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Practitioners often incorrectly assume that activity-based costing (ABC) systems make use of standardized, structured mechanisms similar in concept to the double entry accounting approach employed by general ledgers. In fact, ABC requires a high degree of objectivity, analytical skill, and architectural thinking to be effective. Also, the design of ABC systems varies significantly by industry. Certainly, ABC has the potential to be an important central component of the cost-management system in any enterprise. But it is critical that it be implemented correctly. ABC is, by definition, an analysis of the operations of the enterprise, and it provides a comprehensive view of its economic structure. However, there are many different perspectives on what ABC is and even many different opinions on what is good practice, and what is not. We continue to hear poorly-informed people say that ABC is really just a better way to do product costing, and yet such a view offers a tragically limiting perspective of what ABC truly is. It is a view put forward most often by accountants who are yet to step outside the rules that define their work. And yet, most accountants need to step outside their framework in order to gain a broader view of business operations, and to understand planning, monitoring and control mechanisms. ABC is not an accounting tool; it is a sophisticated, but simple, analytical tool which requires a broad understanding of the business and its operations. A very important principle of the correct design of an ABC system is that activities and resources are assigned, not to products, but to cost objects, based on use. This is because, in many organizations, activities are not used to produce products. In service organizations, for instance, activities are focused largely on service to customers and on sustaining the business. The actual cost of resources consumed in producing "products" can be less than 10 per cent of total indirect costs. The reason that ABC is so important is that it is impossible to manage something if it is not measured correctly. The design of an ABC system is a practical concern, as it must depict the actual physical structure of resources, and activities, and cost objects. It is necessary to undertake a tightly-executed, correct analysis of physical structure -- predominantly of operations rather than of the cost numbers in the general ledger. Design is everything in an ABC system because each organization consumes different levels of resources in performing different activities and has different levels of output or different cost objects. Even within the same industry, different organizations must be very careful to depict their operations as a reasonable facsimile of their specific structure. Care must be taken not to take examples from other organizations in the same industry too literally, even though consultants and industry interest groups promote comparative information. It is most important that you understand your own organization explicitly, before comparing your results to those of others. Beware of consultants bearing best practices or industry-specific activity dictionaries and ABC templates. They can be highly misleading because competitors differentiate themselves by being different. Correct structure will also have significant influence on the definition of strategic goals and measures within an enterprise, because profitability by service/market segment based on traditional allocations is distorted. ABC corrects the distortion and could have significant influence on segment objectives. To demonstrate the point about design, each of the following kinds of organizations has unique economic and physical structures that must be depicted properly in activity-based costing. Distribution Distribution companies are service organizations that handle products, but they don't make them. Activity costs associated with products in a distribution organization include market research, acquisition of products (sourcing, contracting), procurement, marketing and inventorying. Other significant resource costs are consumed in performing activities that "service the customer" such as selling, processing paperwork for customer orders, picking, packing, shipping orders, and then invoicing and accounts receivable. These activities may have an association with products, e.g., the invoice serves to bill the customer for products. However, the cost of processing the invoice paperwork is relatively the same every time one is produced, irrespective of the value of the invoice or the products that are being billed. Some customers place many low-value orders, while others place few large-value orders. The cost per dollar of revenue, therefore, to invoice the low-value-order customer is higher than it is for the high-value-order customer. The behavior of the customer drives cost within the distributor. Other activities are required to sustain the business, that are not used either to process "products," or to service customers. Insurance Usually insurance organizations refer to classes of policy as "products" and "product lines." Most insurance companies concern themselves with managing profitability by "product" and they generally do not have a strong understanding of such other dimensions as the cost of serving different customer segments, or individual brokers. Traditional financial information is highly dependent on extensive allocations of indirect cost. Meanwhile, in increasingly competitive markets, correct information that can be viewed in relation to different dimensions of the business should provide significant management insight. For example, low-value policy holders may prove to be more costly to service per dollar of revenue than high-value customers. The purpose of insurance is to provide peace of mind; it is an intangible, and is therefore defined as a service rather than a product. The semantics issue around the use of the word "product" to describe a service aside, there is reason to consider how correctly an image is conveyed by calling insurance services "products." Consider that insurance services are provided even when no claims are being processed. Peace of mind is attained by the existence of the policy, the servicing of which is accomplished by the processing of premium cheques. Actual activity mix varies by insurance company and the nature of the insurance policies being offered. However, resources are typically utilized in performing activities to sell, directly or indirectly, through brokers (channels) to prepare quotes and undertake actuarial evaluations of risk. Other activities are required to investigate and process claims. Insurance companies are heavily involved with processing transactions, whether they are associated with setting up new policies, processing changes, payments, or statements and claims. Processing these transactions involves significant computing power, and computer resources are often centralized and shared by multiple "product lines" and business units. In addition, the organization consumes resources for purposes of general sustainment (as do all organizations to some degree), such as business