Advanced Management
Accounting
Activity Based Management
ABC: main concepts
Activity Based Costing
 Activity based costing is an approach for allocating overhead costs.
 An activity is an event that incurs costs.
 A cost driver is any factor or activity that has a direct cause and effect
relationship with the resources consumed.
 Machine hours
 Direct labor hours
 Number of employees
 Number of orders
 ….
ABC is appropriate when …
 Product lines differ in volume and manufacturing complexity.
 Product lines are numerous and diverse, and they require different degrees of
support services.
 Overhead costs constitute a significant portion of total costs.
 The manufacturing process or number of products has changed
significantly—for example, from labor intensive to capital intensive
automation.
Examples of commonly used drivers
Activity
Driver
Schedule production jobs
Number of production runs
Set up machines
Number of setups
Receive materials
Number of receipts
Run machines
Machine hours
Support existing products
Number of products
Introduce new products
Number of new products introduced
Signals that Suggest that ABC
Implementation Could Help a Firm
 Significant overhead costs allocated using one or two cost pools
 Most or all overhead is considered unit-level
 Products that consume different amounts of resources
 Products that a firm should successfully make and sell consistently
show small profits
 Operations staff disagreeing with accounting over manufacturing
and marketing costs
From ABC to ABM
 ABC is the main source of information for activity-based management (ABM) .
 After ABC has provided information about the true costs of those activities, ABM
makes use of this information through value analysis and performance measures
which support strategic and operational decision making.
 ABM extends the use of ABC from product costing to a comprehensive
management tool that focuses on reducing costs and improving processes and
decision making.
 Activity-based management focuses management’s attention on activities with
the objectives of improving
Customer value
The profit achieved by providing this value
 Activity based management is a logical technique of planning, controlling and
improving business processes.
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Activity-Based Management
 A method of management that uses ABC as an integral part
in critical decision-making situations, including:
 Pricing and product-mix decisions
 Cost reduction and process improvement decisions
 Design decisions
 Planning and managing activities
ABM Components and Tools
Strategic
Planning
JIT
concepts
Activity
Costing
Target
Costing
Life Cycle
Management
ABM
Benchmarking
Performance
Measuremen
t
Continuous
Improvement
Added Value
Analysis
Areas of Implementation of ABM (I)
 Budgeting and Forecasting
 Performance Monitoring
 identification of performance goals, communication of targets to all employees, and controlling
activities with the intention to achieve afore stated performance level
 Process Improvement
 analysis of business processes with the aim of discovering constraint points and non-value adding
activities
 Controlling Shared Services
 A shared service in an organization shows the supply of service from one section to others, highlighting
the role and consumption pattern of that service across the organization.
 Activity Based Management shows the true picture of size, type and cost of service provided by each
support unit in an organization.
Areas of Implementation of ABM (II)
 Product Profitability Analysis
 determines actual product profitability level by capturing the resources
consumption flow in the total activities for production of an output
 Customer Profitability Analysis
 identifies resources, activities, costs and profit involved in servicing various
customers of an organization, thereby enabling thorough analysis of
customers
ABM Concrete Actions
 Pricing
 Re-pricing up particularly if it is a custom or unique product
 Re-pricing down on mass market products to meet or beat the market
 Product Substitution
 Demonstrating to the customer how they might substitute a less complex product with the same
result
 Re-design
 Examining a particular product to identify areas which can be eliminated particularly areas that
add cost but no value
 Eliminate products entirely
 If necessary Eliminate Capacity
Process Value Analysis (I)
 Process value analysis
 Fundamental to activity-based accounting
 Focuses on accountability for activities rather than costs
 Emphasizes the maximization of organizational performance
instead of individual performance
 Process value analysis is concerned with:
 Driver analysis
 Activity analysis
 Performance measurement
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Process Value Analysis (II)
 Driver analysis is the effort expended to identify the factors that are the root
causes of activity costs.
 Activity analysis is the process of identifying, describing, and evaluating the
activities an organization performs. It should produce four outcomes:
 What activities are performed.
 How many people perform the activities.
 The time and resources are required to perform the activities.
 An assessment of the value of the activities to the organization.
 Performance measurement: the process of developing measurable indicators
that can be systematically tracked to assess progress made in achieving
predetermined goals
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Process Value Analysis (III)
ABM classifies all activities as value-added or non-value-added.
 Value-added activities
 Necessary to remain in business
 By mandate (e.g., comply with SEC reporting requirements)
 May contain nonessential actions that create unnecessary cost.
 Nonvalue-added activities
 All activities other than those essential to remain in business
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Process Value Analysis (IV)
Examples of Non value-added activities
 Scheduling
Uses resources to determine access to processes
 Moving
Uses resources to move inventory among departments
 Waiting
Uses resources while waiting for next process
 Inspecting
Uses resources to ensure conformance to standards
 Storing
Uses resources while goods are held in inventory
Remember: this analysis is costumer value oriented, some of these activities
may add value to the firm
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Types of ABM
There are two main types of activity-based management:

Operational activity based management (doing things right)
 making the organization more efficient by reducing the cost of the activities and
eliminating those activities that do not add value.

