HOW ABC CAN HELP
SERVICE ORGANIZATIONS
The economic analysis provided by ABC
is the foundation on which to build solutions to many of the
critical business issues facing service organizations today
by Don Lambert and John Whitworth, cma
Most of the early work on activity-based costing and
management (ABCM), going back five or 10 years, was based in manufacturing organizations.
And yet, one of the most powerful concepts of ABCM is its focus on organization-wide
activities. Increasingly, ABC/M is being seen as an essential tool to enable both profit
and not-for-profit service organizations to improve their utilization of strategic
resources in order to meet stakeholder performance expectations. We are working with
organizations in a wide variety of service industries including armed forces, railways,
municipal services, banking, insurance, telecommunications, distribution, health care, and
electrical utilities. Our public seminars have seen increasing interest from
non-manufacturers. In 1995, 57 per cent of attendees were from service organizations, up
significantly from previous years.
In the 1990s the distinction between service and manufacturing organizations is becoming
blurred. Is a software company a manufacturing organization? What about a pharmaceutical
company? In both cases, the costs related to boxes of product are relatively trivial. We
submit that virtually all organizations are, in some respect, service entities. Often, it
is the service cost dimension that is crucial to profitability. A classic example, seen
repeatedly, is the customer who pays a premium price but, in the end, contributes less to
profits than other customers because of special service requirements.
A summary of some of the most relevant critical business issues is shown in Figure 1. As
you can see, the critical business issues facing the management of service organizations,
both for-profit and not-for-profit, revolve around many of the same issues that face
manufacturing organizations. With the traditional accounting methodology of allocating
indirect costs "fairly" to products, service organizations face an additional
dilemma -- no inventory of products on which to do this. However, this doesn't prevent
many such organizations from allocating indirect costs to the direct costs of service
provision, typically on per cent of revenues or per cent of budget allocation.
The building block of an ABC system is the analysis of activities in order to identify the
following: the activities within each department and why, and under what circumstances,
each activity is done; how often, and for whom, the activity is performed; resources
consumed in doing the activity; and, what factors determine or "drive" the
activity or resource.
Figure 1: Critical business issues
Figure 2: What is ABC?
In looking at Figure 2, there are several elements worthy of
note. First is that activities happen because an input has triggered them, e.g., an
activity such as "purchase supplies" is caused or triggered by a requisition.
Secondly, we see that resources are consumed by an activity. Resources are the things that
an organization pays for, such as people, machines and equipment, and facilities. We can
measure the consumption of resources by activity. For example, the activity "purchase
supplies" consumes one hour of an employee's time per requisition.
Finally, on Figure 2, activities can be associated with the outputs or cost objects of the
organization. Examples of a few of the cost objects for service organizations that we have
worked with include such things as mortgages, chequing accounts, rail car movement from
point A to point B, or B to C, aerospace engineering training course, 1-800 phone service,
provision of military base support services to operational military units, and, finally,
customers, either individually or in groups. Cost objects consume activities in much the
same way that activities consume resources. Consequently, we can measure how much of an
activity such as "purchase supplies" is required by an organization's service
output, such as "engineering training course." The measurement of consumption is
called an activity-cost driver. Of significant note here is that different cost objects DO
consume activities in different proportions, and that different customers DO consume
activities in different proportions. Traditional allocation models hide this variation in
activity utilization by allocating these indirect costs based on some common denominator,
such as per cent of budget allocation, or per cent of revenue, and hence often provide
quite misleading information.
Figure 3: Extending value to include value analysis
Figure 4: Combining ABC and process improvement
The level at which activities are analyzed can vary widely
from the very aggregate to the very detailed. The level of detail should be matched to the
level of analysis required to improve the decision making within the organization. Even
within a single organization, the level of detail can vary from one part of the analysis
to another. Excessive detail will bog down the project and not provide any material
benefit to the analysis. Too little detail will obscure the meaningful results that could
be achieved.
The usefulness of an ABC analysis can be further enhanced by including a value analysis of
every activity (see Figure 3). We have found that the typical binary assessment of either
value-adding or non-value-adding is too restrictive in scope. A multi-dimensional approach
allows for the variations that exist in real life. The value assessment can only be done
after the data collection phase of a project as it is necessary to have fully costed
activities -- that is, that all the resources associated with an activity have been
identified and their costs attached to the activity. It is also necessary to examine the
output and the customer for each activity. An activity's value can only be examined in
terms of its contribution to the customer.
For those activities which are not correctly resourced (value #s 1,3,4,5, on Figure 3),
once the value ranking has been established, a per cent can be estimated as to how over-
or under-resourced the activity is. The total estimated opportunity for resource savings
can then be calculated based on all the activities within the model. Users have been
finding improvement opportunities in the range of 10-20 per cent of resource dollars that
fall within the scope of the study when this approach has been used. Cross-functional
teams then develop and implement change management strategies in response to these
opportunities. Often there are significant savings achieved in the short term with
relatively little effort (so called " low hanging fruit"). Other changes require
a longer time horizon to implement while others may never be achieved.
For those activities which require a longer time horizon, an ABC analysis can be combined
with a process improvement project. Activities happen within the framework of an
organization's processes. Figure 4 shows how we can identify which core process or
processes an activity contributes to. When all activities have been associated with a
process, and once the ABC analysis has produced activity costs, the result will be a fully
costed "Is" map, i.e., a map of how the organization's work presently functions.
