STRATEGIC COST MANAGEMENT

ABM, MULTISTAGE ABC, TIME DRIVEN ABC

17-Sep-20
Prof. Parmjit Kaur Arshpreet Kaur(07)
Kanika Mehta (13)
Navneet Kaur (17)
Simerpreet Kaur (28)
Table of Contents
ACTIVITY BASED COASTING (ABC) ...................................................................................... 4
THE TWO-STAGE COST ASSIGNMENT PROCEDURE ...................................................... 5
TRADITIONAL COST ACCOUNTING SYSTEM VS ABC ................................................... 5
COST ALLOCATION UNDER BOTH SYSTEMS .................................................................. 8
STEPS IN DEVELOPING AN ACTIVITY-BASED COSTING SYSTEM ............................. 9
IMPLEMENTATION OF THE ABC METHODOLOGY IN A MANUFACTURING
COMPANY............................................................................................................................... 11
BENEFITS OF ACTIVITY BASED COSTING ..................................................................... 12
DISADVANTAGES OF ABC ................................................................................................. 13
RESEARCH PAPER- CASE STUDY ......................................................................................... 13
IMPLEMENTATION OF ABC METHODOLOGY IN THE COMPANY ........................ 17
ACTIVITY BASED MANAGEMENT ........................................................................................ 21
ACTIVITY BASED MANAGEMENT MODEL .................................................................... 24
WORKING OF ACTIVITY BASED MANAGEMENT ......................................................... 25
TYPES OF ACTIVITY BASED MANAGEMENT ................................................................ 30
TYPES OF ANALYSIS ........................................................................................................... 31
AREAS WHERE COMPANIES CAN USE ACTIBITY BASED MANAGEMENT ............ 32
APPLICATION OF ABM IN BUSINESS ............................................................................... 34
ACTIVITY BASED MANAGEMENT TREATMENTS ............................................................ 35
1 PRODUCT COSTING....................................................................................................... 35
2 PRODUCT CONTRIBUTION (PRODUCT PROFITABILITY) ..................................... 36
3 VIEW OF CONTRIBUTION (CUSTOMER PROFITABILITY) .................................... 38
4 VIEW OF COSTS IN A BUSINESS................................................................................. 40
ACTIVITY BASED MANAGEMENT – FUTURE PERSPECTIVE ......................................... 41
MULTISTAGE ACTIVITY-BASED COSTING ........................................................................ 42
Activity-Based Cost Management in the Public Sector: Multiple Stage ABC/M Approach (Gary
Cokins| November,30,2015) ......................................................................................................... 42
RESOURCE CONSUMPTION ACCOUNTING ........................................................................ 47
THE CORE ELEMENTS OF RCA: ......................................................................................... 48
PRINCIPLES OF RCA ............................................................................................................. 48

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CASE STUDY CLOPAY ............................................................................................................. 51
TIME DRIVEN ACTIVITY BASED COSTING ........................................................................ 54
COMPARISON OF CONVENTIONAL ABC AND TIME DRIVEN ACTIVITY BASED
COSTING ................................................................................................................................. 55
TIME EQUATIONS ................................................................................................................. 62
MODEL UPDATING ............................................................................................................... 64
RESEARCH PAPER .................................................................................................................... 65
Time-Driven Activity-Based Costing for Inter-Library Services: A Case Study in a University
by Eli Pernot, FilipRoodhooft, and Alexandra Van den Abbeele............................................. 65
TIME-DRIVEN ACTIVITY-BASED COSTING FOR INTER-LIBRARY LOANS ............. 65
COMPANIES FOLLOWING TIME DRIVEN ACTIVITY BASED COSTING ................... 77
Hunter Company ................................................................................................................... 77
Klein Steel ............................................................................................................................. 80
Banta Foods .......................................................................................................................... 81
REFRENCES ................................................................................................................................ 83

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ACTIVITY BASED COASTING (ABC)

Activity-based costing (ABC) is a method for improving the accuracy of cost determination.
Activity-based Costing (ABC) is a powerful tool for the an organization to have an accurate and
effective cost for its product avoiding cost distortion that may lead sustainable development and
growth which is mandatory to be competitive in the era of globalization and complex business
environment.

To develop a costing system, we need to understand relationships among resources, activities,

and products or services.

Activity A specific task, action, or unit of work done.

Resource An economic element needed or consumed to
perform activities.
Cost Driver A factor that causes or relates to a change in
the total cost of an activity.
Resource Consumption Cost Driver A measure of the frequency an intensity of
demand placed on a resource by an activity.
Activity Consumption Cost Driver A measure of the demand placed on the
resources by products, services, or customers.

Therefore, activity based costing is costing approach that assigns resource costs to cost objects
(products, services, or customers) based on activities performed for the cost objects. The basic
primciple is that a firm’s products or services are the result of activities, and activities require
resources, which have costs. ABC recognizes the causal or direct relationships between resource
costs, cost drivers, activities, and cost objects in assigning costs to activities and then to cost
objects.

For example: a plant is trying to compare the production costs of two products, A and B, both
of which take six hours of production time. Using a standard allocation, which just evenly
divides overhead costs over units, these products would appear to have the same cost of
production. However, if product A takes six hours on a normal machine and product B takes

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six hours on a more complex, expensive machine, the production cost of B is actually higher
than A. In this example, use of each machine counts as an activity, and thus activity-based
costing reveals expense that needs to be captured within product B that doesn’t appear in
product A.

THE TWO-STAGE COST ASSIGNMENT PROCEDURE

It assigns resource costs, to cost pools and then to cost objects.

COST
RESOURCE COST
OBJECTS
COSTS POOLS

TRADITIONAL COST ACCOUNTING SYSTEM VS ABC

Geared toward compliance with financial reporting requirements, traditional cost-accounting

systems often allocate costs based on single-volume measures such as direct-labor hours, direct-
labor costs, or machine hours. While using a single volume measure as an overall cost driver
seldom meets the cause-and-effect criterion desired in cost allocation, it provides a relatively
cheap and convenient means of complying with financial reporting requirements.

In contrast to traditional cost-accounting systems, ABC systems are not inherently constrained
by the tenets of financial reporting requirements. Rather, ABC systems have the inherent
flexibility to provide special reports to facilitate management decisions regarding the costs of
activities undertaken to design, produce, sell, and deliver a company's products or services. At
the heart of this flexibility is the fact that ABC systems focus on accumulating costs via several
key activities, whereas traditional cost allocation focuses on accumulating costs via
organizational units. By focusing on specific activities, ABC systems provide superior cost
allocation information—especially when costs are caused by non-volume-based cost drivers.

