ABC, The Balanced
Scorecard and EVA
A Consolidated Review
Baitshepi Tebogo
Table of Contents
Abstract ..................................................................................................................................................... 3
1.
Introduction ....................................................................................................................................... 4
2.
ABC .................................................................................................................................................. 5
3.
BSC ................................................................................................................................................... 7
4.
EVA .................................................................................................................................................. 9
5.
Are they Dependent or Mutually Exclusive? .................................................................................. 10
6.
Conclusion ...................................................................................................................................... 10
Abstract
The report starts by looking at Activity Based Costing (ABC) and how it improves on traditional
absorption costing method. The weaknesses of traditional absorption costing method are
exposed, and evidence is brought forward to show how ABC is a much superior method.
Furthermore, the Balanced Score Card (BSC) is analysed and explanations given as to why it is
found appropriate under the current business environment. That is, the current business
environment calls for performance evaluation to be multifaceted; as focus has to be placed on all
the necessary value creating activities. Economic Value Added (EVA) is also looked at, and it is
found to be very fundamental in understanding and generating value. EVA also serves to
consolidate the analysis of value creation, in the context of all the three methods (EVA
included). This is facilitated by the fact that value resonates in all discussions relating to all the
three methods.
1. Introduction
The modern business environment is fraught with innovation. This is necessitated by the
dynamic environment in which most companies find themselves operating. Understanding
clearly how a business functions, and how costs are incurred; and how they could be effectively
managed is the best way of ensuring that a company will become competitive, under these
conditions.
There are so many companies operating globally, and this has led to intense competition for
markets. These latest developments call for new solutions, for gone are the days when companies
could push products into the market. The current business environment is characterised by a
situation where a customer is king, as the common adage often goes. Companies, therefore, have
to tailor their products to the unique requirements of their customers.
As such, techniques such as Activity Based Costing (ABC) are inevitable so that costs could be
more accurately allocated to products and services to identify how limited resources should be
used. ABC encourages a better understanding of costs since it helps in tracing overheads to
activities, which cause them. The traditional approach of managing costs treat overheads as if
they are caused by departments or cost centres. With its focus on activities and cost drivers, ABC
enables a better understanding of overheads.
In the past, most of the focus has been shareholder wealth maximisation. But, increasingly,
companies are realising that there are other important categories of interested parties who should
not be ignored when making decisions. On the background of this realisation, methods such as
the Balance Score Card (BSC) have been developed to create a balance in the manner in which
performance is measured. Basically, it has been found that financial performance tends to focus
on historical performance. It is, however, important that companies do not just focus on financial
results, but also on non-financial information, as well. This is because it is the non financial
factors, which, mostly, contribute towards value creation.
The Economic Value Added (EVA) approach is one of the latest metric in the measurement of
performance. It is credited with focusing the attention of management on value creating
activities. And, since most analysts and shareholders are interested in the growth in value of their
companies this method has become very topical, lately.
2. ABC
To better understand the usefulness of ABC it is imperative that we look at the traditional
overhead absorption methods. Under traditional absorption methods, management deal with
overheads by allocating and apportioning them to cost centres. That is, allocation occurs if there
is certainty as to the amount of overheads incurred in a particular cost centre. And, this means
that all such overheads are charged to that cost centre. On the contrary, if the overhead expense
is attributable to more than one cost centre then apportionment is used to share overheads to the
various cost centres. This process is arbitrary, and it is just the beginning of the arbitrariness of
the traditional absorption costing method.
After the initial allocation and apportionment is complete then, follows re-apportionment. The
re-apportionment involves re-allocating overheads from nonproduction to production cost
centres. After this re-apportionment, a suitable basis for absorbing overheads is identified. The
basis of absorption might be machine hours; labour hours; a proportion of material costs; a
proportion of labour costs, etc. Whatever basis is chosen will, ultimately, depend on the intuition
of management. That is, the basis chosen depends on what management believe would provide a
fair estimation of overheads. Essentially, the premise for charging overheads to cost centres is
based on the belief that cost centres cause costs. On the contrary, ABC takes a different
approach.
Under ABC major activities are identified. These activities may be at a unit level; batch level;
product level or facility sustaining level. The contention is that if a company can be able to
identify how costs behave and what causes them, then they can easily be managed.
For each major activity identified, a cost driver is also established. A cost driver is a factor which
causes a change in the cost of an activity. And, then for each activity a cost driver rate or
absorption rate is calculated. This will then be used to recover overheads to be charged to
products during costing.
The major difference between traditional absorption costing and ABC is that, ABC uses multiple
absorption rates compared to just one used under absorption costing. This difference is the key in
providing accuracy during product costing, as the amount of accuracy is relatively higher under
ABC. In addition, the fact that ABC focuses on activities means that the number of activities
could be managed and controlled. ABC also promotes a questioning approach since each activity
performed would have to be justified; otherwise, it would be scrapped. So, under ABC only
value adding activities would, in theory, have to be undertaken. And, as such, ABC would work
well in conjunction with other value focused metrics.
Although ABC is a relatively more accurate method compared to traditional absorption costing
methods, it has some weaknesses. That is, it still depends on accounting information and its
definition of costs is based on what, traditionally, has appeared in the income statement. The
costs of capital, which do not appear in financial accounting records, are as such not dealt with
by ABC.
The other issue is that, although ABC was designed to eliminate arbitrariness in the treatment of
overheads that problem still exists. For instance, at a facility sustaining level, there are costs
whose cause can not be easily ascertained hence are lumped together, without analysis as to the
cost driver. In addition, ABC is applicable where there is a higher proportion of overheads; and
where there are multiple products. In the absence of these, it would not be value adding to use
ABC. And, even in instances where it could be useful, ABC can be very expensive to implement.