Strategic activity based management (doing the right thing)
 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
 Uses ABC information to improve efficiency
 Activities that add value to a product are identified and improved
 Activities that don’t add value to the product are reduced to cut costs without
reducing product value
 ABM does not have to be used in isolation, and can be used alongside
performance management improvement strategies
 Total Quality Management
 Six Sigma
 Business Process Reengineering
Example Operational ABM
(Kaplan and Cooper, ACCA)
 Company A produces technical manuals for the computer industry. The company had run
out of storage space in their main factory, due to a large amount of slow moving inventory
for their biggest customer, IBM.
 So additional storage space was rented several km away from the main factory.
 After production, all manuals produced were transported to the new storage and would be
returned to the main factory or dispatch to the customer when required. This was often
only two or three weeks later.
 The management knew that this back and forth movement inefficient.
 However, since the company used a traditional cost accounting system, the only visible
cost relating to this was the cost of transport ($200,000 per year).
 A solution to redesign the storage process in main factory for the fast moving goods, and to
move the slow moving inventory to the new place (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 $200,000.
 Activity based management was then introduced, and this identified that fact that the
actual costs of operating the inefficient system were much higher than expected.
Example Operational ABM
(Kaplan and Cooper, ACCA)
The annual savings of the proposed solution analyzed by activity were:
Activity
Cost ($)
Reduced rental expense
128,000
Reduced transport costs
271,000
Reduced costs of moving WIP within factory
38,000
Reduced costs of moving finished goods within factory
91,000
Reduced costs of finding materials
88,000
Equipment savings
27,000
Reduced cost of managing WIP
44,000
Reduced cost of managing finished goods
68,000
Eliminated use of outside warehouses
53,000
Total annual savings
808,000
Strategic ABM
Uses ABC information to
 decide which products to develop and which activities to use
 identify which costumers are most profitable and focus on them. 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.
 Make pricing decisions: The use of ABC enables the cost per unit of a
product or service to be measured more accurately and therefore
predict better the profit per unit.
Strategic ABM Example
(Kaplan and Cooper, 1998; ACCA)
 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.
Activity
Driver
Cost per unit of driver
Meter reading
Number of visits
$20
Customer service
Number of calls
$30
Invoicing
Number of invoices
$10
Customer complaints
Number of complaints
$25
Example continued….
 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 (cost of reading the meter
+ issuing the invoice).
 More difficult customers could cost much more.
 Many customers were out when the meter reader came, so a second visit was
necessary. Sometimes the customer was not home second time either, so was requested
to read their own meter and then call the customer service center.
 Using this information, the company was surprised to learn that it made a loss on 20% of its
customers and only broke even on a further 30%.
Example continued….
 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.
Benefits of ABM
 It increases effectiveness of key business processes, activities and
tasks by keeping costs at barest minimum while increasing value to
clients.
 It improves management focus through allocation of resources to
value added activities, customers, products and continuous
improvement system for maintaining competitive advantage.
Challenges of ABM
 ABM can be criticized 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.
 Why ABM implementations may fail
 Lack of support of higher-level management.
 Failure to maintain support from higher-level management.
 Resistance to change.
 Failure to integrate the new system
Exercise ACCA
 Navier Aerials Co (Navier) manufactures satellite dishes for receiving satellite
television signals and supplies the major satellite TV companies who install
standard satellite dishes for their customers.
 The company also manufactures and installs a small number of specialized satellite
dishes to individuals or businesses with specific needs resulting from poor reception
in their locations.
 The CEO wants to initiate a program of cost reduction and use ABM to identify
non-value adding activities.
 The first department to be analyzed is the Customer Care Department, as
management believe that the costs of this department are too high. The costs
from the existing accounting system are shown in Table 1.
Exercise ACCA
Table 1: Existing cost data
$000
Computer time
165
Telephone
79
Stationary and sundries
27
Depreciation and equipment
36
Total
707
The cost accountant has gathered activity based information for the Customer Care
Department as presented in the Table below (Table 2)
Activities
Staff time
Total cost % ($)
Comments
Handling enquiries and
preparing quotes for
potential orders
40%
282,800
relates to 35,000
enquiries/orders
Receiving actual orders
10%
70,700
relates to 16,000
orders
Customer credit checks
10%
70,700
done once an
order is received
Supervision of orders
through manufacturing
to delivery
15%
106,050
Complaints handling
25%
176,750
707,000
relates to 3,200
complaints
Exercise ACCA
 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.
Solution (I)
 Table 2 shows that the main cost activities of the Customer Care 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 organization 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 could be identified as non-value activity as it
does not increase the worth of the product to the customer.
 It is usually not possible to eliminate these activities but it is often possible to minimize
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 as complaint numbers are 20% (3,200/16,000) of orders.
Complaints may arise in many ways and these causes need to be identified.
Solution (II)
 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 (i.e. costs that relate to not conforming to
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.
(Kaplan and Cooper, Cost and Effect, Chapters 6 to 10, published by Harvard Business
Press 1998.)