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Even so, traditional cost-accounting systems will continue to be used to satisfy conventional
financial reporting requirements. ABC systems will continue to supplement, rather than replace,
traditional cost-accounting systems.

VOLUME BASED COSTING:

FACTORY PLANT/
PRODUCTS/
OVERHEAD DEPARTMENT
SERVICES
COSTS AL COST
POOLS

(Source: Cost Management, A Strategic Emphasis, Edward J. Blocher)

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ACTIVITY BASED COSTING:

FACTORY ACTIVITIES PRODUCTS/

OVERHEAD SERVICES
COSTS

Using appropriate resource Using appropriate

consumption cost drivers. activity consumption
cost drivers.

(Source: Cost Management, A Strategic Emphasis, Edward J. Blocher)

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THEREFORE, THE DIFFERENCE:

VOLUME BASED ABC

Cost Pools = production plant or departmental Cost Pools = activities

cost centers.

Cost Drivers = volume based, that bears little Cost drivers = based on an activity or
or relationship to the consumption of resources activities performed for the cost object.
by cost objects.

COST ALLOCATION UNDER BOTH SYSTEMS

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STEPS IN DEVELOPING AN ACTIVITY-BASED COSTING SYSTEM

Identify Assign Assign Activity

Resource Costs Resource Costs Costs to Cost
and Activities to Activities Objects

STEP 1:
• Identify the costs of resources consumed by identified activities.
• An activity analysis identifies the work performed to carry out a firm’s operations. It
includes gathering data from existing documents and records, as well as collecting
additional data using questionnaires, observations, or interviews of key personnel.
• Questions that ABC project team members can ask the employees or managers to gather
activity data-

1. What work or activities do you do?

2. How much time do you spend performing these activities?

3. What resources are required to perform these activities?

4. What value does the activity have for the product, service, customer or organisation?

With the help of industrial engineers and management accountants, the team also collects activity
data by observing the work performed and making a list of all the activities involved.

LEVEL OF ACTIVITIES:
Unit level An activity performed for each unit of the cost
object; volume based.
Batch level An activity performed for each batch of

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 products or services.
Product level An activity performed to support the
production of a specific type of product or
service.
Facility level An activity performed to support operations in
general (that is, an activity not related to
volume of output, number of batches produced,
or the support of individual products).

LEVEL OF ACTIVITIES-examples

UNIT LEVEL BATCH LEVEL PRODUCT LEVEL FACILITY LEVEL

Setting up machines,
eg. inserting a Placing purchase Designing products, Providing security,
component, so orders,
Purchasing parts general purpose
varies as per Scheduling required for machines,
output Production, products, factory property
Conducting engaging in taxes,
inspection by engineering changes insurance.
batches, to modify products.
handling materials by
batch.

STEP 2:
A firm should choose resource consumption drivers based on cause-and-effect relationships.
Typical resource consumption drivers include the number of:

1. Labor hours for labor intensive activities,

2. Employees for payroll-related activities,
3. Setups for batch related activities,
4. Moves for material handling activities,
5. Machine hours for machine repair and maintenance, and
6. Square feet for general maintenance and cleaning activities.

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 Ideally, the cost of resources is directly traced or assigned to activities, which requires
measuring the actual usage of resources by an activity. For example, power used to operate a
machine can be traced directly to that machine’s operation by reading the meter attached to
the machine. When direct tracing is not available, department managers and supervisors need
to estimate the amount or percentage of time (or effort) employees spend on each identified
activity.

STEP 3:
The final step is to assign costs of activities to items of interest, generically called cost objects,
based on the appropriate activity consumption cost drivers. The cost objects are the outputs
resulting from the firm’s activities and, typically, are products or services; however, customers,
projects, and even business units can be cost objects. For example, the cost objects of an
insurance company may be individual insurance policies sold to customers, claims processed,
types of policies offered, insurance agents, or divisions of the company.

IMPLEMENTATION OF THE ABC METHODOLOGY IN A

MANUFACTURING COMPANY
(Reference: Research Paper- Activity Based Costing (ABC) – An Effective Tool for Better
Management)

Experts agree on several essential characteristics of any successful implementation of Activity-

Based costing. First, the initiative to implement activity-based costing must be strongly
supported by top management. Second, the design and implementation of an ABC system should
be the responsibility of a cross-functional team rather than of the accounting department.
According to Cooper and Kaplan (1991), before designing an ABC system, six major decisions
should be made:

Should the system be integrated with the existing cost system or should it be a standalone
system?

Should a formal design be approved before implementation?

Who should take ownership of the final system?
How precise should the system be?
Should the system report historical or future costs?
Should the initial design be complex or simple?

After having answered these important questions one can start with designing the appropriate
ABC system for its demanded purposes. A conceptual model presented in the following figure
has been used to demonstrate the relevance of ABC in manufacturing and service organizations.

The implementation process was broken down into the following six basic steps:

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Step 1: Identify and define activities (such as unit level, batch-level, product-level, customer-
level, organization-sustaining) and activity cost pools.

Step 2: Whenever possible, directly trace overhead costs to activities and cost objects

Step 3: Assign costs to activity cost pools

Step 4: Calculate activity rate

Step 5: Assign costs to cost object

Step 6: Prepare Management Report

BENEFITS OF ACTIVITY BASED COSTING

The growing industrial complexity and product diversity have made the emergence of ABC
system for growing firms. As a powerful tool for decision making purpose, the major advantages
of ABC systems are discussed below:

1. ABC increased operational performance by allocating overhead costs based on the actual
consumption of the resources by each activity.
2. ABC recognizes the interdependencies of cost drivers to activities.
3. It enables the management to see where the most important costs occur as well as what
provides them.
4. Decisions about improving pricing, marketing, product designing and product mix can be
made more efficiently by implementing an ABC system.
5. ABC system is the suitable method for correct and accurate information.

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 6. Redeploying a resource from a non value-added to a value-added activity.
7. By identifying the weak product lines and accurate costs, ABC helps to increase
organizational efficiency and profitability.
8. Completely eliminating a non value-adding activity ABC can takeout costs.
9. Identifying and correcting an error that was not budgeted for correcting an error that was
not budgeted for correction but would have caused an expense had it not been corrected.
10. Provide Growth by removing a bottleneck that was causing a capacity constraint.
11. It helps industrial marketers in three ways; it results in cost estimates to use in pricing,
guides industrial marketers to adjust in negotiations to yield significant cost reductions
and indicates areas for change in operations to permit cost reductions that will allow the
company to satisfy customer wishes better.