3. BSC
The Balanced Score Card (BSC) is a multifaceted performance evaluation method that was
developed by Robert Kaplan and David Norton. The duo noted that most performance evaluation
methods were geared towards profit measurement. However, they had a problem with that since
profitability indicates past performance, which is unlikely to be repeated. For a method to be
effective, they believed, it should look at performance from various angles. It was on this basis
that they developed the BSC, whose focus is financial; customer; learning and innovation, and
internal business perspectives.
Despite being dissatisfied with financial performance measures, Kaplan and Norton still believed
that it was essential. That is, despite the criticisms shareholders would still want to know how
much wealth has been created for them. In light of the criticisms that have been labelled against
accounting results, an opportunity arises here to integrate EVA results into the BSC matrix. That
is, t would be ideal to ensure that the financial perspective is measured through EVA to
encourage a focus on value creating activities. With EVA the focus is most likely to be on
economic profit rather than accounting profit, which is prone to manipulation. And, most
importantly, the BSC strives to ascertain what needs to be done, through the financial
perspectives, to create value for shareholders.
The customer perspective serves to direct management’s attention on activities that appeal to
customers. Every business survives on having a strong customer base, hence it is important to
ensure that customers are kept happy. If customers are satisfied with a company’s offering, then
repeat business is likely to occur and this would generate even more sales. It has, already, been
mentioned before that the business environment has changed from being push based to being pull
focused. These changes, therefore, call for companies to strive hard to keep their customers
happy by producing products and services that customers need.
However, to ensure that the focus on customer satisfaction is value adding; it might be necessary
to conduct some form of customer profitability analysis (CPA). The CPA helps in analysing the
various types of customers and identifying how valuable each type of customer is. And,
incidentally, CPA is a form of ABC as it uses ABC techniques, the major difference being that it
focuses more on customer analysis.
A company should also be able to facilitate learning and innovation. And, therefore, this may call
for resources to be spent on training employees and on research and development (R&D).
Although, training employees may be expensive it is crucial for the survival of every company.
Well trained and skilled employees are sought by all companies, since they are more efficient
and effective in production and service delivery. And, skilled employees are becoming
particularly important in the modern economy, which is mostly knowledge based. As such, it is
becoming more and more apparent that the value created by any company is to a large extent
influenced by the type of employees it has.
In addition, it is essential that companies be innovative. And, innovation, partly, comes about as
a result of investment in R&D. If a company does not spend much on R&D it is likely that in the
long run it will pay large for such a decision. It is likely that its competitors will get ahead of it
and, hence it might start losing its market share; as it begins to lose its loyal customers.
Internal business perspective is another area that has to be taken seriously by management.
Through this perspective, Kaplan and Norton argue that it is important for the way a company
runs its activities and processes to be efficient and effective. In other words, those activities or
processes that do not add value and slow the operations should be removed. This may, therefore,
call for value engineering so that an organisation becomes lean to promote efficiency,
effectiveness and even economy.
4. EVA
EVA is a very important performance measurement technique. One of the reasons it is so
valuable is because it consolidate most performance measurements. A concentration on EVA by
all sections of a business enables everyone to be focused on the same goals, which are meant to
help a company create value. As such, when EVA is in use it is unlikely for there to be
manipulation of financial results. The fact that EVA is a reliable measurement of financial
performance makes it align well with the BSC. This is so, since the BSC has a financial
perspective, and it would, therefore, be ideal that the two methods complement each other.
EVA is also useful in the analysis of costs using ABC techniques. It has been illustrated that
ABC helps in identifying major activities, and such activities should be value generating. If not,
then they will be discarded. In the case of ABC analysis, it would be important to understand
value in the context of EVA.
5. Are they Dependent or Mutually Exclusive?
The three methods, that is: ABC, BSC and EVA are indeed dependent on each other. Both
methods strive to facilitate an understanding of how value is generated. Although they are
different in approach, their goal is on outcomes. And, the desired outcome in this case being
value creation.
As illustrated before, ABC is focused on value creation since it helps in identifying major
activities. And, these activities should be capable of generating value, otherwise they would be
discontinued. EVA can be used to help quantify the amount of value created or destroyed by
undertaking certain activities. The BSC has one of the perspectives focused on finance. Given
the problems often encountered with accounting profits, EVA becomes an ideal choice to
measure the financial perspectives. So, this is yet another case of EVA functioning well with
another performance measurement metric. The same could be said of ABC and the BSC. That is,
ABC techniques could be used to understand how to optimise financial performance; and, this
may involve using EVA concepts in the process. ABC analysis might be applied again in the
form of customer profitability analysis to understand how best customers could be served.
6. Conclusion
ABC, BSC and EVA are modern performance measurement methods, suitable for the unique
environment companies find themselves facing. And, what makes them particularly fascinating
is the fact that all strive to achieve optimal performance needed to increase shareholders wealth.
ABC focuses on an organisation’s major activities and identifies those which are value
generating. It also provides accuracy in the costing of products and services. This helps in
directing management’s attention to those products and services that will contribute most to
wealth creation.
The BSC presents a comprehensive and multifaceted approach to evaluating performance. Rather
than focusing on a single financial performance metric, the BSC addresses other non-financial
aspects, which are pertinent to wealth creation. It is upon this basis that the BSC addresses other
perspectives of customer; learning and innovation, as well as internal business processes.
The EVA has been found to be instrumental in the generation of wealth. The method helps in
focusing management’s attention on value creating activities. It is also credited with helping to
get rid of accounting distortions, whenever it is used. Above all, EVA is very critical in
consolidating an understanding of value creation. And, in this respect, it is capable of bringing
together all the other two methods.