(Activity Based Management)

Activity-Based Management   Activity-based management (ABM) is a cost accounting tool applying cost analysis, target costing and management accounting across the organization. Activity-based management (ABM) enables managers to enhance profits through cost control and tracking practices.

 

CHAPTER  [2] Activity Based Management: Improving Processes and Profitability--Chapter 2. Historical Perspective By Brian Plowman   The First Serious Questions In the late 1980s and throughout the 1990s, the relevance of traditional accounting practices was seriously questioned. Conventional costing, budgeting and management accounts became ever less able to support the business decisions that were now relevant. The relevance debate was founded on three key criticisms. The first criticism was levelled at the lack of technical developments in management accounting practice despite major changes in manufacturing technology. These major changes had resulted in greatly increased productivity, flexibility and quality, together with reduced lead times and inventory. Further, the significant changes in the proportions of ‘direct’ costs to ‘overheads’ had created major distortions in calculating product costs based on simplistic overhead recovery rates. The second criticism held that management accounting was nothing more than financial reporting leading to information that was too distorted, too aggregated and too late to be of much value to management. The final criticism was concerned with the history of management accounting. A mature management accounting tradition was well established in the 1920s. In those days traditional accounting had served the business needs well in terms of cost management, management controls and performance measurement. However, the worldwide dominance of accountancy practice, standard training and examinations means that significant inertia against change exists. The relevance discussions were published at the time of concerns over America’s need to regenerate its industry in the context of the emergent global economy and the lessons from the success of Japan at that time. The moves in management accountancy were towards cost management and away from cost accounting. Developments since have included a concern with understanding such aspects as value adding processes, life cycle costing, market driven target costing, product & customer profitability, customer relationship management, shareholder value added and the emergence of e-commerce. New Costing Approaches Gather Pace Costs have been addressed in many ways in businesses, although traditional practice had formed around the major manufacturing sectors. The key problems with trying to get accurate product costs started to gain the attention of a body called CAM-I (Consortium for Advanced Manufacturing - International). This body researches all aspects of the manufacturing sector in its struggle to come to terms with the changes that modern methods had introduced. The CAM-I Cost Management Systems (CMS) Programme is internationally recognised as a leading forum for the advancement of cost and resource management practices. Organised in 1986 as a coalition of leading thinkers from industry, government, and academia, the CMS Program has accomplished extensive research and development of new management methods. The CMS Program is acknowledged worldwide for raising the awareness of Activity Based Costing (ABC) and Activity Based Management (ABM). Although the manufacturing sector was the first to find that traditional accounting had lost its relevance, the service sector began to catch up. In Financial Services, what is a direct cost, and what is an overhead? Tracking the real cost of its products, services and customers became an issue as the recession and severe competition started to erode the traditional safe profits in Banks and Insurance companies. In the Utilities Sector, the problem had grown rapidly with the changes in legislation that created greater competition. The ‘Regulator’ who wanted to see visibility in a company’s costs and put constant downward pressure on prices further complicated the situation. Where there are virtual monopoly suppliers of services, the Monopolies & Mergers Commission is keen to gain access to the real costs of providing products and services, and handling customers. Another perspective is through the value chain. The term Efficient Consumer Response (ECR) has been coined to encapsulate improving the chain that stretches from the basic raw material sources of a business through to the ultimate consumer. Generally, firms are only involved in part of the overall chain of value creating activities and therefore must endeavour to develop information that permits internal cost management and allows information to cross the company’s boundaries. Activity based approaches form the foundation on which information and costs are analysed throughout the value chain.   The new millennium has brought the prospect of a new dawn to many businesses. But all types of companies are finding they are still in the dark. Their traditional accounting and costing methods remain unable to provide the answers to very relevant business questions. How do we measure commercial success? Which parts of our process add value, or not? Do we make profitable products, provide profitable services? Which is our most profitable customer? What can we afford to negotiate away? Which type of Distributor is important to us? Do some products subsidise others, and by how much? Are some of our customers targets for our competitors? Are we going for volume at the expense of profits? What is the real contribution from our product range? How should we invest this contribution from our current products? Should we go for new products or new markets? Will our new ‘e’ channel provide the profits we yearn for? But most of these questions have always been asked. It is management’s job to answer them. But while struggling to feed ever more irrelevant budgeting systems and answer monthly management accounts variance queries, management has had to fall back on ‘gut feel’. This is a poor substitute for appropriate information. ABM fills the chasm so long filled with inappropriate information. Key Points   The relevance of traditional accounting practices was seriously questioned based on criticisms concerning the distortions in calculating product costs based on simplistic overhead recovery rates, financial reporting that was too distorted to be of much value to management, and the worldwide dominance of accountancy practice, standard training and examinations had created a significant inertia against change. The foundations of ABM were built on the manufacturing sector but the service sector has rapidly caught up driven by regulatory and competitive pressures. Activity based approaches form the foundation on which information and costs are analysed throughout the value chain. Traditional accounting and costing methods remain unable to provide the answers to very relevant business questions. ABM has filled the gap.   Additional Information: This excerpt is from "Activity Based Management: Improving Processes and Profitability" written by Brian Plowman. (Please see  Activity Based Management: Improving Processes and Profitability--Chapter 2. Historical Perspective   Develin & Partners l Abstract)

 