DISADVANTAGES OF ABC

1. ABC system is more costly to maintain than a traditional costing system.

2. The implementation process of ABC system is very complex for managers to understand
and it produces numerous data, activity measures and requires collecting, checking
process etc.
3. Because of complexity of the process the decision making process becomes lengthy.
4. Resistances from the management as managers are accustomed to using traditional
costing systems to run their operations.
5. ABC data can easily be misinterpreted as there are huge amount of irrelevant data.
6. In practice, as managers insist on allocating all costs to costs objects, this results
overstated cost and understated margin results mistakes in pricing.
7. If no one in the organization looks at the new ABC cost and profitability information, the
project team becomes disappointed.
8. Consultants are not familiar with companies operation and problems. Hence they failed
to support management in some cases.
9. Resistance arises because people feel threatened by the suggestion that their work could
be improved.

RESEARCH PAPER- CASE STUDY

The study was conducted in a Portuguese company that produces roasted coffee, and was
focused on a specific area: the production of coffee in capsule. This study concentrated on all
aspects of this new sector of activity in the company: acquisition of new industrial equipment,
manufacturing processes and methods, raw materials and subsidiary products, contracted
services, direct labor, to mention only the most important.
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The company is dedicated to two distinct areas of activity: the production and marketing of
roasted coffees and the marketing of alcoholic beverages, namely wines, Port wine, sparkling
wines and others. The company’s two business areas have similar sales volumes. The marketing
and distribution of the various products is present throughout the national territory and islands.
On the other hand, this company is part of a broader business group, with companies and
facilities in the Iberian Peninsula and in the American continent. The headquarters of the group
and most of its companies are in the same place where this work was developed.

The production of coffees is carried out in facilities that are separated from the rest of the
company's activity. However, the terminal part of the production process, such as the dispatch of
merchandise, shares employees, equipment and facilities with the marketing and distribution of
beverages.

The production of coffees involves different formats and its commercialization is done through
several channels, both in the national market and in the foreign market. In the national market the
sale of the products is directed essentially to 2 channels:

a) HORECA (stands for Hotels, Restaurants and Cafes) and

b) Mod-ern distribution (a term used in the company to designate the sales made to the retail
companies of the large distribution, which offer their products normally in large areas).

Commercialization in the foreign market is carried out through distributors.

As noted above, the product "capsules" represents only a small part of the coffee-based products
produced in the company's industrial facilities. The production of coffees is not the only activity
developed by the company (there is still the distribution of beverages), so there are resources that
are shared not only between activities in the same area, but also between different business units.
In this way, the evaluation of the activities related to the production of a given product are even
more important in order to better evaluate the associated costs and the "weight" they represent
for the organization.

A set of activities were identified as main activities (MA) by their importance and influence in
the production process of the capsule production. For these activities, a direct/linear relationship
with the product was verified. This reason of linearity is verified not only at the level of costs but

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also at the qualitative level and the intrinsic constitution of the final product. The activities
represented in Table1 are those included in the capsules manufacturing flowchart.

These activities are developed in the industrial building of the company and, in most situations,
there is a physical separation of each activity site, as can be seen in the previous table (Table 1).
A considerable part of these activities is common to all coffee products produced in the
company, which corresponds to activities between MA1 (reception of green coffee) and MA5
(roasting). In fact, after the roasting stage, there is a separation of the way forward for each
product that will culminate in the following 6 groups of products that are presented in Table 2.
Because they are activities that lead to the obtaining of products whose base constitution in their
combination is coffee and constitute all the activity of the industrial unit of this company, were
called complementary activities (AC).

Thus, up to the point of separation (MA5), the activities developed are shared by all coffee
products produced in the company, and their execution uses the same resources, both at the level
of facilities, equipment and labor. On the other hand, there is a set of activities of wide scope and
common to several organizational processes, which, despite not having an importance of the

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same order of magnitude of the previously identified group, interfere and influence the
production process. This group includes activities such as purchasing, receiving materials,
maintenance and management and quality control. These activities were designated as secondary
activities (SA), see Table 3.

The production of coffee capsules activity is the result of a set of activities that are upstream of
the production process, and which are developed by suppliers where the resources of this
company are used. These activities include the production (injection) of plastic capsules that will
be used in the industrial coffee manufacturing process. The moulds used in this activity belong to
the coffee manufacturing company. On the other hand, there was a set of actions that led to the
development of the coffee capsule, as well as the entire process of requesting and maintaining
industrial property, which involved and continue to resort to entities outside the organization.
Thus, it is necessary to frame these activities and consider them in the allocation of the
respective costs. This group of activities, because they took place outside the company's
industrial facilities, was called external activities (EA).

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IMPLEMENTATION OF ABC METHODOLOGY IN THE COMPANY

First phase: the allocation of resources to activities

The work began with the survey of all the main, secondary and external activities involved in the
production of capsule coffee. This survey contemplated all the tasks that are performed in each
activity. After this survey, the identification of all the resources that were consumed in each
activity was made: industrial building, labor and industrial equipment.

The costs associated with the industrial building are summed to the value of the rental of the
building, electrical energy, insurance and maintenance. The rent paid annually for the facilities
was easy to quantify and allocated to each activity according to the area occupied by each
activity developed in the company in a global way and in the industrial building in particular.

The energy consumed by the installations relates to the energy consumption of lighting and
common infrastructures such as elevators and hoists and social areas. The energy consumption of
the equipment was as-associated with each one according to its electrical power and was not
considered in the costs of the industrial building. It was considered the overall maintenance
related to the industrial building, such as repair and intervention in infrastructures (paintings,
paving, etc.). The maintenance associated with each equipment was counted individually and
allocated to the respective equipment.

As far as insurance is concerned, the company has a wide range of insurance policies ranging
from the civil responsibility of each employee, business activity / lost profits, facilities, stocks,
etc. On a case-by-case basis, the insurance was allocated in order to better reflect its allocation to
the insured object. Briefly, environ-mental insurance was totally affected by the industrial
building, since the greatest environmental risks (gas emissions and waste generation) were
generated here, civil liability insurance was divided by the total number of employees of the
company and attributed to the number of employees to industrial activity. Finally, it was
quantified the consumption of water verified in the industrial building and its imputation to each
activity was made according to its occupied area, since in the industrial process there is no water
consumption.

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The costs associated with the labor consumed in each task of each activity (main and secondary)
took into account the time consumed by each job / function, based on the measurements made.
The calculation of the labor costs took into account, taxes, social security, subsidies (Christmas
and Holidays) and actual working time. A working year of 11 months and 20 working days was
considered. The same rules were applied to the main and secondary activities.

In the case of equipment, its estimated value was considered in relation to the expected
depreciation (calculated according to the applicable legal requirement as well as the expected life
expectancy for the same equipment), costs related to repairs or relevant interventions carried out
and consumed energy. From these values it was possible to identify the hourly cost of using each
equipment. Thus, by quantifying the time of use of each equipment assigned to each activity, it
was possible to allocate the respective cost.

