Myths about Activity Based Costing - II

Activity Based Costing (ABC) was developed to ascertain the accurate process cost data on activities and products and can be used for Product and Customer Profitability, Operational improvement and Resource Planning. Activity Based Costing has not became popular in India to whatever extent it deserves. There are so many Myths as far as this concept is concerned. Here are some of the myths about ABC and the facts around the myth.

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Myth - A cost system should be kept simple

Fact - This is true. It is actually true for any system. As it has been earlier explained, it is the skill of the implementation team to keep the model simple. At the same time is has to be seen that the simplicity is not compromising the results expected.

Alternatively, the complexity of the model in the conventional terms can be kept with the analysts and the business users are not exposed to it. The business users can use the various reports in different formats.

Myth - We do not need more accurate product costs

Fact - Yes, this true in case if the complexity of the processes from design to delivery of the products does not vary largely. If it is not so, then the typical revelation is that the products with higher volume get higher costs and those with lower volume (may be with higher complexity) get lower costs.

The traditional costing takes all the costs to the products directly. ABC is based on the concept that the cost should be traced to the entity that causes the cost. With this we understand that product is not the only entity that causes costs. There are other entities also like Customer, Channel, Capacity etc. We have to calculate Customer costs, Channel costs, Unused Capacity costs, together with the product costs.

Myth - We know what our products cost

Fact - It is not only the products that cause overheads. The complexity of the business causes overheads in the organization. This complexity is brought by the multiple products, customers, channels, regions etc. We should be able to segregate the costs that caused by the reasons other than the products only. Once we are able to do that, then we can understand the reasons for the same and business decisions can be taken. There is more to understand than only the product costs in ABM.

Myth - The market sets prices, so we do not need product costs

Fact - Let us take this statement as understanding or managing profitability of the organization. Firstly to understand the profit, one has to understand the proper costs. ABC helps to calculate cost more accurately. We also have to understand that the product profitability is different from customer profitability. The same product sold to different customers can bring different level of profit.

All customers are not equal. Generally the customers that bring more revenue are taken as most profitable customers. This may not be true, as various customers ask different prices, discounts, make changes in the schedule, ask non-standard products, order small quantities large number of times etc. This changes the profitability of the customers.

It has been observed typically that the top 15 percent of the customers bring the current level of profit. Top 45 percent of the customers bring 450 percent of the profit and last 20 percent of the customers take away the 350 percent of the profit away from the organization.

The best information for an organization is to understand whether their best customers are buying their best products.

Myth - Cost systems play a limited role

Fact - Traditionally this has been true and it has its own reasons. The calculations were not accurate. As it was based on spreading overheads as ‘peanut butter’, it did not reflect the changes in the business scenario into the costs.

ABM benefits the organization in various ways like

1. Information for effective decision-making
2. Information to continuously improve processes and reduce costs
3. A focus on significant costs
4. A relationship between organizational cost and organizational value
5. Methods to measure performance with accountability
6. ABM can be used strategically to understand and improve profitability of the organization, operational performance and resource planning.

Myth - We cannot do anything about fixed costs

Fact - We can look at fixed costs in couple of ways
Fixed costs are not fixed eternally. If we take into consideration a longer time horizon, then we can see the fixed costs are also changing. In that case we have to understand the drivers that are changing the ‘Fixed’ costs.

Fixed costs are generally attached with building capacities in the organization. The investments could be for adding capacities or replacing the old machines or improving productivity.
When we are adding capacities we should see that the capacity added is saleable in the market. It has also to be seen that if those additions or replacements are adding to the costs. If they are then we have to see if that added costs can be absorbed by the market.
The investments in fixed costs can also be made for having competitive advantage.
These fixed costs have to be taken to the products, customers or channels according to the ‘Cause-and-Effect’ relationship.

Myth - Only manufacturing costs are product costs; and Product costs are not useful for managing overhead activities.

Fact - ABC is based on the ‘Cause-and-Effect’ relationship. We have to see how every resource (people, facilities, expenses) is consumed by activities. In turn how these activities are consumed by the cost objects (products, customers, channels).

Unless we put all the resources and take them to the cost objects through the activities performed by the organizations, we cannot comment on what constitutes the ‘product costs’. The costs can be caused by product, customer, vendor, channel etc. We have to trace the expenses to the proper origin. This helps us to understand the relationship of the costs with the business scenario. With the help of this information we can take current business decisions as well as plan our costs in the future.

ABC is the best way to understand and assign overheads to their appropriate destination. Once this is done, then we can use various methods like root cause analysis, value analysis to find the drivers for the costs. Once we know the drivers, we can take actions to improve.

ABC is like a thermometer. It tells us the temperature. The doctor has to analyze, whether the patient has a fever or is hypothermic. The doctor will prescribe medicine accordingly. ABM is using the ABC data, analyzing it and taking proper action to improve.

Myth - It is very difficult to gather information and set rules for cost allocation

Fact - There are various techniques experts have created to collect the information starting from interviewing people, surveys, story-boarding to auto data transfer from the back-end processing business applications.

The rules are defined in the ‘paper model’ that is created for the organization. This paper model depends on the objectives that the organization has decided for the assignment. This model is different for different objective like profitability, cost improvement, resource planning etc.

Sometimes the main model remains the same but multiple small models can be created for specific business pains. The logic to flow the costs depends on the objective and the model.

Myth - If the company has the good information system (ERP), then it would be an overnight job to run to allocate the costs based on set rules. Otherwise ABC will be labor-intensive with Management Accountants spending lot of time gathering the information rather than analysis them

Fact - If the organization has a good OLTP (ERP) then collecting the data from the system is comparatively easier. Now days we have various ETL tools to get the data. Some of the ABM solutions have created their own adapter for the ERPs like SAP or Oracle etc.

Even if the organizations has any ERP, there is some part of the data that is still not available in those systems like the time spent on various activities or the no. of visits to a prospect (if CRM is also not present). This data has to come from various persons in the organization. Hence, the success of this assignment lies in the participation of the key personnel from various departments.
Technically this kind of data can be collected via web-based survey systems. The organization has to spend some time in the initial model creation and data collection systems, once that is done then the frequency of data collection is once in a quarter. So the people get ample time to analyze the data.

There are implementations methodologies like ‘Rapid Prototype’, where a first model which is very raw can be build in as less as two days. Then this model is expanded as required by the organization in those areas only. In the modeling the definition of the driver (the logic with which the cost flows) should be as accurate as possible. The corresponding data may not be accurate to start with. The accuracy of the data can be improved, but only when it is required. One should not wait for the accuracy for the data to the last minute or Re etc. This is used take business decisions and 80% accuracy in primary data is also good enough.

Now-a-days this collection of data and processing of it is being outsourced and various KPO organizations are available for outsourcing this activity.

Myth - ABC is not feasible for a company

Fact - It is feasible for all the organizations, which have multiple products, customers, channels, locations etc. These types of multiple options create the overheads in the organization which ABC puts using cause-and-effect logic. It would be easier

if one takes professional help in the initial implementation as well as using commercial software for the same. It helps the internal team on understanding how to analyze the data. The calculation of the numbers is better left to the software application.