CHAPTER  [3] Activity Based Management: Improving Processes and Profitability--Chapter 3. So What is ABM? By Brian Plowman   Initially Activity Based Costing (ABC) was presented as a means of establishing product costs more accurately. The emergence of Activity Based Management (ABM) provided a means of enhancing profitability. ABM is underpinned by a theory of resource consumption with activities viewed as giving rise to costs, as in ABC, but taking the analysis further in a way that provides management with insights into managing the business overall. Essentially, these insights are focused on a process view of the business and a deeper understanding of product, channel and customer profitability. Costing and Profitability The ledger, budgeting and monthly management accounts are based on reporting resources; those planned to be used, the consumption month on month and the variances from plan. Resources are those things that provide the means so work can be done in the organisation. Salary costs for the people doing the work, accommodation costs so people can work in buildings, utilities so people can see what they are doing and keep warm, vehicles so goods can be delivered and customers visited. In some cases, the list of types of resources on the ledger may seem endless. But no matter how long the list of resources, nothing in the ledger or the management accounts tells us how the resources are being consumed on doing things, to what purpose or in what way. Resources are consumed by activities and it is at this level of analysis that we see what is actually being done. At this level we can also take a view on whether the activities that are being performed are necessary. We can also find out whether the activities are being done well and use the best methods and so take the business forward, or are they really only sorting out problems that are dragging the business back. Activities are undertaken for many purposes. Some directly manufacture products, while others indirectly support manufacture, such as the Quality Department or Materials Handling. Some activities support the business as a whole, such as Recruitment & Training or the parts of the IT Department that keep the network running. Other activities are directly associated with customers, such as the Salesforce or more indirectly within Credit Control. Other parts of the business are working on activities to create a better future, such as New Product Development, and others are working on influencing potential customers, such as Marketing and Advertising. Some parts of the business have little to do with products, services or customers but are necessary to keep the business legal, such as Statutory Reporting or organising the shareholders annual general meeting or preparing for the annual audit. Activities are the very engine at the heart of the organisation. By understanding what is done, how its done, what causes it to be done and why we are doing it gives us a better chance of understanding if we are getting the best value from the resources we put in place. As a simple analogy, budgeting and reporting on the different amount of food we eat may be partially interesting but what people then do with their time having consumed the resources is what influences the world around them, for better or worse. In conventional accounting, and particularly in manufacturing companies, costs are categorised into two main types; direct costs and overheads. Direct costs include the employees manufacturing the products and the raw material they use. Overheads are the rest. The problem then arises when the costs of the products need to be calculated. Although we will look at this in greater detail in a later chapter, we can say at this point that an ABM analysis accurately assigns the costs of those overheads that are actually influenced by the products being made or the services being provided. Having derived accurate product costs, ABM goes further and analyses the costs of servicing each customer or specific segments of the customer base. Customers create a wide range of differing costs for a host of reasons. The key insight that ABM exposes arises when revenue is brought into the equation. When the actual costs of the products or services going to a particular customer are calculated and the actual costs of servicing that customer derived, we can compare these figures to the revenue from the customer, as shown in figure 3.1   Revenue less the product costs gives the 'ABM product contribution'. Revenue less the product costs less the costs of servicing the customer gives the 'ABM customer contribution'. The sum of all the customer contributions has to pay for all those remaining costs that are not associated with the current products or customers, such as New Product Development and Statutory Accounting. Anything left after that is the Profit.   It is at the level of 'ABM product or customer contribution' that we use the term 'Product and Customer Profitability' as it is at this level that meaningful comparisons can be made between products and between customers. It is this type of analysis that exposes small or negative values prompting a serious review of which products or customers to keep, or at least take action to try and turn the relationship into one that provides positive contributions. We will look at this later in greater detail, as this insight into a company's costs is the central power of using ABM analysis. By understanding how costs relate to those factors that drive the costs we can use the powerful approach of Activity Based Budgeting (ABB). Rather than a futile circular argument centred around resources, such as just asking for more people, the debate focuses on the drivers of cost that influence how much activity is actually required. ABB analyses the products or services to be produced and so determines the level of the activities required. The level of activities then determines the resources to be budgeted. When automated, ABB can rapidly and accurately produce financial plans and models based on varying levels of volume assumptions. The more obvious volume assumptions would take into account levels of product or service being provided. More subtle assumptions would take into account, say, the projected numbers of staff to be recruited and hence the impacts back into the Personnel and HR activities and thus resources. From the customer perspective, more volume of the same products to the same customers would have one set of impacts on activities. In another scenario, additional new customers placing orders for half the previously average quantity per order line but for an average of double the number of order lines per order, would have a quite different impact on activities and thus overall resources in various functions. This is the stuff of the real world where real things are happening. Sitting in a functional silo with no knowledge of what actually drives the costs in a function makes guessing the resources required for the next twelve months one of the most futile exercises that has ever been invented. This probably accounts for the long sad faces when the budget round is announced. Using activity-based target costs throughout the product design and development process brings the real world of the competitive market place right into the start of the process that creates costs. Gone are the days when companies could design a product, work out its costs, add a bit for overheads then announce the price. To grab market share and ensure sustainable growth a company has to know beforehand the price that will ensure the product's success. At the design and development stage more than just the direct costs are designed in. At this stage, the company has to think through all aspects of the processes in the business impacted by the product or service so it does not breach the target cost. Process Improvement An organisation is a series of activities that combine in processes to create valuable products or services for customers. It is the effectiveness of an organisation to perform these processes - to create high value at low cost - which marks out a successful company. Most of a company's significant processes travel across functional boundaries, and it is at these boundaries that delays and quality problems occur. ABM focuses on the company's processes. If the processes are understood then failure activities can be eliminated from those processes. Value adding activities can be examined to see if better methods can be used. Time delays and quality issues can be addressed at the point in the process where they occur. ABM is the management of improvement through the analysis of business processes, and their associated activities. This analysis is done systematically and cross-functionally so that improvement projects can be readily implemented and the changes monitored. ABM is an approach that involves many people within the organisation and is: A vehicle for creating process improvement; both incremental continuous improvement and radical restructuring of the organisation. A model for showing how costs (and revenues) are created through processes and activities. If you understand the activities, then you can understand the costs. If you understand the processes, then you understand the business. A means of measuring the company's progress in the key areas of the business that need change and improvement. We will look at this use of ABM in greater detail later as the insights gained from process analysis are central to reducing unit costs, eliminating waste and improving levels of service to customers.   Although ABM can be used to address a specific project or process that needs improvement, it is at its most effective when the company uses ABM as a standard approach to business improvement. This way the entire organisation can be involved in process improvement and over time every process within the company studied, and changes initiated. Key points Nothing in the ledger or the management accounts tells us how the resources are being consumed on doing things, to what purpose or in what way. Activity analysis allows us to find out whether the activities are being done well and use the best methods to take the business forward, or are really only sorting out problems that are dragging the business back. Revenue less the total product costs gives the 'ABM product contribution'. Revenue less the product costs less the total costs of servicing the customer gives the 'ABM customer contribution'. The sum of all the customer contributions has to pay for all those remaining costs that are not associated with the current products or customers, such as New Product Development and Statutory Accounting. Anything left after that is the Profit. It is at the level of 'ABM product or customer contribution' that we use the term 'Product and Customer Profitability' as it is at this level that meaningful comparisons can be made between products and between customers. Activity Based Budgeting (ABB) focuses on the drivers of cost that influence how much activity is actually required. ABB analyses the products or services to be produced and so determines the level of the activities required. The level of activities then determines the resources to be budgeted. An organisation is a series of activities that combine in processes to create valuable products or services for customers. It is the effectiveness of an organisation to perform these processes which marks out a successful company. ABM includes the management of improvement through the analysis of business processes, and their associated activities.   Additional Information: This excerpt is from "Activity Based Management: Improving Processes and Profitability" written by Brian Plowman. (Please see Activity Based Management: Improving Processes and Profitability--Chapter 3. So What is ABM?   Develin & Partners l Abstract)

 