The production of capsules also includes a set of activities that are developed outside the
facilities through outsourcing and which are limited to activities developed in the field of R & D,
industrial property (industrial patent submission and maintenance), as well as costs associated
with moulds which are found on the premises of the supplier of empty capsules. Since these
fixed costs are specific to the activity of capsule production, and do not absorb internal resources
of the organization, those resources are easily identified and allocated to the coffee production
capsules activity. In this way, these were allocated to the specific activity of coffee capsules
production: MA7-degassing to MA12 - expedition. In this way, it was possible to clearly identify
the resources used only in the coffee capsules production.

The allocation of resources to the respective activities where they are consumed was done
through the resource drivers (Fig.).

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 Figure 1: The ABC implementation flow chart.

Second phase: the allocation of activities to products and the definition of

industrial cost

Once the resources were allocated to the activities those were allocated to the product capsules
in its various aspects. It was used for the driver activity: produced roasted coffee (kg) and
produced coffee capsules (units). The calculation of the industrial cost of the product is finalized

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with the introduction of the values associated with the bill of materials of the products
concerned. Fig. 1 shows very briefly how the resources were allocated to the activities, as well as
their allocation to the industrial product.

In a brief summary, all the activities involved in the production of coffee capsules were
identified, as well all the resources that are consumed in these activities. The distribution of the
resources through the activities was done over previously identified cost drivers. In a second
phase, activities were attributed to the products through the cost drivers of the activities that
directly and linearly reflect their consumption. Finally, the total cost of the product was
calculated according to the activities consumed and the respective bill of materials (Fig.).

Figure 2: The ABC implementation methodology used in this work.

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ACTIVITY BASED MANAGEMENT
Activity-based management advocates argue that top managers must not use financial shadows
either to control operating activities, the work that links employees and other company associates
with final customers or to plan marketing strategies. The gap between appearance and reality
between financial shadows and the activities causing those shadows is too great; say activity
based management authorities, to assume that traditional management accounting will point a
company toward competitive and profitable outcomes. Top managers may, of course, believe
that they control reality by manipulating financial variables especially if their knowledge of
business comes primarily from studying financial shadows, not from studying customers or
operating activities. Undoubtedly that was the belief of a great many executives who ran
American businesses in the 1970s and 1980s. Companies often lost market share and profitability
because financially oriented managers let the cart studying the results get ahead of the horse
understanding how resource consuming activity satisfies customer wants.

ABM is a system-wide, integrated approach that focuses management’s attention on activities

with the objectives of improving customer value and the profit archived by providing this value.
ABC is the major source of information for activity-based management.

Thus, the activity-based management model has two dimensions: a cost dimension and a process
dimension. The cost dimension provides cost information about resources, activities, and cost
objects of interests such as products, customers, suppliers, and distribution channels. The
objective of cost dimension is improving the accuracy of cost assignments. The cost of resources
is traced to activities, and the cost of activities is assigned to cost objects. This activity-based
costing dimension is useful for product costing, strategic cost management, and tactical analysis.
The second dimension, the process dimension, provides information about what activities are
performed, why they are performed, and how well they are performed. This dimension’s
objective is cost reduction. This dimension also provides the ability to engage in and measure
continuous improvement. ABC system is used to improve the operations of an organization in
ABM. Costs are incurred in organization because of activities.

A key feature of activity-based costing systems is that they measure and track the costs of
significant activities over time. In addition, using the activity cost information collected in an
ABC system, ABM involves the collection of financial or operational performance information
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about significant activities in the enterprise. The motivation for this process is twofold. First, the
costing system attempts to assign the costs of significant activities to the products that cause
those costs to be incurred. Second, by identifying the cost of activities, managers can attempt the
reduction or elimination of unnecessary costs.

ABC and ABM tend to strike a familiar chord with a variety of managers and employees
throughout an enterprise. Activities are expressed in terms of events that are familiar to such
diverse people as sale personnel, engineers, purchasing managers, inspectors, material handlers,
production employees and shipping personnel.

In today’s business environment, ABM is a useful cost management system. One of the most
useful applications of ABM is distinguishing between value-added costs and non-value-added
costs. Another ABC related technique that has gained popularity is benchmarking, the
continuous process of comparing products, services, and activities to the best industry standards.
ABC system also focus on activities, its results are a very useful tool in cost management
systems. ABM is using the output of an ABC system to aid strategic decision making and to
improve operational control of an organization in order to achieve the aims: to improve the value
received by customers and profits by identifying opportunities for improvements in strategy and
operations.

According to Kaplan, ABM refers to the actions managers take, on the basic of an ABC study, to
improve the efficiency of the activities and the profitability of products. Other ABM actions aim
at improving processes, particularly the processes performing batch and product-sustaining
activities. Another ABM action for transforming loss products into profitable ones is to impose a
minimum other size to eliminate short, unprofitable production runs. The ABC system has
provided managers with many insights that they can exploit to transform their currently
unprofitable operations into profitable growth. Thus, to establish and apply ABM system to
improve product quality, reduce costs in order to improve quality of life, eliminate poverty, and
create wealth for social. It is the mission of the enterprise.

ABM is better than traditional accounting in the following ways:

• ABM provides visibility in the way costs flow through the business.

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 • ABM establishes the links between activities and those factors, internal or external, that
drive the level of activity up or down.
• ABM eliminates the false divide between direct costs and overheads.
• ABM separates out those costs that deal with today’s business from those that secure the
future.
• ABM ignores gross margin and uses accurate product and customer contributions as the
basis for comparing product and customer profitability.
• ABM exchanges functional myopia for a cross-functional process view of the
organisation.
• ABM exchanges the stilted definitions of value-added and non-value-added for sensitive
categories that highlight the subtle impact of internal process failures and external
customer behaviour.

ABM can be usedto analyze the profitability of a new product a company is offering, by looking
at marketing and production costs, sales, warranty claims, and any costs or repair time needed for
returned or exchanged products. If a company is reliant on a research and development
department, ABM can be used to look at the costs of operating the department, the costs of
testing out new products and whether the products developed there turned out to be profitable.

Another example might be a company that has opened an office in a second location. ABM can
help management assess the costs of the running that location, including the staff, facilities, and
overhead, and then determine whether any subsequent profits are enough to make up for or
justify those costs.

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ACTIVITY BASED MANAGEMENT MODEL

• Cost Driver Analysis: For the purpose of managing the activity costs, the factors that result
in the activities to take place are to be identified.

• Activity Analysis: Activity Analysis is all about finding out the activities of the organizations
and its centres, that are ought to be utilized in the activity-based costing. Based on the costs
and benefits of the alternatives, the activities are divided into the number of activity centres.
Further, it ascertains value added and non-value added activities:

• Value Added Activities: The activities which are very essential for the completion of the
process are categorized as value-added activities.

• Non-Value Added Activities: Those activities which are not having any worth for both
external and internal customers are termed as Non-value added activities. Indeed these
activities do not enhance the quality of the product rather they have a negative impact on
the cost and prices of the product or services as they create wastes, delays, increase the
overall value etc.

• Performance Analysis: It involves discovering a proper measure to analyse the performance

of the activity centres.

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WORKING OF ACTIVITY BASED MANAGEMENT

1. Analysis of activities

In this section, the details of the analysis of activities are discussed. The analyses of activities
involve: (i) identification of value-added and non-value-added activities; (ii) analysis of critical
activities; and (iii) comparison of the performance of those activities with that of benchmarked.

1.1. Identify value-added and non-value-added activities

Once activities are specified and the cost of each activity is calculated, the next step is to
identify value-added and non-value-added activities. This judgement should be made
within the context of company-wide and well understood definitions for the terms. A
non-value-added activity is often defined as `an activity that can be eliminated with no
deterioration of product attributes (e.g. performance, functionality, quality, perceived
value)’. The following are a few examples of non-value-added activities in an
organization:

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 • Machine setup is a non-value-added activity (as the machine is not producing
anything while being setup).
• Logistics in the factory is another non-value-added activity (moving a product
does not make it more valuable).
• Inspection is a non-value-added activity.
• Stock holding is a non-value-added activity (inventories do not add value to a
product or customers).
1.2. Analysis of critical activities
In a SME, generally the number of activities in a business may range from 10 to 200. It
is not possible to analyse all of them at once due to limited time and resources. The key
is then to focus on the most critical activities that will add value to customers or help the
effective operation of the business. Moreover, these are the activities that provide the
significant opportunities for improvement. The Pareto analysis can be used to determine
the critical activities. This analysis should be carried out separately for both the value-
added and non-value added activities. The activities can be ranked in descending order
of cost and the cumulative percentage of the cost of all the activities can be calculated.
Then, it can be found that 20% of the activities causes 80% of the total cost, and those
activities are worth analysing.
1.3. Compare activities with benchmarking
All activities should be compared with similar activities in another company or within
the organization which performs the best in class. Benchmarking should be carried out
for both value-added and non-value-added activities. Comparing an activity with a
benchmarked of good practice helps to determine the scope for further improvement.
The activities should be measured based on factors, e.g. quality, lead-time, cost,
flexibility and customer satisfaction. Then, each activity should be rated against an
identified best practice. A company with a number of different departments can improve
the efficiency and effectiveness of each activity by comparing similar activities of
different departments. Obtaining information from other companies is quite difficult.
Therefore, benchmarking within the company or with the best practice is mostly used in
real-life situations.
2. Improvement of activities

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The following are some of the improvement strategies/ methods that have been generally
considered for improving the performance of any organization using the information obtained
from an ABC system:

2.1. Reduce the time or effort required to perform an activity

A key element of improvement is to reduce the time and effort needed to perform an
activity. This reduction can come from a process or a product improvement. For
example, the time to set up a machine can be reduced by improved training, eliminating
conflicts in employee assignments, placing tools and dies in convenient location, and
changes in the product design. For example, a reduction of 90% in setup time is not
unusual. Reduction in time and effort may come not from the activity in question, but
may be from the preceding activity. For example, the defect rate of parts received by a
machining activity is a cost driver for that activity. Improving quality in the preceding
activity reduces the quantity of this cost driver and hence the overall efforts required by
the machining process.
2.2. Eliminate unnecessary activities
Some activities are candidates for elimination because they are not valued by customers
or not essential to running the organization. It is possible, e.g. to eliminate material
handling activities through changes to the process or products, e.g. reducing the number
of components, using GT cells or even by outsourcing. There are a number of different
options to eliminate any unnecessary activities. In any organization, steps should be
taken to ensure that all incoming materials and parts are fit for use. The parts can then be
delivered directly to the shop floor as needed. For instance, changes can be requested in
the vendor’s production process to improve quality, flexibility and increase the
responsiveness. The parts that cause quality problems can be eliminated by instilling the
responsibility of delivering quality products onto suppliers. Once these changes have
been made, all the activities of a storeroom can be eliminated. Activities, e.g. material
handling and inspection will be reduced automatically. Eliminating these activities will
reduce the overall cost and the cost of products that no longer use these activities
2.3. Select low-cost activities
Designers of products and processes often have choices among competing activities.
This offers a means for reducing cost by picking the lowest cost activity. A designer of a

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 product may be able to specify the type of activity required for the assembly of a
product. Depending on the design of components, several automatic assembly lines can
be used for the assembly of a product instead of manual assembly of a product. Each of
these activities has a different set of resources associated with it. Manual assembly is a
direct labour activity. An automatic assembly, however, requires equipment, software,
skilled workers, and additional pro cess engineering and training. Because these
activities have different costs, the selection of an activity has an important impact on the
cost. The process designer faces similar choices. For example, a part designed for
machine insertion might also be inserted manually. A process designer may choose to
have the part inserted manually because a reduction in the batch size makes it
uneconomical to program and setup an insertion machine.
2.4. Sharing of activities
If a customer has unique needs, it is necessary to perform activities specific to that
customer. However, if customers have common needs, it is wasteful not to serve those
needs with the same activities. For example, product designers can use the common parts
in new product designs. A common part is one which is used in several products to
perform the same function (e.g. a gasket used in several car models). The only parts that
need to be unique are those that add product-differentiating functions as valued by the
customers. The activities associated with the common parts, e.g. part number
maintenance, scheduling and vendor relations, and are shared by all products that use
them. This sharing increases the volume of parts produced each time when an activity is
carried out, thus reducing the cost per part. The process designer can also cut costs by
grouping of products into work cells. This is possible when products have similar
designs (members of a product family) and when the manufacturing process is
sufficiently flexible to handle any differences in parts. The cost has decreased because
the products in the cell share activities, e.g. supervision, testing, training, scheduling,
material handling, storage and documentation.
3. Performance measurements
In an ABM system, performance measures include both financial and non-financial
measures, and are designed to influence the behaviour of cost management. A fundamental
issue is that a single performance measure will not reflect all the aspects of a company.

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 Managers may require multiple performance measures even from individuals. Generally,
activities involve groups of employees, and the performance measures therefore usually
relate to the group rather than the individual and to the process as well as the output or result.
The ABM system uses cost drivers of a company’s activities as a basis for changing the
performance measurement system. In particular, some companies are concentrated on non-
financial operational performance measures to monitor the improvements in their business
processes. It is important to appreciate those performance measures which not only attempt
to measure the performance, but also control and evaluate the performance, and motivate the
people. The behavioural impact of performance measures is one of the most significant
aspects of ABM. Certain general guidelines for selecting performance measures are:
• The performance measures chosen should assist in monitoring the progress of
controlling activity costs. These include throughput time, and the number of
engineering changes and production schedule changes.
• The performance measures selected should be reviewed periodically. As the business
and the internal and external environments of a business change, performance
measures may have to also change accordingly.
• Everyone should be able to understand the performance measures. These not only
must be clearly defined, but also the relationship to the company’s strategic
objectives must be explained.
• The performance indicators relevant for one individual or group should not be too
many.
• Daily operations should be managed on the basis of these key measures.
• The evaluation of employees should be linked to the performance indicators selected.
• The selection of these performance indicators is a critical process and the success of
this process depends upon a sound analysis of the critical activities for that particular
business.
• Whilst activities-based approaches are neither a panacea nor even an end in them,
they do at least recognize the need to effectively manage the activities of a business.
This should be reflected in the way the costs are reported and performance measures
are employed. The analysis of activities as value added and non-value added is the
basis of ABM. The main task of ABM is to direct improvement efforts in eliminating

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 or reducing the volume of non-value-added activities and improving value-added
activities.

TYPES OF ACTIVITY BASED MANAGEMENT

1 Operational ABM

Operational ABM involves scrutinizing the cost of each activity and increasing operational
efficiency by enhancing value-generating activities and eliminating unnecessary costs and non-
value-generating activities. It allows managers to identify anomalies in the costing process and
investigate accordingly.

Activities that do not generate adequate value can be ceased, and resources can be allocated to
other activities – leading to higher efficiency. It enhances asset allocation and lower costs; its
focus are on doing things right and performing activities more efficiently. Operational ABM
applications use management techniques such as activity analysis, business process
improvement, total quality management, and performance measurement.

2 Strategic ABM

Strategic ABM uses activity-based costing to analyze the profitability of an activity – which may
even be the unrolling of a new product or acquiring a new customer. It allows the company to
obtain a strategic picture of which products and customers to develop and/or pursue in order to
boost sales and profitability.

Strategic ABM is used for strategic decision-making when it comes to advertising through a
certain channel, launching a new product, or targeting a certain demographic group of customers.
It focuses on doing right things and choosing appropriate activities for the operation, eliminating
non-essential activities, and selecting the most profitable customers. Strategic ABM applications
use management techniques such as process design, customer profitability analysis, and value
chain analysis.

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TYPES OF ANALYSIS

Activity Analysis

To be competitive, a firm must assess each of its activities based on its need by the product or
customer, its efficiency, and its value content. Ideally, a firm performs an activity for one of the
following reasons:

• It is required to meet the specification of the product or service or satisfy customer

demand.
• It is required to sustain the organization.
• It is deemed beneficial to the firm.

Examples of activities required to sustain the organization are providing plant security and
compliance with government regulations. Although these activities have no direct effect on the
product or service or customer satisfaction, they cannot be eliminated. Examples of discretionary
activities deemed beneficial to the firm include a holiday party and free coffee. Some activities,
however, may not adequately meet any of the preceding criteria, making them candidates for
elimination.

Value-Added Analysis

Eliminating activities that add little or no value to customers reduces resource consumption and
allows the firm to focus on activities that increase customer satisfaction. Knowing the values of
activities allows employees to see how work really serves customers and which activities may
have little value to the ultimate customers and should be eliminated or reduced. In order to
ensure that no activities are missed in the value-added analysis, management may want to
prepare a process map. The process map is a diagram that identifies each step that is currently
involved in making a product or providing a service. Development of the process map should
include input from those currently involved in providing the product or service.

A high-value-added activity increases significantly the value of the product or service to the
customers. Removal of a high-value-added activity decreases perceptively the value of the
product or service to the customer. Inserting a flange into a part, pouring molten metal into a
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mould, and preparing a field for planting are examples of high-value-added activities, as are
designing, processing, and delivering products and services.

A low-value-added activity consumes time, resources, or space, but adds little in regard to
satisfying customer needs. If eliminated, customer value or satisfaction decreases imperceptibly
or remains unchanged. Moving parts between processes, waiting time, repairing, and rework are
examples of low-value-added activities.

Reduction or elimination of low-value-added activities reduces cost. Low-value-added activities

are those that:

• Can be eliminated without affecting the form, fit, or function of the product or service.
• Begin with prefix “re” (such as rework or returned goods).
• Result in waste and add little or no value to the product or service.
• Are duplicated in another department or add unnecessary steps to the business process.
• Produce an unnecessary or unwanted output.

AREAS WHERE COMPANIES CAN USE ACTIBITY BASED MANAGEMENT

1) Developing Corporate Strategy:

ABM can help the firms to develop appropriate company strategy, long-term plans and
competitive advantage by focusing on and managing activities. Some firms have competitive
advantage by providing a low-cost product or manage activities to reduce costs. To reduce costs
generally requires changes in activities. Anyone can cut costs—if the operation is closed, costs
will be reduced. However, ABM has the objective of cutting costs while maintaining quality and
quantity of output.

2) Making Activity Analysis:

ABM aims to achieve continuous improvement by making activity analysis i.e. by classifying
each activity as value-added or non-value added. A value-added activity is an activity that adds
value to a product or service from the view point of the customer. A non-value-added activity is
an activity that does not add value to a product or service from the viewpoint of the customer.

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The value-added activities make up value-chain. The value chain is a linked set of value-creating
activities leading from raw material sources to the ultimate end use of the goods or services
produced. Value chain analysis is an ongoing process in which activities are constantly being
classified, eliminated and improved.

Non-value added activities merely add to costs which can be eliminated without reducing
product quality, performance or value.

For example, in manufacturing industry non value added activities can be:

• Movement:
Time spent for transfer around the factory floor where value-added activities are
performed.
• Waiting:
Idle time does not add value to products. Reducing the time spent between value-added
activities reduces cost of idle time.
• Set up:
Time spent preparing to perform a value-added activity.
• Inspection:
Time spent verifying that a value-added activity was done correctly.
• Storage:
Storage of materials, work-in-process, or finished goods inventory is a non- value added
activity.
3) Reducing Customer Response Time:

ABM helps to reduce customer response time by identifying activities that consume the most
resources in value and time. ABM also helps in reducing customer response time by identifying
and eliminating non-value added activities. This way the customer response time and cost will
decline. Customers also appreciate a quick response time to their orders which is facilitated
through activity-based management.

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 APPLICATION OF ABM IN BUSINESS

1. Cost Reduction:Activity-based management facilitates the organization to identify the costs

against activities to determine the ways to reduce costs and even eliminate the entire activity if it
is not adding any value to the products.
2. Activity-Based Budgeting: ABB supplies a framework for forecasting the input required as per
the budgeted level of activity. A comparison is made between actual results and estimated results
to outline the activities with a high level of variances from the budget for a probable reduction in
the supply of inputs.
3. Business Process Engineering: It entails examining and redesigning the processes and
workflows of the organisation for improving the performance and also gaining excellence in
business operations. It involves making significant changes regarding the way in which
organisation operates currently. ABM helps in improving the business process efficiency and
effectiveness.
4. Benchmarking:Benchmarking is the process of making a comparison of the products and
services offered by the company with that of the other organisations. It aims at identifying the
ways to improve products and services of the firm.

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5. Performance Measurement: Nowadays, most of the firms concentrate on activity performance
by observing the efficiency and effectiveness of activities, so as to compete successfully in the
market.

ACTIVITY BASED MANAGEMENT TREATMENTS

1 PRODUCT COSTING
In ABM the indirect and overhead costs associated with each product are determined for each
product. The characteristics of two products can be quite different in the way they need overhead
activity to support manufacture.

A company that traditionally had made its name manufacturing bogies for railway trucks and
carriages had branched out into making braking systems for long haul diesel road vehicles.
While the technology surrounding the railway business had not developed significantly over the
years, the road vehicle technologies had advanced in complexity at a rapid rate. Using direct
labour as the determinant of the proportion of overhead costs had led to overpriced railway
products and underpriced road vehicle products. The growth in the road vehicle business then
seriously eroded overall profits and the stable rail business was drifting to competitors.

In the figure below are shown two of the company’s products costed using the conventional
overhead recovery rate, in this case 300 per cent. For product ‘Pr1’ the direct labour had 50 units
of cost so the manufacturing overhead was assumed to be 300 per cent of this: 150 units of cost.
Product ‘Pr2’ again used the 300 per cent and this was applied to the direct labour cost of 200
units giving a manufacturing overhead of 600 units of cost.

Using a conventional overhead recovery rate took no account of the real differences in the
amount of overheads that either product required. Product ‘Pr1’, a road vehicle braking system,
was complex, had many production changes, and used difficult manufacturing technology. There
were also many discussions with specialist suppliers. Product ‘Pr2’, a railway truck bogie, used
simple manufacturing technology, enjoyed a steady demand with few changes to schedules, and
had used the same suppliers of raw material over a long period.

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Using the ABM approach the direct and actual overhead costs reflected the real situation as
shown in the figure below. Note that for Pr1 the conventional approach gave a contribution
nearly double what it actually was. In other words, in reality the product was less profitable than
they thought. Conversely, Pr2 was much more profitable than they thought. Using the overhead
recovery approach meant that Pr1 was underpriced. They had orders but made little profit. Sales
of Pr2 could be higher if it wasn’t overpriced.

2 PRODUCT CONTRIBUTION (PRODUCT PROFITABILITY)

In traditional accounting we find the term gross margin, defined as the revenue less the direct
costs. As long as the gross margin is a positive number then the product is deemed to making a
‘contribution to overheads’. In other words, whatever the overheads actually are, at least there
exist some funds to pay for them. The issue is that we do not know, other than at the overall
company level, whether this contribution has any bearing whatsoever on the real overheads
involved in producing each particular product.

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The ABM Product Contribution is a fairer basis by which to compare one product to another. If
ABM Product Contribution i.e. revenue less actual product costs, is a positive number then
product costs are covered and the sum left over now contributes to the other overhead costs in
the business such as Sales, R&D, invoicing and so on.

We can show each product on a graph where we plot the cumulative product contribution,
highest to lowest, for all the products. The resulting graph, the appropriately named ‘hook curve’
is shown in the figure below. The hook curve is one of the most powerful ways to display the
outcome of the ABM analysis.

As we would expect, one product is something of a cash-cow, such as ‘Pr1’. The traditional
gross margin calculation also gave a high figure and we now know that there are no issues
concerning high levels of indirect and overhead activity. However, as we add more and more
products to the graph, such as ‘Pr2’, we eventually find those where the revenue only just covers

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the real costs of manufacturing. The ABM Product Contribution gets smaller and smaller until
some products balance out to zero. At the tail end, we might be unfortunate to discover that some
products, such as ‘Pr3’, which have a negative ABM Product Contribution. In other words, the
revenue we obtain is insufficient to cover the actual manufacturing costs of the direct materials
and labour and the appropriately assigned indirect and overhead costs. What is often surprising is
finding products in this category where the gross margin is positive. We believe the situation is
acceptable as long as they are making ‘a contribution’ to overheads. The reality is that any
volume increase seriously erodes overall profitability rather than building up a useful
contribution to cover overheads. The increased volume contributes only to losing even more
money.

3 VIEW OF CONTRIBUTION (CUSTOMER PROFITABILITY)

An ABM analysis of these activities enables us to assign the customer-related costs to each of the
customers. In some cases, individual customers will be appropriate, whereas in others,
meaningful segments or groups of customers will be the basis for the analysis.

In a particular company, customer ‘X’ manually raised large numbers of low value orders, raised
many queries, made many returns due to ordering errors, and had a poor payment history.
Customer ‘Y electronically raised a small number of high value orders, paid through Bank
transfers and never raised any queries or made product returns.

The gross margins made from both customers could well be equal but the costs of doing business
with one are significantly higher. By calculating revenue less the real costs of the products the
customer is ordering and less the real cost of servicing the customer, we are left with the ABM
Customer Contribution. This figure is an appropriate basis to compare one customer to another.

We can now plot a graph of cumulative customer contribution, highest to lowest, for each
customer. Again we would generally find a hook curve but usually flatter than for the products.
Many customers could be giving no contribution at all as shown on the figure below with some
seriously eroding profitability.

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As we would expect, one customer could well be a cash-cow. The traditional gross margin
calculation gave a high figure and we now know that there are no issues concerning high levels
of overhead activity associated with the customer. However, as we add more and more customers
to the graph, we find those where the revenue only just covers the real costs of the products and
the real costs of servicing the customer. The ABM Customer Contribution gets smaller and
smaller until some customers balance out to zero. At the tail end, we might be unfortunate to
discover than some customers have a negative ABM Customer Contribution. In other words, the
revenue we obtain is insufficient to cover the actual manufacturing costs plus the customer
servicing costs. What is often surprising is that customers in this category may have positive
gross margins. Again we believe the situation is acceptable as long as they are making ‘a
contribution’ to overheads. The reality is that any volume increase seriously erodes overall
profitability rather than building up a useful contribution to cover overheads. We know,
instinctively, that some customers are more profitable than others. We also know that some are
probably loss-making. We may also have some idea of which customers are probably the least
profitable and which are the most profitable. So, anecdotal evidence will pick up the extremes.
The hook curve shows the situation with the other 99%. This is often a profound shock to
management.