development and the monthly accounting closing of the books, and strategic planning. These activities are not consumed in producing the "products" or servicing the customersand, therefore, they should not be "allocated" to them. In order to understand the entire organization correctly, it is necessary to examine the elemental components of its makeup. Because the business of insurance companies is so transaction-oriented, it is necessary to understand the cost characteristics of each transaction in order to correctly develop an aggregate economic picture. Each transaction consumes activities in varying quantities. The operational cost structure of each transaction is described in ABC by using: a) a bill of activities (list of activities utilized to process the transaction) and, b) activity-driver quantities (quantity of activities required to process each transaction). Each transaction is a cost object in its own right. In addition to cost, each transaction has properties that can be captured; for example, each transaction is processed for a specific customer. Each transaction is associated with a specific policy, which in turn defines the "product" or "product line" to which the transaction cost can be assigned. Because the policy is sold by a specific sales person, agent or broker (channel), each transaction can be related to the channel in whatever level of detail that is required to manage the business. These different characteristics of cost objects are referred to as dimensions. Telephone The cost structure (resource consumption) of telephone companies is strongly influenced by the physical network architecture of the business. Telephone company employees often refer to their services as products, for example "data" or "long distance." As with the insurance organizations, these "products" are intangible and are, therefore, described incorrectly. However, most telephone company accountants routinely prepare "product profitability" reports that include massive allocations of cost. These reports depict a fictional representation of the economic structure of the business, and contribute to a poor understanding of the dynamics of the profitability of the organization. Even in a telephone company, a significant proportion of cost pertains to large numbers of people employed, in addition to the cost of operating the network. Activities are performed by people to sell services, process new service provisioning, process billings, as well as plan, configure and maintain the network. The network itself consists of machines that perform activities. For example, peripheral equipment circuit pack, such as a line card, provides a capability for processing calls dedicated to a specific telephone number. The activities of the line card consist of: 1) processing calls, 2) waiting for calls, and 3) not working. Every element of the network is analysed in ABC to determine what the activities are, and what cost objects the activities are to be assigned to. For example, when the line card is processing a call, it may be described as providing a billable service; however, when it is not processing a call it is still dedicated to the customer, and costs money. When the line card is waiting, it is a cost of servicing the customer. When the card is not working, or down, it is neither performing a service, nor is it serving the customer -- depreciation and maintenance costs are paid for out of the profits generated from the service revenue, after deducting the cost of serving the customer, i.e., customer cost object. Therefore, the cost of down time should be assigned some other cost object category, most probably business sustaining. Overall, the distribution of resource cost in a telephone company is heavily skewed towards business-sustaining and customer-serving activities, rather than service performance. Of particular significance is the cost of providing service to remote customers in comparison to serving customers in densely populated geographic areas. Downtown-city-core areas are often substantially more profitable than rural areasbecause the cost per dollar of revenue to serve low-revenue customers in a rural area is much higher. By allocating all costs to products, the accountants are misrepresenting the economic structure of the business and, probably, heavily influencing decision making in the wrong direction. In telephone companies, profitability of customers by geographic area is most significant and varies dramatically with population density. The traditional costing approach applied by telephone companies completely misrepresents the true economic story. It is my opinion that the regulatory process in Canada supports the misrepresentation of costs by making extensive use of allocations. Railroad The ABC structures in railroad organizations have similarities to those of telephone companies. Both consist of large interconnected networks that move traffic from a point on a distribution system, through a series of switches, ending at an exit point in the distribution network. Obviously, there are huge technological differences, and resources and activities are substantially different; however, the design approach and architecture are relatively consistent. ABC demonstrates similar findings in railroad companies as in telephone companies, in that low-revenue customers are relatively more costly and less profitable than high-revenue customers. An interesting aspect of a railroad company's ABC analysis was that product profitability was defined by commodity type, e.g., grain, automotive, or container (intermodal). In addition, there was interest in determining profitability by train and by corridor, e.g., New York to Chicago. To obtain corridor profitability, it is necessary to determine both the revenue and the cost of moving goods through the corridor. This is very difficult unless the majority of the freight enters the railroad network only within the corridor. If the freight enters the network elsewhere (say Los Angeles) then determination of revenue is impossible, other than by allocation. Therefore, both cost and revenue are based on allocated numbers in the conventional profitability reports. Accordingly, the only analysis that is meaningful is network-wide. An alternative would be to use market prices to establish intercompany or corridor pricing. Banking The economic structure of a bank is a hybrid between the telephone company and the insurance company examples. The banking business has changed dramatically during the last 20 years as a result of computing and communications technology. Branches and physical documents used to be the centre of all activity in the past, whereas today, perhaps as much as 80 per cent of all transactions occur electronically. Branches are primarily customer-service centres that provide a human interface between the customer and the computer terminal. As a result, banks, too, consume a high proportion of resources in running data centres and networks. Accordingly, they have greater similarities to the economic structure of telephone companies than to the banks that we have known in the past. Tips on how to ensure that ABC design
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