CHAPTER  [4]   Activity Based Management: Improving Processes and Profitability--Chapter 4. Frameworks for Measurement and Improvement By Brian Plowman   Frameworks for Measurement & Improvement Although ABM can be used as a stand-alone approach to understand processes, product and customer costs and profitability, it provides a more powerful means of decision support if it exists as part of a larger framework of measures. Over a number of years a number of frameworks have been developed, each endeavouring to bring a more rounded perspective on the business and a reduced emphasis on the previous domination of financial measures. Although traditionally profit has assumed the dominant role as a measure, the many means of its attainment are recognised as being much more varied and complex to measure and control. Consequently, as well as being concerned with sales and margins, it is necessary to have information on such things as production times, component commonality, quality initiatives, customer satisfaction, customer service activity, employee skill development, employee turnover, legislation changes, environmental impacts and many other variables in the business. In fact any element of performance can be important if it is related to success in the market place. Their integration has been more formally recognised by the use of a number of frameworks that attempt to bring a more rational balance to the variety of measures used in the business. ABM is a key component of these measurement frameworks. The Balanced Scorecard Professors Kaplan and Norton first described the balanced scorecard in an article in the Harvard Business Review in 1992. The term 'balanced' reflects the objective of reporting to stakeholders other than the owners of the business, as well as in ways quite different to financial reporting. The balanced scorecard includes four perspectives as shown in figure 4.1 As well as the more traditional measures found in the financial perspective, the scorecard includes customer, internal business, and learning perspectives. The customer perspective can include measures of quality, lead times, reliability and customer service as these impact on customer satisfaction, repeat business and referrals. The internal business perspective is concerned with processes and productivity. Crucially, there is a recognition that the workforce is a vital stakeholder whose skills and commitment to the organisation cannot be taken for granted. The fourth perspective, that of learning and innovation, is concerned with performance improvements and the ability to introduce successful new products and services. All four perspectives reflect the need to sustain a strategic position in the market place to create value for shareholders, provide challenging employment opportunities for its workforce and enjoy a sustained partnership with customers, both corporate and consumers. It is therefore imperative that an appropriate range of measures exists to integrate in the scorecard. A by-product of using a scorecard is that it raises the awareness throughout the organisation of measures and in a language that people can understand in their own areas of responsibility and influence. However, where useful information is lacking, ABM becomes a powerful tool to understand and answer fundamental questions that arise around processes, products and customers. Profitable customers served by ineffective processes will not lead to success. Impeccable processes serving unprofitable customer segments will also drag the company down. Employees focusing their learning and innovation on products and services that attract disproportionately high, but largely invisible costs, can bring a business to its knees. The balanced scorecard by itself is not a guarantee of corporate success. The underlying behaviour of costs and an understanding of what drives costs provide the knowledge and insights to drive improvements. In this respect, ABM is a fundamental building block.   The Business Excellence Model The European Foundation for Quality Management (EFQM) business excellence model arose during the time that 'Quality' and 'Total Quality' had ascended to the highest point of management’s consciousness. The quality movement had tended to follow the course of ISO9000, an international standard that focuses on quality systems within the business. In response to this trend, a number of companies leading the Quality movement searched for a means of describing a business across a range of features that went beyond just looking at the internal quality systems. This endeavour led to the formation of the EFQM and the publication of the Business Excellence Model. The model defines nine elements as shown in figure 4.2. Five elements are known as Enablers and the remaining four are the Results. Each element has a weighting and when taken as a score, a company having a total of 80 per cent or more is recognised as achieving excellence. In Europe, such high scores put a company in the running for the annual European Quality Awards. Interestingly, a company that states that it has implemented ABM as an approach to inform and change its scoring on a number of elements only achieves an enhanced score if it actually produces the ABM information and acts on it. Implementation of ABM without using it acts as a de-merit. Shareholder Value Added The measure of Shareholder Value Added (SVA) is unashamedly financial. SVA, the generic term, known also as Economic Value Added, was introduced as a measure by the American consulting firm Stern Stewart & Co. Their term and the three-letter acronym, EVATM, are both trademarks of their company. The definition is simply Shareholder Value Added (SVA) equals the net operating profit after tax minus the capital charge. The net operating profit after tax brings into focus prices, volumes, the cost of sales and all the operating expenses in the business, as well as taxes. It is therefore imperative that the business knows which products and customers are profitable, and why, and that its processes operate at the lowest unit cost. Whatever techniques or approaches are used to achieve these ends it is important that information in the business is structured to support the right decision making. ABM is a building block to create this knowledge. The capital charge is all capital (net working capital plus net fixed capital) multiplied by the cost of capital. Capital comprises working capital (debtors, creditors and inventory) plus fixed capital (property, plant and equipment). Actions to reduce debtor days and work in progress would be simple examples of increasing the value in the business. Investing in capital equipment focused on profitable products to profitable customers requires greater finesse in ensuring that the right decisions are made. All financial measures, including SVA, tell us the outcome of many different things, but they usually hide the causes of good or bad profitability. The good or bad performance of individual processes is seldom visible in financial performance measures and the real profitability of products and customers is completely obscured. Depending on the type of business, actions to increase value will differ. Inside an SVA measurement framework, ABM is the means to actually influence the value drivers in the business. It is this knowledge that makes a difference so people can make decisions and take actions to increase value.   Positioning and Capability The collection of measures that are encapsulated within the term 'Positioning & Capability' was developed by the UK consulting firm Develin & Partners and is founded on the principle that organisations need to make a series of steps from where they are now to some future goal. To guide the company a map is required, where the axes of the map are Positioning and Capability. The basic map is shown in figure 4.3. Positioning is to do with external factors such as: understanding customer needs, understanding product and customer profitability understanding competitor initiatives, determining the business's financial needs, meeting changing legislation; and meeting environmental constraints. Getting positioning right leads to higher levels of revenue through providing profitable products & services, increasing market share, increasing the size of the market and by retaining profitable customers.   Capability is to do with internal factors such as: key business processes, procedures and systems, competencies, skills, education and training, and attitudes, style and behaviours. The capability is changed to deliver the desired positioning. Capability creates the costs in the business. The journey joins revenue and cost. Getting the balance right between positioning and capability enhances profits and the value of the business. ABM is the vehicle by which companies journey along their chosen route. ABM informs key aspects of positioning, particularly when used to provide accurate product costing and to derive product and customer profitability. ABM informs key aspects of capability, particularly when used to understand process costs, failures within processes, and to establish the link between costs and the drivers of cost.   ABM provides the basis for management to make better informed decisions both on positioning and capability. In other words, the company can determine which products, markets and customer segments it wishes to retain, it can make relative pricing decisions based on competitor initiatives, and it will be able to focus on those aspects of capability which leverage profitability through process improvement and a reduction in unit costs. Using ABM during the positioning work provides an opportunity to undertake customer-engineering as an action to guide changes in capability. Avoiding activity may then be an initial action rather than spending effort on improving what could be an unnecessary process.   ABM analysis of the current business, prior to making changes to any processes, can answer a number of positioning questions: Can the salesforce be directed toward more profitable segments in relation to the costs of servicing the business that is generated? Will a switch away from just volume selling to focused selling improve short-term profitability? Can some customers or product lines be dropped and achieve an increase in company profitability? Can we better apply discounts to achieve volume and know that we remain profitable? Can we switch some customers to wholesalers or other third parties rather than service every customer ourselves? ABM is the way to link a company's trading relationships (positioning), to its internal cost structure (capability). The basic premise is that activities consume resources and convert them into products and services to customers. Costs are therefore the consequence of resource decisions, and income the consequence of linked activities, the business processes. The requirement is therefore to improve resourcing decisions as the means of managing costs, and to improve processes as the means of improving business effectiveness and thus customer service and revenue.   In the positioning and capability framework, ABM plays a key role to inform the journey. On the positioning axis, ABM is used for profitability management; such as costing and profitability analysis, customer and product mix decisions, and support for marketing decisions. On the capability axis, ABM is used for resource and performance management; such as resource and service level changes, activity based budgeting and cost driver analysis, and for process improvement to eliminate process failures and reduce unit costs. Key Points The integration of many elements of performance has been more formally recognised by the use of a number of frameworks that attempt to bring a more rational balance to the variety of measures used in the business. ABM is a key component of these measurement frameworks. The Balanced Scorecard includes four perspectives: financial, customer, internal business, and learning. The underlying behaviour of costs and an understanding of what drives costs provide the knowledge and insights to drive improvements. In this respect, ABM is a fundamental building block. The EFQM’s Business Excellence Model defines nine elements. Five elements are known as Enablers and the remaining four are the Results. ABM is an approach to inform and improve the scoring on a number of elements. Shareholder Value Added (SVA) equals the net operating profit after tax minus the capital charge. ABM is the means to influence the value drivers in the business that will help increase SVA. Positioning is to do with external factors and getting this right leads to higher levels of revenue through providing profitable products & services, increasing market share, increasing the size of the market and by retaining profitable customers. Capability is to do with internal factors, a change to which delivers the desired positioning. Capability creates the costs in the business. Positioning & Capability thus join revenue and cost. Getting the balance right enhances profits and the value of the business. The journey of change can be mapped on using the two axes of Positioning & Capability. ABM provides the information for both axes to plan the journey and measure how far you have travelled. Additional Information: This excerpt is from "Activity Based Management: Improving Processes and Profitability" written by Brian Plowman. (Please see Activity Based Management: Improving Processes and Profitability--Chapter 4. Frameworks for Measurement and Improvement    Develin & Partners l Abstract)

 

