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:
- Identifying processes that need improvement and establishing priorities
- Providing cost justification for proceeding with the project
- 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.
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: