Can you create a model with 520,729 activities in ABC?

This was the question asked by a consultant who had tried developing an Activity Based costing (ABC) model. First of all the answer to the question is 'YES'. Obviously I asked him, why do you need those many activities? Also what was the objective of the assignment? He told me that the client wanted the performance of each of the processes in the organization and hence we had defined so many activities. After doing this, they concluded that the cost of finding this information would not be acceptable. A big ‘YES’, I said. This is one of the examples of the expectations that people have created about the ABC concept. It’s been always told that ABC is more accurate than the traditional costing. This makes people think that ‘if it has to be accurate then it has to be in detail’.

With this notion various attempts have made by people to make the costing in detail. One of the ways as mentioned here, they create a huge number of activities. This will make any type of method to collect the cost expensive. Some created many cost centers, so that they can directly associate the expenses with the cost centers. Of course this is will help, but to get ‘Cost Center Accounting’ in detail. I have explained this in my earlier post ‘Deeper Cost accounting v/s Activity Based Costing’ http://activitybasedmgmt.blogspot.com/2009/07/deeper-cost-accounting-vs-activity.html.

Another line of thinking goes to entering the expenses to activities at the time of booking the expenses. I have seen some of the consultants working in the area of ABC using spreadsheets with this understanding. They always thought that the software solutions for ABC are nothing but doing this kind of transactions. Against this backdrop, when we try to make a statement that in ABC the accuracy needed can be up to 85% , these people feel that then there is not much difference between traditional and ABC. Let us see from the scratch i) what ABC is ii) how it differs from traditional costing iii) hence the details as otherwise expected are not required.

“Activity Based Costing is a methodology to calculate the cost of activities (what we do) and cost of cost objects (products/services, customers, channels etc.).” This is the definition as per CAM-I glossary. In ABC there is a ‘cause-and-effect’ relationship. Product, customers etc.(Cost Objects) make the organization perform activities and activities are performed by people, machines and they require some facilities (all these are Resources). Hence it is called as hence called as Cost Objects consume activities and activities consume resources. If we flow the cost with this logic then there is an obvious cause-and-effect relationship in that. This is the most important difference between the traditional and ABC.

If we take example of various cost centers in an organization and see how the logic of the cost flow (drivers) is there in ABC, we will understand the difference.

Sales overheads – Typically these expanses are taken to the products on the basis of cost of sales or revenue etc. As I have mentioned this quite a few time, in traditional costing every penny spent is taken to the product. It is not the case. They are related to the product, customer, channel, capacity, doing business etc.

The sales expenses are not cause by the products, but they are caused by the customers and/or the channels that you use. So these expenses should go there. This helps to understand the ‘cost-to serve’ the various customers through different channels. This alters the profitability of the customers even if they are brining same revenue. In a humorous way we explain that the sales overheads are not in a linear proportion with the revenue. Actually it is in inverse proportion to the revenue.

Shared Services expenses – These the expenses of the cost centers like Administration, HR, IT etc. If those cost centers are shared by various business units (BU) then it is even more important to use ABC. Typically these expenses are shared based on the ‘headcount’. More the number of employees in the BU/cost center more the share of costs. Within a BU these costs are taken to the products based on may cost of production and shown as ‘Admin Overheads’ in the product costs.

The definition of the services provided by the functions like Admin, HR, IT etc. is the first step to flow their costs to various cost centers. Recruit people, Measure performance etc. for HR, Book tickets, Arrange seminar etc. for Admin, Manage application, Create user etc. for IT are some of the examples. Using ABC the cost of each of this services is calculated and then based on the volume of the services utilized the costs are taken to the cost centers within various BUs. This solves the major issue of the sharing the cost of these cost centers among the Bus. Most of the software solutions can take care of the ‘reciprocal’ way of flow of expenses as typically HR can provide services to IT and receive services from IT as well.

Once the costs are taken to the various cost centers they lose their existence and become the part of the expenses of the cost centers. From there they go as manufacturing expenses or sales expenses etc.

Procurement expenses – Let us understand the completeness of procurement expenses. This process starts from planning the material up to the payment to the vendor. In this various activities are performed by different cost centers as material planning by Planning, vendor management and purchasing by Procurement, quality checking by QA, storing by Stores, payment by Accounts Payable (AP) department. In traditional costing typically the expenses of Planning, Procurement, QA and Stores go to the products as manufacturing overheads, expenses of AP as admin overheads.

First of all ABC segregate the expenses from various cost centers in to ‘Procurement expenses’ based on the various activities performed by those cost centers. From here these expenses are taken to the various materials and vendor that are supplying the materials. With this information the organization can understand the cost procuring same material from various vendors. This gives information about the ‘cost to serve the vendors’. This depends on the lot size, distance, payment schedules, quality etc. This is very important information as it gives the ‘real’ landed cost of a material to the organization.

The requirement of the details and level of those and reason for the same are already explained in the post ‘Incremental progress is better than delayed, or unattained, perfection’ at http://activitybasedmgmt.blogspot.com/2009/08/incremental-progress-is-better-than.html.

These examples will give an idea about how the ABC differs from the traditional costing and accuracy of ABC does not lie in the details but most important concept of ABC and that is ‘cause-and-effect’. The cause-and-effect’ relationship let us know that the costs are not always caused by products. Hence, not all the costs go to the product. If we try to take all the costs to the product and calculate the product cost, it does reflect the changes in business scenario in the cost of the products. This leads to erroneous decisions making with respect to products, customers, channels etc. ABC can not only reveal these details but it also makes us understand the obvious drivers for the same. This information as ‘where’ it is going wrong and possibly ‘why’ it is going wrong help us to take better business decisions.