ACTIVITY-BASED MANAGEMENT AT AT&T

Managers have a clear connection to understanding the cost of servicing each business segment.

BY TERRENCE HOBDY, JEFF THOMSON AND PAUL SHARMAN

Throughout its history, North America's telephone business has been regulated. Pricing formulas have been determined by regulators under a mandate established by political process.

The Federal Communications Commission developed its methods for establishing tariffs (prices) on the basis of cost plus an allowable profit. Allowable profit was calculated on the basis of a predefined return on investment (ROI).

In order to satisfy regulators that the cost of a tariffed service was correct, AT&T was required to develop sophisticated cost allocation procedures. Thus, an important management process was concerned with how to allocate cost in order to satisfy the political/legal process. The staff worked hard to obtain funding and manage the budget within a framework heavily influenced by outside interests.

The Big Breakup

AT&T's breakup into smaller, more focused business units combined with the advent of price-cap regulation (instead of the predefined return on investment regulation) made managing rather than allocating costs critical. The company's business units compete in a open market, and the need for accurate cost and profit information by service is vital.

Each of AT&T's 22 business units consists of a number of strategic business units. AT&T's management believes the business is managed better and customer segments served more effectively by holding business managers accountable for profit, market share, and customer satisfaction within a smaller, more focused market.

Allocation methods had been developed to assign costs of the business unit, strategic business unit, and substrategic business unit managers. Initially, however, costs were allocated most often on the basis of "convenient," high-level volume drivers. They were not allocated according to service, customer segment, or actual activity being performed.

For example, the costs to maintain and manage the telephone typically were allocated to service based on network telecom minutes of use. Some billing costs were allocated on the basis of the number of invoices produced, but different invoice types required significantly different levels of computing support and staffing requirements in order to validate, sort, and mail.

A new accounting system was developed in 1992 and succeeded in telling the business and strategic business units what their results were at a detailed service level - with an assurance that all of the service-level numbers added up to the business unit level. But what they did not have was a process that allowed them to do the following:

* Provide business unit managers with the ability to manage the costs of cost centers that allocate significant expense to their profit and loss statement. For example, if network costs were allocated according to relative minutes of use, it might result in lower minutes of use rather than analyzing the value of those activities that drove the cost.

* Enable these managers to relate their operational decisions to the bottom line. For example, if a manager is able to lower his service order rejection rate by a certain percentage, the improvement should be reflected in the manager's profit and loss statement.

* Make it possible to predict how certain operational decisions will impact the bottom line.

* Establish funding/budget levels for internal suppliers using a fact-based process that identifies activities, activity cost drivers, and value added. The existing funding negotiation process focused more on allocations and less on eliminating non-value-added activities. It also was influenced by emotion and intimidation rather than by the goal of solving a problem in which the business managers had a stake.

ABC Awareness

At the same time, AT&T managers became aware that the process view of operational and nonfinancial relationships was more critical to understanding and driving the business than the old financial measurements. During the fall of 1991, Neville O'Reilly, division manager - business ABC has improved AT&T's trip on the information Highway

communications services financial support, personally took up the challenge to identify a better method of cost analysis to support the business. At the time, business communications services was responsible for all domestic business and international voice and communications services offered by AT&T. Its annual sales were many billions of dollars.

Mr. O'Reilly and two associates attended a seminar on activity-based costing (ABC) sponsored by the Institute of Management Accountants. During the seminar, Mr. O'Reilly was introduced to the operations-based process modeling approach to implementing ABC. The process modeling approach creates a visual image of operating process flows and associated costs at each stage of the business. This information is used to build a computer simulation model.

A statistician by training, Mr. O'Reilly spent a lot of time examining the alternative cost decomposition approaches. "Process modeling is the only approach that allows for the integration of cost management with process management - because costs follow process definitions - and financial and nonfinancial metric development," Mr. O'Reilly observed. Through his efforts, an ABC pilot project was initiated.

Getting Started

The business billing center was selected for the ABC pilot project. Product managers with P&L responsibility wanted better insight into the center's operations and an identification of specific activities that added value.

A billing control office and the bill print center were the business billing center's main functions. The billing control office's activities included monitoring billing process records, editing checks, validating data, and correcting errors. The bill print center was responsible for printing, sorting, and dispatching invoices to business customers.

A process-focused team-based approach was used to achieve the following objectives:

* Integrate financial management results (economic value added) with operational management and customer results (customer value added).

* Identify operational cost improvements and quantify cost savings from proposed initiatives (for example, cost of rework). Identify and manage costs according to process.

* Analyze productivity increases or decreases in the business billing center.

* Establish a fact-based process for business planning and budget negotiations. The process should focus on the benefit/cost of specific activities. It should not result in emotional disagreements over allocations.

* Benchmark the business billing center's costs with other billing centers and internal business billing center groups.

The first phase of the project involved an analysis of specific activities in the business billing center. These activities included: billing control office and staff, headquarters staff associated with the billing control office, support staff located at the business billing center (for example, management of information technology), and all resources other than staff such as facilities and computers. The first phase also analyzed the total number of employees and the center's annual expense of $30 million.

Prior to the implementation of ABC, the center was unable to determine accurate unit cost information for decision-making purposes. Previously, these steps were followed to report unit cost:

1. Billing center employees reported hours by activity to the unit cost administrative group on a weekly basis.

2. This group would divide the total monthly expenses for a specific workgroup by the total number of activity hours for the month. For example, if monthly expenses totaled $100,000 and the total hours spent to process service orders were 25% of the group's total activity hours, then $25,000 (.25 x 100,000) would be assigned to the cost to process service orders.

3. To obtain a unit cost, the $25,000 monthly expense amount was divided by the appropriate unit cost measurement. In this case, it was service orders. Therefore, $25,000 divided by 1,000 service orders yields a unit cost of $2.50 per service order processed. Although this process produced a rudimentary unit cost, the unit cost data were insufficient for decision-making purposes because they relied too heavily on allocations and not on true cost (activity) drivers.

Process Modeling Approach

Process modeling calls for costs to be traced to outputs - in this case services performed - through the many process stages that exist as a result of operational relationships. In our case, we began with tracing costs directly to resources. Resources were traced to activities, and activities were traced to whatever entity consumed their physical output.

For example, the cost of the floor space used by the computing function was based upon the number of square feet the computers occupied. Local computer facilities were then traced to activities based on use. Activities were traced to processes based on the quantity of driver units consumed. Finally, process outputs were traced to service provided to each customer.

The cost was traced directly to each resource from the general ledger and required no preallocation. Costs cascaded through the model from level to level based on the operational consumption characteristics described in Figure 1. Three cost objects were defined for the billing control office based on the product/service types supported by this center. Additionally, about 15 cost objects were defined for the bill print center on the basis of product/service invoice types printed and mailed from this center.

The cost of service support of these individual customers was determined by identifying activity and driver consumption characteristics. The cost per driver unit was calculated by the model for that customer group. For example, the cost of printing, sorting, and dispatching of individual invoices or all invoices for a service type could be determined by identifying activity and driver consumption characteristics. Each cost object was costed by multiplying the quantity of driver units of each activity consumed by the cost per driver unit.

Instead of using the more limited two-stage driver model, a multi-stage analysis was used to identify operational and cost relationships. Drivers were defined as activity, process, or resource related.

The team avoided thinking in terms of cost allocations. Instead they believed that operational relationships would be obvious when physical transactions were processed in a clear and measurable way. Furthermore, cost would follow these operational relationships.

Deciding on the activity drivers was relatively straightforward because team members from the various functions were familiar with the operations.

Some of the activity drivers confirmed by team members were number of customers tested, change requests, service orders, bill groups (customer locations), bill resolution groups, printer hours, and pages printed.

A schematic flowchart of the business and operational relationships was prepared to identify how resources and activities related to each other. The flowchart also showed the final outputs of the organization. We considered this documentation critical because it revealed how the organization conducted business. Managers also were able to see how cost flows are a function of operations and how they consume costly resources.

We then used the flowchart to identify data collection requirements. Approximately 75% of all the data required were nonfinancial. The financial analysis was straightforward and involved no allocations.

We used a PC-based, windows version ABC software called NetProphet to model operational relationships and trace costs. The software is a process-oriented graphical user interface and is designed to perform "what if" analysis.

The design of our system closely follows the software's architecture. To ensure that the ABC model could be updated monthly, interfaces to other systems were developed.

Clear Connection

Initially the ABC system analysis was conducted on a per-month basis. Later it was integrated into our routine monthly reporting.

The analysis identified different types of information, including the cost of each type of service provided by the billing control office. Services provided by the office included daily verification, bill verification, reject correction, message investigation, and resolution of unworkable orders. Total cost of the center was traced to the cost objects. It was discovered that 25% of total center costs were traceable to message investigation.

Rejected work orders were analyzed according to customer group. Because different employees in the office center handle different customer groups, we could identify which functional group was more efficient at processing service orders and reject corrections. Costs were calculated for all activities, resources, and their drivers. In the bill print center, costs were calculated for the invoicing of different types of services and the special handling of one service type.

