THE ROLE OF THE
COST FLOW DIAGRAM
IN ACTIVITY-BASED COSTING
If the implementation of
ABC appears to be an overwhelming task,
here is some practical information
on how to design the structure of the system.
by Paul Sharman
Many management accountants have accepted in principle that
ABC provides a relatively accurate method with which to calculate the cost of activities,
processes, cost and profitability of the products, services, customers and served markets
that represent the tangible outputs of their organization. However, relatively few
organizations have actually implemented ABC as their primary source of cost information.
A number of management accountants have commented that they
have read many articles and the few available books on the subject of ABC, and they are
convinced that it is something that they should implement. But, they say that they have
not found a viable description of how to actually do so.
In the past, accountants would simply ignore the activity
dimension of resource utilization in their hurly burly rush to allocate cost fairly to
products. To this day, we hear veteran accountants talk of the need to fully allocate
cost, because they need to know how much products cost. After 10 years of ABC, the vast
majority of accountants still don't get it. If an activity is not utilized in the
production of a product, then its cost must not be allocated because the resulting number
will mislead management. In management accounting and for the purpose of supporting
decision making, it is wrong to allocate cost, period. In fact there are serious questions
about the relevance of cost allocations for inventory valuation and reporting purposes. At
one time, someone obviously felt the need to make up some rules, but the resulting
valuations are generally inaccurate.
Apart from the confusion about what the purpose of ABC is,
perhaps the biggest problem for management accountants who wish to implement ABC is that
they typically don't have an organized, reliable methodology with which to actually do it.
Simply put, ABC is a cost and operational analytical exercise which is highly dependent on
the gathering and assembly of both financial and non-financial operating data. It is
designed to provide management with information at a level of materiality sufficient to
guide both strategic and operational decisions. In fact, most ABC systems contain high
levels of aggregation and numerous assumptions. Therefore, effective implementation is
highly dependent on three things: knowledge of the business; a straightforward
methodology; and, good project management skills.
The basics of ABC
ABC is the tool with which to correctly document and
calculate the cost and profitability (if appropriate) of products, services, customer and
market support. These costs are calculated by identifying the cost of activities and
resources consumed in their production. The cost of resources employed to perform
activities that do not produce products, services and support customers or markets are
classified as business sustaining activities, and they are not allocated to products. The
business sustaining classification includes cost of activities and resources consumed,
such as regulatory reporting, business development and idle capacity. Business sustaining
costs are paid for out of profits made from the sale of products and services to
customers, after having paid for the cost of making sales calls and processing orders in
support of the customer. In ABC, the economic outputs of the organization, which include
products, services, customer and market support and business sustaining, are referred to
as cost objects. Rather than trying to allocate cost fairly, ABC sets out to assign cost
to activities and cost objects based on measurement of resources consumed.
The primary purpose of ABC is to analyze indirect costs.
This is irrespective of industry, whether manufacturing or service, for profit or not,
private or public. The primary building material for ABC is knowledge -- knowledge of the
activities performed by the people and other resources employed by the organization. Armed
with information on activities and resources, a cross-functional implementation team has
to link them to cost objects in order to develop an understanding of the economic
architecture of the organization. This linkage describes the cost and operational
relationships of the organization.
The cost flow diagram
To clearly understand the cost and operational
relationships and to make the information usable, it is necessary to prepare some form of
documentation. We refer to this document as the cost flow diagram. Its components include
a list of the activities that are performed by the people in each department, buildings,
machinery and equipment employed, their outputs, cost drivers, cost objects and the flow
of operational relationships between them. The purpose of the cost flow diagram is to
define what economic relationships exist within an organization and to explicitly identify
what operational data is necessary to build an ABC analysis. In some instances, the
document appears as a style of flowchart with symbols, lines and connectors. In other
instances, it appears as lists of activities coupled with the use of "post - it"
notes, demonstrating relationships between the resources, activities and cost objects.
Irrespective of the style and actual look of the document,
the principle of cost flow diagrams is the same. Basically they provide a record of how
the ABC implementation team views the economic relationships of its organization.
Accountants have used flow charts to symbolize flows of cost and conceptualize operational
relationships for as long as we have done cost accounting. What is different about the
cost flow diagram is that it is a disciplined and critical step within a seven-step
process required to build an ABC system. It is used as a vehicle with which to bring order
to the otherwise haphazard understanding that most people have of how their organization
functions economically. The cost flow diagram is the single most important tool used by
ABC implementation teams because of its role in defining the software model architecture
and data requirements. It also provides a mechanism with which to control design
complexity, and the amount of detail to be managed. Without it, implementation teams tend
to be constrained to entering data into the preconfigured fields within the software, and
hoping like crazy that the software firm and/or the consultants understand both ABC and
their business needs.
Preparation of the cost flow diagram is the stage in ABC
implementation that requires the most concentrated thinking from the team. The
overwhelming characteristic of the cost flow diagram exercise is that the team holds
extensive discussions. Therefore, it requires the full dedication of the team's attention
and participation. It is important to minimize distractions and to complete the exercise,
once it has begun. Frequently the team meets off site.
To be fully effective, design of the cost flow diagram
occurs after the team has completed activity analysis. Some consultants suggest that
detailed activity analysis is unnecessary because ABC can be prepared on a macro basis.
Experience would suggest that such macro analysis is dependent on the team's having a
strong comprehension of the actual activities being performed by every function. However,
most people have a general understanding of the outputs of their functions, but it is
incomplete and their knowledge of how long it takes to perform activities is minimal.
Hence, macro ABC models are often built on the basis of incomplete information and
assumptions. They tend to yield a more detailed allocation system. This is not ABC.
Activity-based costing is only as accurate as the analysis of activities.
There are a series of steps that the team cycles through
when designing the diagram. A number of them are iterative and repeated constantly as the
resources and activities of each function and department are reviewed. Other steps are
handled as discrete exercises for the entire organization when analysis of all of the
departments is complete. (See Cost flow diagram steps sidebar.)
Cost flow diagram preparation
Most cost flow diagrams in manufacturing or
equipment-intense service organizations (telephone or railway companies) are initiated by
the team discussing and documenting machinery and other operational equipment. The team
evaluates each of the major productive components in order to determine what functionality
is provided, outputs produced, resources consumed, and what the appropriate driver
measurement is. For example, a machine typically consumes floor space, electricity,
operator time and maintenance resources. The driver measurement for a machine, whether it
be a computer, a locomotive or steel-stamping press, is often "number of machine
hours." The outputs or activities of machines are therefore defined in terms of time
utilization, such as "running," "set-up," "down," and
"idle." Where the organization has a number of similar machines, e.g.,
locomotives or stamping presses, they can be grouped into classes. For instance, if the
company has five 1000-ton presses, and seven of another kind, it is unnecessary to review
each of the five 1000-ton presses individually, but rather to deal with them as a group.
This approach recognizes that each item of the group has the same characteristics as other
items. If the team perceives that there is not a material difference between the
characteristics of the five 1000-ton presses and the seven of another kind, they may
decide to group the five and seven together.
Each machine within the organization is reviewed and
discussed individually and decisions are made. As the team progresses through its
discussions, care is taken to document all of the decisions made. This is accomplished on
flipcharts and is often entered into the ABC software simultaneously.
Having completed the analysis and documentation of
productive equipment, the team moves to the analysis of human activities. Each team member
presents the results of his or her activity analysis interviews to the assembled team. The
team discusses the types of activity and agrees on which activities are material to the
overall ABC analysis. The interviewer may present a series of activities that appear to be
linked by a common output and the team may decide to group them as one activity,
particularly if they have a common driver (e.g., number of orders). For example, the
various tasks in receiving and handling a customer order may have been broken out
separately, i.e.: receive phone call; call up customer on screen; and enter customer
requirements. As with the discussion of equipment, the team moves methodically through
each of the activities performed by all of the functions or departments and documents its
decisions on flipcharts.
As with machines, functions that perform similar functions
(e.g., bank branches) can be reviewed in groups. To make sure nothing is overlooked,
typically the most complex example of the group is discussed in detail and then the other
similar entities within the group are reviewed to see if they have any different
activities that need to be added to the list.
During the exercise, the team creates and applies a
numbering system, so that each activity within the document is given a unique
identification. Most ABC software products require a form of numbering, some are
alpha-numeric, some simple, others complex. Rather than get hung up on complex numbering
systems during the design, it may be better just to start at "one" and keep
counting. The numbers can be modified later to suit the proprietary needs of the software
when the model is being built. It is also possible to define certain characteristics of
activities at this stage. For example, activities are reviewed to determine whether their
cost will be assigned to product, customer and business-sustaining cost objects, or
reassigned to other activities.
Other activity characteristics or attributes can be noted
at this stage. For example, some organizations like to note whether an activity is
perceived to be value adding, or non-value adding.
The cost flow diagram
is a critical step in
understanding the economic structure of an organization -- the relationships
among resources, activities
and cost objects.
As well, information on whether the activity is deemed to
be unit, batch, product or facility-oriented can be recorded. Another attribute type that
may be noted is the name of the process within which the activity functions. This permits
the organization to calculate the cost of processes, which is highly desirable during
process reengineering. Readers should note that processes operate across departments,
functions, and consist of a group of activities which have a common purpose, e.g., the
order fulfilment process. It is important to note that the cost flow diagram should not be
confused with a process map.
Cost objects are identified on the flipcharts by using
large "post-it" notes to depict groups of products or services, customers and
business-sustaining activities. When all of the activity and resource analysis discussions
and reviews are complete, the team proceeds to identify the flow of outputs from each
activity to the cost objects. This is accomplished by using one- inch square
"post-it" notes. Each team member writes activity numbers on "post-it"
notes and physically attaches them to the cost objects or other activities that will later
be assigned the cost of the output of the activities. The department or cost object to
which a "post-it" note is attached is referred to as the destination. If the
output of an activity (origin) is to be assigned to more than one destination, i.e., a
number of different products or departments, then the team member attaches a
"post-it" note to each destination with the same activity number on it. In this
fashion, the structure of the ABC model is defined. Each "post-it" note
represents a point at which a data relationship exists between the originating activity
and the destination cost object, or other destination activities.
By making a note of where the "post-it" notes are
on the activities and cost objects, team members are able to begin to collect data for
entry into the software model. This will include gathering information on the number of
driver units produced by each activity (origin) and the quantity received by each cost
object or receiving activity (destination). During data collection, each team member is
responsible for preparing a description of the activities for which he or she collects
data. This will be included in a reference document called a dictionary of activities.
In summary, the cost flow diagram is a critical step in
understanding the economic structure of an organization. The economic structure is
represented by the relationships among resources, activities and cost objects. Although
the cost flow diagram maps operational relationships, it is a basic cost accounting tool
because it describes how the cost of resources is consumed by activities to produce the
organization's outputs and therefore correctly matches cost with revenue. With this tool,
management accountants have a practical and disciplined method with which to undertake
activity-based costing. cma
Paul Sharman, features editor for CMA magazine,
is president of Focused Management Information Inc. The company helps businesses to
implement new cost management techniques.
Reprinted from the
CMA magazine with permission from The Society of Management Accountants of Canada.
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