CHAPTER  [5] Activity Based Management: Improving Processes and Profitability--Chapter 5. The ABM Framework By Brian Plowman   In chapter 4, we saw how ABM fits into a number of overarching frameworks of measurement and improvement. In chapter 6 we will see how ABM is used in a 'real life' example to illustrate how ABM handles costs to assign them to activities then onwards to products, channels and customers. However, before going into an example it is wise to take a few moments to describe how ABM views the treatment of costs, which differentiates it from traditional accounting approaches. This chapter explains the way ABM handles costs and the characteristics of activities compared to conventional approaches as well as introducing the language of ABM. Traditional Resource Accounting Most established accounting systems normally capture and distribute resource costs based on one or more of the following methods: Organisation structure or Cost-centre accounting Budgetary control Cost allocation accounting From their longevity of practice we must assume that in the past they have met the needs of organisations to some degree. Yet every one of them fails to meet the full requirement for management information that will adequately support decision making in today's competitive environment.   Cost Centre Accounting This is a popular method for applying resource costs to an organisation. The accounting system identifies each of the organisational parts of the traditional functional structure and applies the identifiable costs to that part of the structure. In many traditional organisations, the only costs that are identified to the organisation's functional departments are the salary costs. Though overhead costs are sometimes distributed to cost centres, it is more common to find that these costs are ignored at the unit level. Many overhead costs are held centrally by the providers of services and not sub-divided to the users of the services. For example, the cost of 'Vehicles' would be held in the function or department that looks after the vehicles. The cost of 'Postage' would be held in the Post-room where the mailing physically takes place. This system was created to provide management with some information on the costs of the organisation's departments. Some argued at the time that this would make 'controllable' costs visible to those managers that have to control the costs. However, under cost pressure the owners of resources supplied to others would turn the tap down or off. The Stationery department refusing to issue paper for other departments' photocopiers is a result of this approach to cost control. Where attempts to get a true picture of departmental costs were applied, managers of resources that were supplied to others apply cross-charges to users, based on a rate for the service. The rate would be based on a collection of costs the service department actually incurred, such as its own staff salaries, to which it added a mysterious amount to cover its own overheads and the costs that it had received as cross-charges from others. The cross-charging game can reach heights of absurdity when internal sub-divisions of the organisation are made into profit centres. The charge out rate then includes a bit extra which it calls 'profit'. In some instances this accumulating figure was then used to purchase something from outside on the basis that it was using spare income and not a departmental cost. From the organisation's perspective, this is real money going out the door. However, trying to get accurate costs to the place in the organisation where the budget for the funds is held can also create absurd situations as one situation aptly illustrates:   A Company introduced a simple method to improve the cost effectiveness of the use of taxis. By arranging to use a single supplier, any travellers only had to print and sign their name against the meter cost recorded on the taxi's log sheet. To prevent fraud, the passenger retained a tear-off copy slip of the cost. On a monthly basis, the taxi company presented its itemised bill which a clerk in Accounts dutifully used to look up where each passenger worked. The cost centre manager's name and cost centre number were also looked up and noted. The annotated invoice then started its journey around the site for each manager to authorise and add the cost centre allocation number for taxi journeys to the invoice. Later, these costs would be accumulated and reported to each cost centre manager.   Three months later, the irate taxi company would begin to demand payment. The problem for the Accounts Department was knowing where the invoice was in its journey around the site. In a year, 40 per cent of the invoices never found their way back to the Finance Function. Regularly, the taxi company would threaten court action for payment. Accounts Payable would just ask for a faxed copy of the invoice and pay the same day on receipt of the fax. Finally, someone did question whether the whole process added any value, or did it just add unnecessary cost. In all this striving for accuracy, accountability and control, hardly any real attempt is ever made to trace costs to the activities or process flows in organisations or to the ultimate output, the products and services for customers.   Budgetary Accounting The tracking of costs to a budgetary account is often combined with cost centre accounting. In this case, the major concern of the spenders of resources is to ensure that their total expenditures do not exceed the allocated budgetary amounts. Consequently, accounting systems become a safeguard mechanism to capture commitments, undelivered orders, and expenditures, normally divided into the cost centres that reflect the organisation structures, to enable tracking of actuals, budgets and variances. The measure of success and thus the major objective of each accountable manager is to fully use the resources assigned rather than enhance productivity or reduce expenses. In some types of organisation, any attempt to conserve resources or work more effectively to come under budget runs the risk of receiving a reduction in the future budget resource level.   The budgetary control mechanism can reach heights of absurdity.   In a government research organisation the scientists received funds to undertake research projects. Towards financial year-end, the researchers had unspent funds, but there were insufficient hours of research capacity to do the research before the year-end. The fund providers wanted the funds spent (for fear of their own funds for the following year being reduced), but were only concerned that the money was spent on 'project-related' costs. In this case, buying equipment was acceptable. As specialist equipment would be pointless, the researchers looked for something more generic. Two weeks later, three large vehicles arrived on site bringing top of the range desk-top computers.   As there was no immediate scientific purpose for the computers they remained in their boxes and researchers used them as additional seats. Among the Support Departments frustrations reached boiling point when they saw the vehicles being unloaded. The cap on their costs always precluded them from getting decent equipment. Worse was to come. Given the different funding regimes for the two groups, the overhead functions were not allowed to use the spare computers languishing in their boxes. Like cost centre accounting systems, the budgetary control mechanisms make no attempt to cost the outputs of all the work or in many cases to even bother to define the output. If real customers are at the end of a supply chain of activities in such environments, then their needs can be well down the list of priorities, with 'meeting budget' firmly at the top. Cost Allocation Accounting Where an organisation has the characteristics of a business then it generally has a need to distribute its costs to an output so it can price its products or services. Revenues also come into the picture and we talk about revenues less total cost leaves us the profit. To make the costs visible 'true' cost accounting systems were established to capture and distribute costs to the outputs such as goods or services. These cost accounting systems use the classic model of cost distribution which was designed around the major sector of the economy at the time, manufacturing. In this system, the focus of gathering costs and collecting them under generic headings relied upon the simple classifications of direct labour, direct materials and overhead. Businesses and business-like organisations have relied upon the historical model of cost accounting for over 100 years. However, the traditional cost accounting methodology does create significant inaccuracies in output costs because of the manner in which overhead costs are apportioned to output rather than assigned or traced to output. When this erroneous method of cost distribution finds it way into the ultimate price of the output it leads to poor management decisions on which products or services to promote hard or which to discontinue, and which customers it should sell to or drop. As traditional accounting has such a grip on most organisations we would argue that it is in the areas of the fundamental flaws it contains that ABM really differentiates. In particular, ABM is superior to traditional accounting in a number of ways: ABM provides visibility in the way costs flow through the business ABM establishes the links between activities and those factors, internal or external, that drive the level of activity up or down ABM eliminates the false divide between direct costs and overheads ABM separates out those costs that deal with today's business from those that secure the future ABM ignores gross margin and uses accurate product and customer contributions as the basis for comparing product and customer profitability ABM exchanges functional myopia for a cross-functional process view of the organisation ABM exchanges the stilted definitions of value-added and non-value-added for sensitive categories that highlight the subtle impact of internal process failures and external customer behaviour   ABM versus Traditional Treatments of Costs At many levels, ABM brings a different perspective on how costs are treated. ABM challenges the traditional approaches to product costing, gross margins, profitability, functions and hierarchies, value and non-value added, and budgeting.   