Thanks to ABC, significant cost reductions in the business billing center have been achieved despite an increase in revenue and volume during the past two years. Volume in billable minutes increased 26% in 1992 and 20% in 1993. More important, business billing center costs have decreased 8% and 18% during the same time period.

Other benefits include the ability to provide relevant and reliable unit cost results in a timely fashion, perform benchmarking analyses, implement process improvements, and reduce cycle times. Unit cost results to support management decision making are now available in several different formats. They include unit cost by activity, unit cost by process, and unit cost by functional workgroup.

The model also provides such beneficial cost information as unit costs by process. Figure 2 shows the unit costs for service order processing and message processing.

These results allow management to make a fact-based risk assessment of the costs for supporting these processes. Thus, management can use the information to determine the number of resources (people, telecom, and so on) to support the processes. More important, the center has used the cost information to improve internal customers' understanding of the costs related to supporting their processes.

Once ABC was implemented we decided to benchmark service order processing and message investigating activities in the business billing center. Both areas were studied to determine the average amount of time required to process one unit of output, such as a service order or an unidentified message investigation unit (UMIU) case. The results of the analysis for the January through June 1993 time period are shown in Figures 3 and 4. For example, June's average time to process a service order for workgroup 4 was about 3.79 minutes as compared to 7.24 minutes for workgroup 3.

Similarly, Figure 4 depicts the average time to process an UMIU case for the same time period. These results also compare processing times across the same workgroups.

As a result of the benchmarking analysis, a key process improvement was made that reduced cycle times for the service order activity. Business billing center associates were given on-line access with split screen capability for the ordering system. This process improvement allowed the associates to perform an on-line comparison of the service order report. Consequently, over 19,000 paper copies of service orders were eliminated, resulting in an estimated cost saving of approximately $42,000 per month. Additionally, the elimination of paper copies reduced the time required to file these documents significantly.

Other process improvements were implemented to improve the operational efficiency for the message investigation activity. For example, business billing center associates were provided access to additional operating systems. By allowing access to these systems, associates were given end-to-end responsibility for message investigation. Therefore, referrals to other workgroups were eliminated. To further enhance their productivity, associates were trained to use the systems.

Several recommendations to improve the efficiency of the message investigation activity also have been proposed. For example, managers are currently evaluating whether or not to mechanize the comparison of the UMIU retention report. Associates now reconcile the UMIU retention report by using colored highlighter pens to indicate if the message was old or new. We believe there could be a significant reduction in the cycle time spent investigating UMIU.

One Year Later

One year following implementation - not only are the "customers" satisfied, but listed below are examples of how the ABC model is being used to better manage the center's operations. It:

1. Performs a fact-based risk assessment of the cost of performing special projects at the business billing center.

2. Measures associates' productivity in completing certain activities (monthly volume of service orders processed). Manages the center's overtime costs.

3. Conducts benchmark studies among the center's functional groups. Specifically, functional workgroups are organized by customer type (for example, 10th of the month bill cycle) and are responsible for performing activities such as bill verification in support of these customers.

4. Allocates resources and performs workload balancing. Determines the correct resource type for performing activities.

5. Supports the budget process by providing P&L managers with fact-based business choices driven by the identification of activities, their value added, and related cost drivers.

6. Assists workgroups in determining staff training needs. As a result, there was more cross-training for the team responsible for providing monthly cost results and analyses.

Successful Transmission

The business billing center activity-based costing implementation project was successful because of the team members' efforts as well as the contributions made by other stakeholders. Not only was the final output an innovative tool to better manage costs, but it was an education to enhance the operation of our business. Here are some of the key lessons learned:

* Management learned it is possible to determine unit cost information for the outputs of its organization and could determine the costs associated with servicing each business segment.

* Management's understanding of the relationships among processes, drivers, and transactions improved. This insight improved management's understanding that old allocation methods could be improved upon dramatically. By improving the cost/performance tracking system it is possible to hold more meaningful budget discussions with client organizations. Thus, it is now possible for these internal customers to examine their own processes and see what drives activities and cost.

Finally, ABC has taught management how to manage the business proactively with the objective of increasing productivity and profits. It has led to improvements in internal processes, supplier relationships, and customer satisfaction.

Terrence Hobdy is communications services finance manager, and Jeff Thomson is CFO-custom offers at AT&T. They can be reached at (908) 658-2721 and 2708. Paul Sharman, is president, Focused Management Information, Inc. He can be reached at (905) 829-2658.

Reprinted from the Management Accounting magazine with permission from The Society of Management Accountants of Canada.