This can provide very powerful insight and focus to the entire process-improvement effort,
especially when combined with the value analysis we have already discussed.
When constructing an ABC model, activity costs can be either traced directly to a cost
object, or to the other activities which they support. These enabling or support
activities then form part of the cost of the activities which are mapped to the cost
objects. Examples of enabling activities include "paying employees" and
"supporting PC users." We can then generate reports for these activities in
various formats that show both the direct resources as well as those support activities
that form part of the total cost. Reports generally list the activities from highest cost
to lowest cost, such as in Figure 5. Management can then evaluate these activity costs in
terms of whether they are too high, too low, or in the expected range. This is again a
focusing mechanism for management in evaluating its resource utilization patterns.
Figure 5: Activity cost results
The ABC analysis will also provide an analysis of activity-driver results (see Figure 6).
There is usually an expectation of what range these transactional unit costs should be.
Results that fall out of the expected range indicate either that the data has problems or
that management's expectations were not realistic. As we can see in Figure 6, the cost per
unit of activity driver can also be reported from highest to lowest, but this is not
necessarily the most relevant ranking. For activities that have very large transaction
volumes such as cheque clearing in a bank, cost per driver unit will be small, but the
smallest variation will have a significant impact on total cost.
The value analysis results as shown in Figure 7, when sorted from highest savings
opportunity to lowest savings opportunity, can again yield a significant insight into the
organization's activities. When doing the value analysis, if activities are incorrectly
resourced, then a reason needs to be provided and an identification of how the savings
would be realized. Usually a pattern develops in terms of how the savings opportunity
could be achieved. Many times we see things such as changing priorities of management,
competing and ineffective reward systems, lack of training, lack of technology, and poor
scheduling being identified across a wide spectrum of the organization. When looked at in
this light, the value analysis clearly provides a focusing mechanism on where resource
utilization could be improved.
Figure 6: Activity driver results
Figure 8 shows the results of a recent ABC analysis vs. a traditional analysis based on
the allocation of customer-serving costs on a per cent of revenue in a subsidiary of a
world-wide service company. The ABC results showed that customer- serving costs per
transaction were reasonably flat by customer group. The analysis also showed that the
larger customers had, within the bounds of materiality, the same number of transactions
per year as the smaller customers. What distinguished the customer groups was the dollar
value per transaction, i.e., the larger customer groups had much larger dollar values per
transaction than did the smaller customers. The traditional allocation method which they
used showed that all customers were profitable, as indirect costs were allocated based on
revenue dollars. This meant that the smaller customers appeared to be profitable despite
the fact that there were significantly more smaller customers than larger customers which
generated little or no revenue. We can see this result as the bottom curve on Figure 8.
The ABC analysis showed, however, that based on the consumption of resources and based on
the cost driver quantities associated with the activities (such as the number of
transactions), the larger customers had only 35 per cent of the total transactions (and
approximately 35 per cent of the total resource cost) but generated 81 per cent of the
total revenue -- not the 35 per cent expected when costs were allocated based on revenue
dollars. The analysis also showed, therefore, that the smaller customers had 65 per cent
of the total transactions (and approximately 65 per cent of the total resource cost) but
generated only 19 per cent of the total corporate revenue -- not the 65 per cent expected
when costs were allocated based on revenue dollars. Therefore, small customers were
unprofitable and large customers were subsidizing them. These results are shown as the top
curve in Figure 8. With this new strategic insight into its business, the organization was
in a position to successfully re-profile its small customer-service level, and pricing
decisions, in order to not grow the company into financial difficulty.
Figure 7: Value analysis results
This cost information can be integrated with the decision-making process taking into
consideration other strategic issues such as market share, competitive environment, and
key customer relationships.
We recently worked with a company where a significant portion of its engineering-design
team's activities was devoted to a new project which:
1. lost substantial money ( in main, due to design activities);
2. had a low probability of a repeat order;
3. could have been declined;
4. could have been priced more aggressively without jeopardizing the customer
relationship;
5. and where resources could have been re-deployed in support of profitable work.
With the successful completion of the ABC project, the company was able to modify its
project evaluation criteria to incorporate ABC information into the project approval
process.
As in this example, the objective of an ABC implementation is not to provide a
decision-making system for the organization, but rather to integrate financial and
non-financial data along with strategic considerations in support of the organization's
critical business issues.
Figure 8: Cost object results
In summary, activity-based costing has proven itself to be a viable costing methodology
for almost any organization that incurs a substantial amount of indirect resources.
Service organizations, whether for profit or not, have accepted ABC as a viable costing
tool for their purposes. No longer is it perceived to be just another
manufacturing-costing tool. The economic analysis provided by ABC is the foundation on
which to build solutions to many of the critical business issues facing service
organizations today. More and more service organizations are finding this to be the case. cma
Don Lambert is an associate of Focused Management Information Inc., (Oakville,
Ontario), and also runs his own consulting practice, DF Lambert & Associates. He spent
nine years with the Canadian Forces, as a logistics finance officer, involved in cost
analysis, economic forecasting, budget management, and ABC systems.
John Whitworth, cma, specializes in ABM implementation and training as a principal of ACT
Consulting Services, and an associate of Focused Management Information Inc. He has been
involved with ABM in diverse industries including auto parts, extrusion, glass
fabrication, building products, foundries, machine shops, and pharmaceuticals.
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