Traditional Product Costing It is in the area of product costing that serious weaknesses in the traditional approach first became a cause for concern. In the days when traditional accounting practices were being formed and internationalised, the dominant industries were in the manufacturing sector. In a typical large manufacturing company, there would be large numbers of employees concerned with direct manufacturing and a much smaller number in the overhead departments. In a situation where the direct labour costs could be as high as 90 per cent and overheads ten per cent of total costs it was important to get some accuracy in terms of the hours, and therefore costs, of actually making components and assemblies. Work-study and other techniques found a ready use in determining the direct labour content of any product. The direct material costs were also simple to calculate for each product based on raw material content, scrap rates, bought-out parts and so on. How much of the overhead activity was actually associated with each product was seen as a lot of effort to work out for such a small improvement in the accuracy of the product cost. This led to the use of the Overhead Recovery Rate (ORR) as the fundamental method of product costing. To derive a method of calculating the proportion of overheads to allocate to each product a simple ratio was derived, known as the ORR. A company would simply find the overall ratio between total Overhead Costs and total Direct Labour, say ten per cent. The direct labour for each product made, and any new ones developed, would then have ten per cent added to account for the Overhead and so give the product cost. As manufacturing became more complex, the proportion of overhead activities to direct activities started to increase. Product costs now became far more sensitive to the indirect and overhead costs associated with each product. The traditional overhead recovery rate became highly suspect as a means to calculate product costs. Some products could be seriously under-costed, and thus probably highly competitive, but an increase in sales volume would actually erode profitability. Conversely, over-costed products would be unattractively priced and few sales made. As the proportion of overhead costs increased in a business, the more serious the distortion in product costing became through using the ORR method. ABM Product Costing In ABM the indirect and overhead costs associated with each product are determined for each product. The characteristics of two products can be quite different in the way they need overhead activity to support manufacture.   A company that traditionally had made its name manufacturing bogies for railway trucks and carriages had branched out into making braking systems for long haul diesel road vehicles. While the technology surrounding the railway business had not developed significantly over the years, the road vehicle technologies had advanced in complexity at a rapid rate. Using direct labour as the determinant of the proportion of overhead costs had led to overpriced railway products and underpriced road vehicle products. The growth in the road vehicle business then seriously eroded overall profits and the stable rail business was drifting to competitors.   In figure 5.1 are shown two of the company's products costed using the conventional overhead recovery rate, in this case 300 per cent. For product 'Pr1' the direct labour had 50 units of cost so the manufacturing overhead was assumed to be 300 per cent of this: 150 units of cost. Product 'Pr2' again used the 300 per cent and this was applied to the direct labour cost of 200 units giving a manufacturing overhead of 600 units of cost. Using a conventional overhead recovery rate took no account of the real differences in the amount of overheads that either product required. Figure 5.1   Product 'Pr1', a road vehicle braking system, was complex, had many production changes, and used difficult manufacturing technology. There were also many discussions with specialist suppliers.   Product 'Pr2', a railway truck bogie, used simple manufacturing technology, enjoyed a steady demand with few changes to schedules, and had used the same suppliers of raw material over a long period. Using the ABM approach the direct and actual overhead costs reflected the real situation as shown in Figure 5.2. Note that for Pr1 the conventional approach gave a contribution nearly double what it actually was. In other words, in reality the product was less profitable than they thought. Conversely, Pr2 was much more profitable than they thought. Using the overhead recovery approach meant that Pr1 was underpriced. They had orders but made little profit. Sales of Pr2 could be higher if it wasn't overpriced. Figure 5.2 Traditional View of Gross Margin In traditional accounting we find the term gross margin, defined as the revenue less the direct costs. As long as the gross margin is a positive number then the product is deemed to making a 'contribution to overheads'. In other words, whatever the overheads actually are, at least there exists some funds to pay for them. The issue is that we do not know, other than at the overall company level, whether this contribution has any bearing whatsoever on the real overheads involved in producing each particular product. ABM View of Product Contribution (Product Profitability) In the product costing examples we saw above, the ABM analysis uncovered the actual indirect and overhead costs associated with producing each product. Now when we calculate the revenue less the actual product costs we have a number that is called the ABM Product Contribution. In other words, if this is a positive number then we know that product costs are covered and the sum left over now contributes to the other overhead costs in the business such as Sales, R&D, Invoicing and so on. The ABM Product Contribution is a fairer basis by which to compare one product to another. We can show each product on a graph where we plot the cumulative product contribution, highest to lowest, for all the products. The resulting graph, the appropriately named 'hook curve' is shown in figure 5.3 The hook curve is one of the most powerful ways to display the outcome of the ABM analysis. Figure 5.3   As we would expect, one product is something of a cash-cow, such as 'Pr1'. The traditional gross margin calculation also gave a high figure and we now know that there are no issues concerning high levels of indirect and overhead activity. However, as we add more and more products to the graph, such as 'Pr2', we eventually find those where the revenue only just covers the real costs of manufacturing. The ABM Product Contribution gets smaller and smaller until some products balance out to zero.   At the tail end, we might be unfortunate to discover that some products, such as 'Pr3', which have a negative ABM Product Contribution. In other words, the revenue we obtain is insufficient to cover the actual manufacturing costs of the direct materials and labour and the appropriately assigned indirect and overhead costs. What is often surprising is finding products in this category where the gross margin is positive. We believe the situation is acceptable as long as they are making 'a contribution' to overheads. The reality is that any volume increase seriously erodes overall profitability rather than building up a useful contribution to cover overheads. The increased volume contributes only to losing even more money. ABM View of Customer Contribution (Customer Profitability) So far we have emphasised comparing revenue to actual product costs to give the ABM Product Contribution. This contribution has to pay for a number of significant costs associated with getting the sales in the first place, getting the products and services to the customers, and finally collecting payments. All these activities are customer-related costs. An ABM analysis of these activities enables us to assign the customer-related costs to each of the customers. In some cases, individual customers will be appropriate, whereas in others, meaningful segments or groups of customers will be the basis for the analysis. In a particular company, customer 'X' manually raised large numbers of low value orders, raised many queries, made many returns due to ordering errors, and had a poor payment history. Customer 'Y electronically raised a small number of high value orders, paid through Bank transfers and never raised any queries or made product returns. The gross margins made from both customers could well be equal but the costs of doing business with one are significantly higher. By calculating revenue less the real costs of the products the customer is ordering and less the real cost of servicing the customer, we are left with the ABM Customer Contribution. This figure is an appropriate basis to compare one customer to another. We can now plot a graph of cumulative customer contribution, highest to lowest, for each customer. Again we would generally find a hook curve but usually flatter than for the products. Many customers could be giving no contribution at all as shown on figure 5.3 with some seriously eroding profitability. Figure 5.4 As we would expect, one customer could well be a cash-cow. The traditional gross margin calculation gave a high figure and we now know that there are no issues concerning high levels of overhead activity associated with the customer. However, as we add more and more customers to the graph, we find those where the revenue only just covers the real costs of the products and the real costs of servicing the customer. The ABM Customer Contribution gets smaller and smaller until some customers balance out to zero. At the tail end, we might be unfortunate to discover than some customers have a negative ABM Customer Contribution. In other words, the revenue we obtain is insufficient to cover the actual manufacturing costs plus the customer servicing costs. What is often surprising is that customers in this category may have positive gross margins. Again we believe the situation is acceptable as long as they are making 'a contribution' to overheads. The reality is that any volume increase seriously erodes overall profitability rather than building up a useful contribution to cover overheads.   At the start of Chapter 1 we said that we know, instinctively, that some customers are more profitable than others. We also know that some are probably loss-making. We may also have some idea of which customers are probably the least profitable and which are the most profitable. So anecdotal evidence will pick up the extremes. The hook curve shows the situation with the other 99%. This is often a profound shock to management.   