Activity-based management

Prioritizing the value of opportunities

Marketing management sees activity-based costing as a means of rolling up more accurate product costs to determine the true profitability of a given product. In the past, product cost was the total of direct labour, direct materials, and overhead. Typically, overhead was expressed as a percent of direct labour.

However, as our factories become more automated, the direct labour component is shrinking, to as low as five percent for some high-tech manufacturers. Marketing, therefore, requires a more accurate way of apportioning the growing overhead component. With activity-based costing, allocations are made based on the quantity and cost of resources consumed for a given product or service, charged to a certain activity.

Determining product costs under activity-based costing has made some startling revelations for some companies. For example, a product could be soaking up a greater share of the overhead than was previously realized. Perhaps the product required a lot of research for design and development. Maybe the product requires many bulky raw materials that occupy considerable space in the warehouse. Or, the equipment required to build the product may be very costly to set up, run, and maintain. These could turn what was once thought of as a profitable product line into a clear money loser.

The good news is that by drilling down to the activity level, management can identify which activities are causing what costs to be incurred. High-cost activities can then be targeted for re-engineering. ABM--Another three-letter acronym (TLA)

Activity-based cost management, or simply activity-based management (ABM), is a natural extension of activity-based costing involving the analysis of activity costs. Under the activity-based management framework, processes are mapped end-to-end in order to capture each of the activities in sequential order. Activities are classified as value-added or non-value-added through a methodology known as value analysis. Examples of non-value-added activities are rework, inspections, and waiting for parts. By streamlining or re-engineering processes, non-value-added activities are eliminated and value-added activities are made more efficient.

Activity-based costing is, by itself, a better costing system. Coupled with a continuous improvement or change management program, activity-based costing can be used more effectively to manage business processes. Thus, activity-based management integrates activity-based costing into an overall management approach.

How to ensure a smooth implementation
Listed below are six critical success factors for implementing an activity-based management program.

• cost accounting is more concerned with serving the needs of corporate accounting than operations,
• cost accounting is inaccurate and inadequate,
• the new numbers will be used against them,
• activity-based costing will affect the basis for remuneration,
• activity-based management will remove jobs, and
• things are fine the way they are now.

Broad-based involvement--The implementation team must represent the key stakeholders in order to ensure broad-based ownership of the results. Accounting should not be seen as the driver of the project.

Proper identification of activities and drivers--The activity-based costing team must work with the stakeholders to define suitable activities--the events, and the drivers--whatever causes resources to be consumed, such as number of work orders.

One of the big issues is always granularity. For example, activity codes should not be confused with the more detailed symptom, cause, action, and failure codes employed by CMMS packages for reliability analysis.

Thorough testing of the model--Start with one plant or a single department and spread to the rest of the company once initial bugs have been worked out and benefits become clear. In a multi-plant environment, local management should be intimately involved to avoid the feeling that activity-based costing has been imposed from head office.

Adequate integration of key information systems--One of the key benefits of integrating activity-based costing, accounting, manufacturing, shop-floor data collection systems, and maintenance systems properly is providing a single, consistent repository of data. This
removes the need to reconcile the numbers from multiple sources, thereby improving the accuracy and timeliness of reporting.

Focused analysis of data--An effective improvement program requires prioritization of the opportunities uncovered by activity-based costing. Management must focus on eliminating the high cost of poor quality and the more costly non-value added activities.

Benefits of activity-based management
Although each company has a unique strategy, culture, and organizational structure, most companies would gain something by implementing an activity-based management program. The key benefits are discussed below.

Management support--Having functional areas using the same fully-integrated cost accounting system is fundamental to activity-based costing. Although many activity-based costing systems are stand-alone applications, it is preferable to have an enterprise-wide integrated solution. This avoids the inaccuracy and time delays associated with batch links between systems or the inadequacies of after-the-fact paper reports.

For example, suppose a purchase requisition for spare parts is input into the CMMS. The requisition is then passed manually or on a batch basis to the purchasing module running on say, an MRP system. After a purchase order is cut, the goods are received and acknowledged on the MRP system. Finally, an invoice is received and reconciled by accounts payable on the accounting system. Depending on the way in which the systems are patched together, if at all, the maintenance department may never know what the actual cost of the order was. Similarly, maintenance workers may be forced to record labour hours twice, for payroll purposes and for logging hours against work orders, because of poor integration of the CMMS and payroll systems.

An activity-based costing system provides a flexible tool for pinpointing the source and magnitude of costs. Three-dimensional reporting of costs is available, that is, by project, cost centre, or activity including drill-down and roll-up capability on any dimension. Traditional systems report costs by project and cost centre only.

The benefit of the additional dimension is that you can determine the cost of performing a given activity for one project or cost centre and compare it to the cost of performing the same activity for another.

Further drill-down and analysis may point to significant productivity improvement potential, such as using spare parts from a different manufacturer. For maintenance operations, this kind of analysis coupled with reliability-centred maintenance can be an especially powerful combination.Marketing support--More accurate distribution of indirect and overhead costs to products and services leads to better understanding of unit costs and profitability. This, in turn, allows marketing management to determine which products and services to drop, expand, or change. As well, marketing analysts will be able to determine more accurately which customers, geographic regions, and distribution channels are profitable. Finally, more realistic unit costs take the guesswork out of make or buy decisions.

Improvement opportunities--Through value analysis, process mapping, re-engineering workshops, and other improvement techniques, opportunities are identified for minimizing or eliminating activities that provide little or no value. This leads to new processes being created and new information systems implemented.