices based on estimated consumption for the other quarters of the year. It introduced a website where customers could enter their own meter readings if they were not home at the date of the reading, thus reducing the amount of time used by the customer service department. These actions are examples of operational activity-based costing as they relate to reducing the cost of existing activities.

The company also made attempts to stop supplying loss making customers by increasing prices above those of competitors, encouraging loss making customers to switch to other providers, while offering big discounts to profitable customers, encouraging them to remain loyal. This is an example of strategic activity-based costing, as it focuses on which customers the company should supply to.

Evaluation of ABM

The benefits of ABM (and ABC) are greatest in organisations that have high indirect costs. A major reason for the increase in the use of ABC in the last 30 years has been the fact that as manufacturing processes have become more IT based and sophisticated, overhead costs have increased, while direct costs, particularly labour, have fallen.

ABC is most useful in organisations with a wider range of products, as it is these organisations that will have the most difficulty in allocating overhead costs among different products.

ABM can be criticised for being too inwardly focused. It aims to increase profits by reducing the cost of the activities that it already performs. It does not consider external factors, such as changes in consumer demand for its product.

Users of ABM and ABC often assume that all overhead costs are variable. This is not the case, and some overhead costs will be fixed, so will not be saved if activities are reduced.

ABM is also complex and is expensive to implement. For small businesses, or businesses with narrow product ranges, the benefits of implementing ABM may not justify the costs. 

Question

Note – this question is an abridged version of a question that appeared in the June 2013 Paper P5 exam.

Navier Aerials Co (Navier) manufactures satellite dishes for receiving satellite television signals. Navier supplies the major satellite TV companies who install standard satellite dishes for their customers. The company also manufactures and installs a small number of specialised satellite dishes to individuals or businesses with specific needs resulting from poor reception in their locations.

The CEO wants to initiate a programme of cost reduction at Navier. His plan is to use activity-based management (ABM) to identify non-value adding activities. The first department to be analysed is the customer care department, as management believe that the costs of this department are too high. The costs for the most recent year from the existing accounting system are shown in Table 1.

Table 1: Existing cost data

 $000
Computer time165
Telephone79
Stationary and sundries27
Depreciation and equipment
36
 707


The cost accountant has gathered information for the customer care department in Table 2 from interviews with the finance and customer care staff. She has used this information to correctly calculate the total costs of each activity.

Table 2: Activity-based data

Activities of department
Staff time
Total cost % ($)
Comments
Handling enquiries and preparing quotes for potential orders
40%282,800relates to 35,000 enquiries/orders
Receiving actual orders
10%70,700relates to 16,000 orders
Customer credit checks10%70,700done once an order is received
Supervision of orders through manufacturing to delivery15%106,050 
Complaints handling25%176,750relates to 3,200 complaints
  707,000 


The CEO wants you to consider the implications for management of the customer care process of the costs of each activity in that department. The CEO is especially interested in how this information may impact on the identification of non-valued added activities and quality management at Navier.

Required:

Assess how the information on each activity can be used and improved upon at Navier in assisting cost reduction and quality management in the customer care department.    (12 marks)

Solution

The information in Table 2 shows that the main cost activities of the CC department are pre-sale preparation (handling enquiries and quotes) and post-sale complaints handling. Together, these activities consume 65% of the resources of the customer care department.

The pre-sale work is essential for the organisation and the department converts 46% (16,000/35,000) of enquiries to orders. It would be beneficial to try to benchmark this ratio to competitor performance although obtaining comparable data will be difficult, due to its commercially sensitive nature.

However, the complaints handling aspect is one, which would be identified as non-value; adding in an activity-based management analysis. Non-value adding activities are those that do not increase the worth of the product to the customer; common examples are inspection time and idle time in manufacturing. It is usually not possible to eliminate these activities but it is often possible to minimise them. Complaints handling is not value adding as it results from failure to meet the service standards expected (and so is already included in the price paid).

Complaints handling links directly to issues of quality management at Navier as improved quality of products should reduce these costs. These costs are significant at Navier as complaint numbers are 20% (3,200/16,000) of orders. Complaints may arise in many ways and these causes need to be identified. As far as the operation of the CC department is concerned, it may cause complaints through poor work at the quotation stage where the job is improperly understood or incorrectly specified to the manufacturing or installation teams. This leads to non-conformance costs as products do not meet expected standards and, in this case, complaints imply that these are external failure costs as they have been identified by customers

Quality of the end product could also be affected by the supervision activity and in order to ensure that this is functioning well, the CC department will need to have the authority to intervene with the work of other departments in order to correct errors – this could be a key area for prevention of faults and so might become a core quality activity (an inspection and prevention cost).

The other activities in the department are administrative and the measures of their quality will be in the financial information systems. Order processing quality would be checked by invoice disputes and credit note issuance. Credit check effectiveness would be measured by bad debt levels.

Bibliography
Kaplan and Cooper, Cost and Effect, Chapters 6 to 10, published by Harvard Business Press 1998.  

Nick Ryan is lead tutor for performance management subjects.

Last updated: 30 May 2018