With accurate information we are now in a position to question how we can change the relationship with the customer and thus the costs incurred. In the extreme we might consider ceasing to do business with the customer. The appropriately named 'hook curves' are a revelation to many companies that undertake an ABM analysis. Hidden from view by the smoke screen of gross margins, the reality of products that lose money and customers that lose money are now shown in sharp relief. The question then arises over what to do about the low or negative ABM Contributions. The first instinct is likely to be an instant desire to get rid of the products and customers who are in the negative part of the hook curve. However, caution should be the first response. It is in this area that the hidden additional profit lurks. The approach should be to convert the negatives into additional positives. The quick answer is to raise prices for the products or to specific customers. While this may seem fair, particularly to 'awkward' customers, in general, market forces probably determine the upper limit on prices, usually the current prices! The first approach is to look at the characteristics of the products or customers in the high ABM Contribution end of the hook curve and then attempt to create these characteristics for the negative area. This would be the 'best practice' approach. In some cases the processes that interact with the customer may be creating problems for both parties. Resolving these types of issues opens up a constructive dialogue with customers where the outcome is likely to be a reduction in process costs for both. This is a win-win solution and should be the first outcome to search for. Another consideration before eliminating customers is the amount of 'fixed' costs that may be affected. In ABM we argue that no costs are fixed, all of them can be influenced in some way. However, for a warehousing and distribution business, it is not easy to reduce the size of the warehousing facilities or vehicle fleet in the short term. In this situation, taking actions to change from a negative to a positive ABM Contribution is the first course to explore. As a last resort, letting negative customers go to competitors is one way of shifting known unprofitable business to other companies that will be glad of the volume but will not be aware of the unprofitable nature of the business. Figure 5.5 The impact of volume and ABM Contribution can be shown graphically in a way that helps determine the next course of action to take. In figure 5.5 are shown a number customers on a graph of the percentage 'ABM Customer Contribution divided by Sales Revenue' set against Total Sales Revenue per customer. This highlights which customers are priorities to resolve. For any one customer, a graph can be plotted of the percentage 'ABM Product Contribution' set against Total Sales Value for each product the customer takes, as shown in figure 5.6. This highlights which products are priorities to resolve for that customer. Figure 5.6 What if a particular customer is ordering a mix of products, where one or more products has a negative ABM Product Contribution? Is does not automatically follow that you tell the customer they cannot have a particular product anymore. This issue is one of taking a balanced view about the future relationship. It may pay overall to leave the situation as it is if the overall relationship is sufficiently profitable. The key to using an ABM analysis is that a business makes decisions with knowledge that it can trust.   Traditional View of Costs in a Business As we have said earlier, in traditional accounting a business reports the use of resources and may split these simply into direct costs and overheads. However, in the overhead departments there exists a large diversity of costs. There may be training and personnel departments that enhance the skills and competencies of other departments. There may be new product or service design departments that are looking at ways to ensure the business has a future. There may be a legal department that looks at such things as litigation taken against the business or the formulation of commercial contracts to new markets.   In the accounts these costs are expensed under headings such as 'salaries' and lumped together as business overheads. This simple categorisation of diverse activities obscures the rich diversity of tasks being undertaken in a business to serve many purposes. ABM View of Costs in a Business Where a company allocates all its costs to products and customers (full absorption costing) it loses the real relationship between cost drivers and those costs that are influenced by the drivers. It also loses the visibility of the difference between the current business that is generating income and the real contribution that can be used to develop the future business. Full absorption costing destroys the ability to make meaningful relative judgements of product and customer profitability. In ABM, the diverse costs and activities are categorised so we can understand what is happening inside the business. There are certain key activities that are being performed that we define as Frontline. A frontline activity is one that has something to do with producing the primary product or service and any activities that interface with customers. Frontline activities have a direct cause-and-effect relationship to products and customers through cost drivers. This relationship may be a simple one based on, say, production hours to produce a product or number of invoices processed for each customer. They are current costs paid for by the revenue from current products and services for current customers. If more volume of the cost driver is forecast then more resource will be required. However, changing the methods used can change the unit cost of doing the work. There are other costs and activities that exist because the organisation is a legal entity and must fulfil specific tasks. The annual audit and financial reporting would fall into this category. Such costs are largely independent of the product or service being provided. They are the costs of being in business. These we call Infrastructure. These costs and activities have no direct relationship to current or future products and services. The level of costs is unlikely to change with throughput volumes or number of customers. However, the actual costs can change if the method changes or a service is obtained at a lower rate. For example, the auditors can be changed to reduce the level of fees charged. In most organisations, doing nothing to develop future products and services will guarantee the demise of the business. Organisations need to have funds to pay for the current costs of the people doing, say, new product development, but the benefits are expected to be derived in the future. The current product throughputs or current customers do not directly influence these activities. We call these activities Sustaining and they are essentially an investment to achieve a return in the future. The organisation has a choice over the level of Sustaining costs it wants to have. A reduction in Sustaining costs would transfer directly to the bottom line, but it would risk the future of the business. Companies invest in Sustaining costs so they make a higher return in the future. It could be argued that Sustaining costs should be made specifically visible to shareholders as they are investments in the business made out of retained profits that could have been distributed. The final category we call Internal Service. Typically, training, recruitment, current use of IT networks and the like are an internal service to all the other departments in the organisation. There are no direct relationships to current products and customers other than through the frontline activities that are supported. The key here is to understand and then assign the internal service costs and activities in an appropriate manner to all the other areas of the business that are supported. Given the four categories of costs and activities we can now structure the costs in an ABM model in a way that is far more meaningful than using conventional accounting categories and thus aid decision-making. Having analysed the activities in an organisation, the first task is to re-assign the Internal Service costs and activities to those of Frontline, Sustaining and Infrastructure. This uplifts the Frontline costs and links the cost drivers to the Internal Service costs. One can imagine a need for more frontline staff in say the invoicing department requiring an increase in the training department to train more invoice clerks. The link may be the number of people trained per annum, which would be the cost driver volume.   The uplifted frontline activities are assigned to the products and customers. The ABM Contributions are the revenue less the uplifted Frontline costs, either at customer or product level. It is at this point that it is meaningful to compare ABM Contributions for each product and for each customer. This is what Product and Customer Profitability means in ABM.   The total ABM Customer Contribution has to pay for the Infrastructure costs. After that, any amount that is left has to pay for any Sustaining costs and activities the company has determined it needs to secure its future. Increasing Sustaining costs reduces profit to shareholders. This is the acid test of management's decision to spend on Sustaining activities. The four ABM categories of cost are not shown in the accounts. However, these categories better identify the nature of the decisions that management is called upon to make. It also focuses Management on two clear objectives. To ensure that cost effective methods are used to produce current products to current customers at a price that generates the maximum positive ABM Product and Customer Contributions. To ensure that the ABM Contributions are used effectively to generate new products and services to new markets such that the return on the investment in Sustaining costs is greater than that which would be achieved by shareholders investing elsewhere. Traditional View of Functions and Hierarchies Companies seem to go through an irreversible life cycle that leads them towards specialisation, complexity and functional parochialism. However hard a business tries to avoid the situation developing, the entrepreneurial start of the business, where everyone can virtually do any of the necessary tasks within it, slowly evolves into functions. As functions clone staff together over the years, the rigid development of formal functional structures leads them to become fortresses, the contents of which become the jealously guarded property of the occupants. Inside each fortress allegiances are high and people speak their own language, a mechanism to spot intruders and confuse communication.   Organisations are hierarchical, although the transactions and workflow that provide services and products to customers take a horizontal path through the business. The traditional management structure causes managers to put functional needs above those of the multi functional processes to which their departments contribute. This results in departments competing for resources and blaming one another for any of the company's inexplicable and continuing failures to meet or exceed current customers' needs efficiently. In highly functional organisations the different lines of command inside the 'functional silos' create conflicting priorities along multi-functional processes. The performance measures are functional and tend to make functions compete, often at the expense of the customers. There is poor end-to-end visibility of what drives what inside the business. In these circumstances, management loses confidence in the decision support information if it is based on mirroring the functional structures. ABM View of Processes Internally, the delivery of products and services to customers is the end result of co ordinated activities by different groups working within the business. A process can be identified at many different scales. At the two ends of the scale we could have the process of building a ship and the process of authorising an invoice for payment. Conventionally, a process is defined as a set of linked activities across a number of departments. The 'Purchasing Process' in figure 5.7 is a typical example: Figure 5.7   A list of all the activities found in an ABM analysis may be interesting in its own right but the primary objective should be to examine all or part of the company's processes to develop implementation plans to improve efficiency and effectiveness. In overall terms, a key driver for change could be that costs must reduce while simultaneously improving quality and customer service.   