Activity Based Management (ABM)

Posted by Khalid Aziz

•Activity Based Management is a cost reduction approach that first identifies the value added
and non-value added activities
•Attempts to minimize non-value added activities by identifying the root cause(s) which are
preventable and prevention is always cheaper.
•To improve customer value and overall profit.
Definitions
• Activity-Based Management:
A system wide , integrated approach that focuses management’s attention on activities.
Activity Management:
An assessment of the value of the activities to the organization, including a recommendation
to select and keep only those that add value.

• Value-Added Activities Necessary, perfectly efficient activities. Example: Direct labor,

Additional direct materials, and machining. The filing requirements of the IRS, reporting
requirements of SEC, and preparing financial statements per GAAP requirements. 
• Non-value-added Activities : Activities that are either unnecessary or necessary but
inefficient and improvable. These activities cause non-value added
costs.Example:Scheduling,moving,waiting,inspecting,and storing.
Dimensions of Activity Based management
• Cost Dimension Concerned with accurate assignment of costs to cost objects, such as
products and customers.ABC is the focus of this dimension.
• Process Dimension Provides accurate information about why work is done and how well it is
done.

Process Dimension Includes:

• Driver Analysis: Concerned with identifying the root cause(s) of activity costs. Knowing the
root causes of activity cost is the key to improvement and innovation.
• Activity Analysis: The process of identifying, describing, and evaluating the activities an
organization performs. It involves:
1. What activities are done.
2. How many people perform the activities.
3. The time and resources required to perform the activities.
4. An assessment of the value of activities to the organization, including 
a recommendation to select and keep only those that add value.

Furthermore, activity analysis help management to select and keep- adding activities that
brings about cost reduction and greater operating efficiency, thus providing support for the
objective of continuous improvement. Moreover, activity analysis can reduce costs in four
ways.
• Cost Reduction:
• Activity elimination: the identification and elimination of activities that fail to add value.
• Activity selection: the process of choosing among different sets of activities caused by
competing strategies. 
• Activity reduction: the process of decreasing the time and resources required by the activity.
• Activity sharing: Increasing the efficiency of necessary activities using economies of scale.
• Activity performance measurement: Assessing how well activities( and processes) are
performed is the fundamental to management’s efforts to improve profitability. There are two
types of measurement : Financial and non financial forms. These measures are designed to
assess how well an activity was performed and the results achieved. 

• Activity performance is evaluated on three dimensions:

• Efficiency :focuses on the relationship of activity inputs activity outputs. e.g.
producing the same output with lower costs for the inputs used.(financial and non financial)
• Quality: concerned with doing the activity right the first time it is performed. Otherwise the
unnecessary costs will incur and will have adverse effect on efficiency.(financial and non
financial)
• Time: the time it takes to develop and produce a product and delivering to customer.(non
financial).

ABM STEPS
• Set a benchmark (standard) for value added activities.
• Identify activities
• Classify activities: Value added and Non-value added
• Search for the root causes for non-value added activities.
. Recommend how to improve non-value added activities by using:
1. activity selection 
2. activity reduction
3. activity elimination
4. activity sharing

Illustration of ABM Application

• Setup time for a product is 5 hours. A firm that produces the same product and uses JIT has
reduced setup time to 15 minutes. Setup labor is $10 per hour.
Value-added costs: (15/60)($10)=$2.50
Non value-added costs:(5-15/60)($10)=$47.50
15 minutes is considered to a benchmark .Root cause—product design—strategy—activity
selection

• Warranty work costs the firm $1,000,000 per year. A competitor’s warranty costs are
$200,000 per year.
• Value-added costs: $0.00
• Non-value added costs: $1,000,000
• With zero defects there should be no warranty costs.-- Root cause---.( Total Quality
Management)—strategy: Activity elimination 

• The company keeps 5 days of raw materials on hand to avoid shutdowns due to raw
materials shortages. Carrying costs averages $1,000 per day.
• Value-added costs: $0.00
• Non-value-added costs: $1,000*5=$5,000.
• Delivery problem---Root Cause--(suppliers) Use JIT. Strategy: activity elimination

• By redesigning the plant layout, the time required to move materials can be reduced from 2
hours to 30 minutes. The labor cost is $12 per hour.
Value-added costs: (30/60)($12)=$6
Non-value added costs= (2-.5)($12)=$18
Root cause: plant layout…Strategy: Activity selection

Summary

• Activities are classified into: Value-added and non-value added costs.

• Identify the root causes for non-value added costs
• Recommend how to eliminate and / or improve inefficiency related to non-value-added
activities.
• ABC and JIT are complimentary to ABM.
• To improve customer value and overall company’s profitability
• Identifying non-value added