A fundamental requirement for success of any process improvement programme is the notion of internal customers and suppliers working together in cross-functional processes. An ABM database of activities showing the activities in processes provides this perspective and is an objective basis for: understanding any current failures to meet external customers' needs; challenging the existing output or levels of service, both externally and internally; evaluating the benefits of improvements of methods; understanding cross-functional organisational relationships; understanding the interactions within multi-functional processes; and identifying and evaluating systems opportunities. Process mapping is a powerful technique to track the cross-functional flow inside a business process. Such maps quickly highlight failure feedback loops and potential over-complication within a process. The emphasis needs to be on understanding the interaction between the people and the processes in which they work particularly the points where the processes cross-functional boundaries.   Process charting will also raise a number of issues concerning conventional departmental and functional budgeting procedures. In a typical budget statement for a purchasing department, extracted from the monthly accounts, one finds that the accounts headings are to do with the resources that go into the department. The headings would include such things as staff costs, travel, telephone, stationery, and premises, computer charges and so on. However, the ABM activity analysis raises questions around the type of activities and why they exist. One of the activities of a purchasing department is 'assessing needs'. This involves deciding which supplier should quote for the component. The process defines how activities in one department are driven by the outputs from another. If there were no new parts coming from the Design Department then there would be no requirement for the activity in Purchasing. If the activity were associated with finding suppliers or prices for a part that was on its third modification in three months, then we would focus on what is now driving the activity. The design office may have rushed an inferior design into production and the rate of design change reflects putting the subsequent problems and warranty claims right. A key aspect of ABM is the emphasis that is placed on achieving a process perspective of the organisation and constructing the model in a way that focuses effort on finding ways to improve processes. Traditional View of Value and Non-Value added In books and articles we find the terms Value Added (VA) and Non-Value Added (NVA) regularly used to separate out those activities that are good for the business and those that are not. From these categories we would learn that creating scrap is bad, that checking is bad, and so forth. However, the terms VA and NVA are too coarse a definition of activities in the business as the subtleties of how failures occur in processes and the impact of customer behaviours is largely invisible. At a personal level, using the terms VA and NVA can be counterproductive when trying to analyse what is going on when talking to staff. If a situation is found where people are struggling against the vagaries of a process failure then it is hardly motivating to tell someone that for the last five years their job has been entirely non-value adding. The nature of process failures is that people do not come to work to cause them but have to deal with the consequences of failures, usually originating upstream in the process. ABM View of Types of Activities We have found that it is more enlightening to have three categories we call core, support, and diversionary. The terms are defined as follows: Core activities use specific skills and expertise and add real value to the business. Core activities are those that provide a necessary service to internal or external customers. Support activities make it possible for core activities to take place. For example, a salesperson's time spent negotiating with a customer is a core activity. The travelling time to get to the customer is support. Diversionary activities are caused by a process failure somewhere in the organisation. Such activities include correcting errors, chasing other groups for information, resolving queries and so forth. Diversionary activities have many causes including, for example: inadequate training; inadequate tools, procedures and systems; poor documentation; poor communications; poor quality suppliers; conflicting functional objectives and performance measures; inadequate understanding of customer needs; and poor customer behaviours. Poor efficiency and effectiveness can only be eliminated by isolating the root cause of the problem. Frequently, failures cascade through a number of sections picking up further diversionary activity and therefore costs. By identifying the source of failure and the associated diversionary activity costs, a key outcome should be to change the mix of core, support and diversionary activity within each area of the business. The requirement is to place more emphasis on core activity to enhance service quality, and so avoid diversionary activity elsewhere.   An ABM database of activities identified to processes can be coded in order to show the proportions of core, support and diversionary activity as they track through processes. In a typical example a process started with poor order specification. The effect was compounded as each department attempted to overcome the difficulties created by each department upstream in the process. The delays created pressure from customers, leading to short-term prioritising of manufacture schedules and assembly, and excessive overtime working to meet deadlines. The final symptom that highlighted the crisis arose when production attempted to overcome the backlog of late deliveries. Working from pre-design sketches, production converted a whole order quantity of raw material into piece parts (aluminium vehicle panels). The customer, on visiting the plant, while delighted that the delivery dates would be met, was curious to know why the specification ordered was not being adhered to. Only a large discount persuaded the customer to take the vehicles as manufactured. The vagaries of process failure are always around us. Parts do not fit together every time on assembly, invoices have mistakes on them, specifications are incomplete, the computer breaks down, the materials are often inferior, and things just keep letting us down. The processes we are using are not capable of doing the job. And, if the process is not capable, then despite our best efforts our output will be of inferior quality. Only by working on the process can it become capable and its results stable and predictable. Figure 5.8 is an example of how the salesforce and sales administration department of a manufacturer of office equipment used their time. Figure 5.8   It was found that only 15 per cent of the whole department's activity was devoted to customer contact. For a typical salesperson, the core activity of 'selling' occupied only 50 per cent of the time spent with customers. The remainder was spent on a diversionary activity, dealing with queries and complaints about delivery performance. Other activities in head office, such as credit notes, special invoices, keeping statistics on the problems, and a substantial proportion of management and administration was driven by the same problems. Not surprisingly, the saleforce had little time to spend on new calls to win new customers.   When the process was investigated each link in the chain pointed to another link as the cause. The atmosphere was one of finding other departments to blame. In this case striving for functional effectiveness was the underlying root cause of the problem. Functional measures were driving everyone's behaviour. The saleforce were measured on numbers of orders sent in, with month-end panics being the norm. Production ran larger than necessary batches in order to improve machine running-time utilisation. Distribution's standard costing variances were reduced by running full loads every time, even if this meant changing customer delivery dates. No end-to-end process measures were in place that related to the processes' ability to satisfy customers at lowest unit cost to the business. By identifying the root causes of poor delivery performance, a substantial proportion of the salesforce's time was released, allowing it to focus on winning more orders. Time was also saved in sales administration; some taken as a cost saving, while some was re-deployed into dealer support, handling increased volumes and a new task of telesales. ABM is key to quantifying the process perspective including the subtle nature of the activities being performed. Traditional View of Budgeting A magazine article discussed how new parents should budget for the new-born baby. The article suggested that parents should budget for functional warm and cool weather clothes - at least 20 outfits, 10 new-born undershirts, fifteen pairs of socks, and two dozen diapers or nappies. On top of these you should have baby-wipes for all purpose cleaning up, a sturdy big bag, preferably canvass, a baby sling, car seat, cream for rashes, and finally a rocking chair - for just sitting and nursing during the day. In this context, planning ahead to divide and reallocate scarce resources makes sense. The baby is coming, the situation is inevitable, and its minimum needs must be met. The situation is not dissimilar to planning a new building project. Materials have to be obtained, in the right sequence and timing is critical. However the budgeting process in organisations that results in a monthly set of figures showing budgeted and actual expenditure on resources does not connect with the tangible activities that are performed to provide products and services to customers. What is causing resources to be used, and are they being used effectively are questions that are not asked during the budgeting process or answered in the monthly reports. The annual budgeting process is often the only attempt by management to plan the future. At a minimum it is accepted with reluctance, at worst, it is a vehicle to play an extended game of bidding for more cash than is needed to end up with less than is vital. The frustration of the budgeting cycle starts with some sort of strategic plan issued by the board. However, functions are focused on short term objectives so their own set of objectives tend to have no visible links to show the impact on other functions. The plan is translated under the headings that finance recognise, such as people costs, equipment, and so on. These headings are the resources required so that work can be done. The functional budgets are consolidated to company level using the same input resource headings. Usually the consolidated totals are more than the Board expected so a cycle of intensive negotiation and compromise starts in order to achieve acceptable budgets. The articulate and politically astute functional managers tend to do well in these situations. Finally, Finance divide the acceptable total number by 12 and issue departmental monthly budgets. Each month the accounts are issued and departments are asked to explain their 'VARS', the difference between actual and budget for the month. Something the astute manager can do quite easily. Cross-charges and reconciliation queries start to cloud reality. The game for the new budget year is now fully operational. The conventional budgeting process is fundamentally flawed. Although the budget should be a reflection of the costs to execute and deliver the plan to take the whole business forward, the budgeting process is actioned by inviting each separate function to make bids for resources. The budgeting process also ignores cross-functional processes, and the fact that much activity is one function is driven by the actions in others. Much of managers' budgets can be outside of their control. Cross-charges are an inferior method to make some attempt to link services from one department to another but the underlying drivers of the activities are never the focus of a meaningful discussion between the parties who are generally at loggerheads over cross-charges. The budget is expressed as inputs; the resources needed to do something. However, the result of the activities is outputs, the things that impact on internal, and finally, external customers. These key relationships are never expressed in 'budgets'. The key measure should be 'What did we get for the money?'. However, the measure defaults to being 'Did you meet budget?' Success is seen as meeting budget, rather than achieving the desired outcome from the resources devoted to achieving it. Budgets extrapolated from the past have no bearing on the plans for the future. Lacking a link between activities, volumes and product and customer mix, managers fall back on just adding ten per cent in the hope they might get five. ABM View of Budgeting Activity Based Budgeting (ABB) can be categorised as looking at costs in the reverse direction from conventional budgeting. Rather than determine resources (ledger line items) ABB starts with forecasting the number of products and services, the number of customers and level of service to them. ABB then identifies the activities that would be needed and finally identifies the resources required so the new level of activities can take place. An ABM model is built by working forwards from resources to activities and on to products, services and customers. This provides the base data for ABB. Stripped to its basics, ABB starts with a knowledge of which activities are related to, say a particular product, service or customer. The relationship between a product and the activities to produce it is called the driver of the activity. If the product were an insurance policy sold via a call centre operation then the activity of 'sell policy' would have a driver and driver volume called the 'number of policies sold'. By forecasting the volume of policies to be sold in the future budget period we can derive the level of activity required to service the demand. This assumes the current service level using the current methods, both of which could be changed by management decision or process re-design.   Having determined what products or services will be provided, and the quantity of each activity that will be consumed, the next step is to determine what resources will be required. The costs of each activity will have been determined in the ABM model by analysing and assigning the resources in the ledger down to activities. Activity costs naturally include the salary costs of the people doing the work, but also the costs of the space they occupy, the IT they use, the stationery they consume, and so forth. Having determined the likely level of activities required to provide the services, ABB works backward from activities to the resources which the activities consume using the relationship between resources and activities. If the level of physical activity is forecast to increase by, say 20 per cent then the assumption is that salary costs would rise by the same proportion, as more people are needed. If the accommodation costs have been assigned to activities on the basis of area, then the new level of activities is assumed to require more space in which to do the work based on the same proportions of space to activity level that was used in the model. For activities such as 'driving a vehicle', then an increase in activity levels implies an increase in the number of vehicles. Where a computer terminal is used then at some point more terminals would be needed.   In reality, the relationships between product, activities and resources are not so simple. Some costs may be semi-variable or even fixed in the forecast scenario. For example, although training costs will have been assigned to the activities of people in the business who receive training, only parts of the total training department's costs, such as the trainers themselves, would vary as other activities in the business increase. The training department's building would remain at the same cost. Other costs would have been assigned but there exists spare capacity that can be used when volumes somewhere else increase. Some costs, such as year-end financial reporting, have almost no relationship to the volumes of products being produced. All these factors must be taken into account when calculating the budget based on the products or services being provided and the number and types of customers being serviced. By thinking through the logical relationships and making the necessary adjustments depending on the cost types, ABB traces activities back to ledger accounts from the starting point of products, services and customers. Although not quite at the 'touch of a button', we could predict a significant reduction in organisational angst and lead-time by using Activity Based Budgeting. Key points: Traditional product costing relies on using an Overhead Recovery Rate (ORR) to allocate overheads to products causing high distortions to product costs. In ABM the indirect and overhead costs associated with each product are determined accurately for each product. In traditional accounting we find the term gross margin, defined as the revenue less the direct costs. The issue is that we do not know, other than at the overall company level, whether this contribution has any bearing whatsoever on the real overheads involved in producing each particular product or serving each customer. ABM analysis uncovers the actual indirect and overhead costs associated with producing each product and servicing customers. Revenue less the actual product costs gives the ABM Product Contribution. Revenue less the real costs of the products the customer is ordering and less the real cost of servicing the customer gives the ABM Customer Contribution. ABM Contributions are an appropriate basis to compare products and customers. In the accounts costs are expensed under headings such as 'salaries' and lumped together as business overheads. This simple categorisation of diverse activities obscures the rich diversity of tasks being undertaken in a business to serve many purposes. In ABM, the diverse costs and activities are categorised as Frontline, Internal Service, Sustaining or Infrastructure so we can understand what is happening inside the business. In highly functional organisations there is poor end-to-end visibility of what drives what inside the business. In these circumstances, management loses confidence in the decision support information if it is based on mirroring the functional structures. A fundamental requirement for success of any process improvement programme is the notion of internal customers and suppliers working together in cross-functional processes. An ABM database of activities showing the activities in processes provides this perspective. Value Added (VA) and Non-Value Added (NVA) are terms that have been used to separate out those activities that are good for the business and those that are not. These terms are too coarse a definition to expose the subtleties of how failures occur in processes, and the impact of customer behaviours is largely invisible. It is more enlightening to have three categories that are called Core, Support, and Diversionary. In ABM, quantifying the process perspective by including the subtle nature of the activities being performed identifies the benefits of making process improvements and changing customer behaviours. However the budgeting process in organisations that results in a monthly set of figures showing budgeted and actual expenditure on resources does not connect with the tangible activities that are performed to provide products and services to customers. Activity Based Budgeting (ABB) looks at costs in the reverse direction from conventional budgeting. Rather than determine resources (ledger line items) ABB starts with forecasting the number of products and services, the number of customers and level of service to them. ABB then identifies the activities that would be needed and finally identifies the resources required so the new level of activities can take place. Additional Information: This excerpt is from "Activity Based Management: Improving Processes and Profitability" written by Brian Plowman (Please see Activity Based Management: Improving Processes and Profitability--Chapter 5. The ABM Framework   Develin & Partners l Article)

 

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1. Activity-Based Costing Survey: How ABC is Used in the Organization
   BetterManagement l Article

2. Activity Based Management: Improving Processes and Profitability--Chapter 1. Introduction  Develin & Partners l Abstract

3. Activity Based Management: Improving Processes and Profitability--Chapter 2. Historical Perspective
   Develin & Partners l Abstract

4. Activity Based Management: Improving Processes and Profitability--Chapter 3. So What is ABM?
   Develin & Partners l Abstract

5. Activity Based Management: Improving Processes and Profitability--Chapter 4. Frameworks for Measurement and Improvement    Develin & Partners l Abstract

6. Activity Based Management: Improving Processes and Profitability--Chapter 5. The ABM Framework
   Develin & Partners l Article