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 4 VIEW OF COSTS IN A BUSINESS
Where a company allocates all its costs to products and customers (full absorption costing) it
loses the real relationship between cost drivers and those costs that are influenced by the drivers.
It also loses the visibility of the difference between the current business that is generating income
and the real contribution that can be used to develop the future business. Full absorption costing
destroys the ability to make meaningful relative judgements of product and customer
profitability.

In ABM, the diverse costs and activities are categorised so we can understand what is happening
inside the business.

i. Frontline: A frontline activity is one that has something to do with producing the
primary product or service and any activities that interface with customers. Frontline
activities have a direct cause and effect relationship to products and customers through
cost drivers. This relationship may be a simple one based on, say, production hours to
produce a product or number of invoices processed for each customer. They are current
costs paid for by the revenue from current products and services for current customers. If
more volume of the cost driver is forecast then more resource will be required. However,
changing the methods used can change the unit cost of doing the work.
ii. Legal entity: These costs and activities have no direct relationship to current or future
products and services. The level of costs is unlikely to change with throughput volumes
or number of customers. However, the actual costs can change if the method changes or a
service is obtained at a lower rate. For example, the auditors can be changed to reduce the
level of fees charged.
iii. Sustaining: Organisations need to have funds to pay for the current costs of the people
doing, say, new product development, but the benefits are expected to be derived in the
future. The current product throughputs or current customers do not directly influence
these activities. They are essentially an investment to achieve a return in the future. A
reduction in sustaining costs would transfer directly to the bottom line, but it would risk
the future of the business. Companies invest in sustaining costs so they make a higher
return in the future. It could be argued that Sustaining costs should be made specifically

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 visible to shareholders as they are investments in the business made out of retained
profits that could have been distributed.
iv. Internal Service: Training, recruitment, current use of IT networks and the like are an
internal service to all the other departments in the organisation. There are no direct
relationships to current products and customers other than through the frontline activities
that are supported. The key here is to understand and then assign the internal service costs
and activities in an appropriate manner to all the other areas of the business that are
supported.

ACTIVITY BASED MANAGEMENT – FUTURE PERSPECTIVE

The criticism can be made of existing modes of activity analysis. They do not magically reveal
how to organize work to profitably satisfy global terms of competitiveness. However, they do
provide vital information about activities and work that managers need to continuously improve
operations once they understand and adopt the mindset of global competitiveness. Moreover,
focusing on activity information, rather than traditional or ABC cost information, should make it
easier for companies to make the transit from the old to the new management mindset. That is
now the most important challenge to shift companies from a management mindset focused on
products, resources, and costs to one focused on people, time, and customers. Turning once more
to the metaphor of Plato's cave, the challenge is to lead managers away from financial
management in the cave and toward quality driven activity management in the outside world of
associates and customers. Global competitors that move away from managing numbers in the
cave toward nurturing the talents and fulfilling the desires of people above the ground will still
give consideration to accounting and financial shadows. Indeed, they will develop and use
variance tools, activity-based costing, and other tools to analyze financial and accounting
information. Companies will of course compile such information for public reporting, for "what
if analyses, and for budgeting. Management accounting information has filled those purposes for
nearly two centuries of industrial history, and it will continue to do so for many years to come.
However, companies that come out of the cave will no longer use accounting and financial
information to dictate people's activities.

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MULTISTAGE ACTIVITY-BASED COSTING

In practice, because of a firm’s complexity due to the diversity of its products, services and
manufacturing or operating processes, some activities are intermediate cost objects for other
activities while others are assigned directly to cost objects. To capture and calculate accurately
the costs for this complexity, some firms use multistage activity-based costing rather than two-
stage ABC. In multistage ABC, resource costs are assigned to certain activities which in turn are
assigned to other activities before being assigned to the final cost objects like, firm’s products,
services or customers.

Activity-Based Cost Management in the Public Sector: Multiple Stage ABC/M

Approach (Gary Cokins| November,30,2015)

To adequately trace costs using the ABC/M) method requires more stages than the two-stage
assignments. Rather than simply tracing the cost of resources to activities and then to cost
objects, the multiple-stage approach models cost flows in a manner that more closely reflects the
actual flow of costs through an organization.

Often there are support people who support other support people who ultimately support the
primary workers who make products for or deliver services to external parties, such as citizens or
other agencies.

These cascading stages of indirect and shared costs should not use arbitrary broadly averaged
cost allocations, but should comply with costing’s causality principle as ABC/M does.

Therefore, the multi-stage cost assignment approach includes an understanding of the

relationships between indirect work activities and other activities, as well as between those
activities and cost objects. Costs are traced from activity to activity in a series of stages, all based
on cause-and-effect relationships.

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To understand the above figure, imagine the cost assignment paths (the arrows) as pipes and
straws where the diameter of each path reflects the amount of cost flowing.

The power of an ABC/M model lies in the fact that the cost assignment paths and their
destinations provide traceability to segment costs from beginning to end, from resource

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expenditures to each type of, or each specific, customer—which is ultimately the origin for all
costs and expenses.

The cost assignment network captures and reflects the diversity and variation on how cost
objects uniquely consume activities, which in turn consume resources. To understand costing, it
is useful to mentally reverse all the arrowheads in above figure. This polar switch reveals that all
expenses originate with a demand-pull from customers or citizens. The calculated costs simply
measure the effect in the opposite direction.

The bottom portion of figure reveals multiple final cost objects—supplier-related activity
outputs, products/services, and citizens/customers. It displays a “nested” consumption sequence
of final cost objects. A metaphor for this consumption sequence is the predator food chain where
mammals eat plants and large mammals eat small mammals. The final-final cost object, which in
this figure are the citizens/customers, ultimately consumes all the prior final cost object costs
except for the organizational sustaining costs.

Organizational sustaining costs are activity costs that are not caused by making products or
delivering services to customers or citizens. The consumption of these costs cannot be logically
traced to products, standard service lines, channels, or customers (they can be arbitrarily
allocated but not with a causal relationship).

An example would be when the accountants close the books each month. These activity costs
would be traced respectively to senior management as an example of an organizational
sustaining cost object. Allocating them to products, services, or customers would be misleading
because they did not cause these activities and would overstate those costs—which sends wrong
signals to employees who use product cost information for decision making.

OPERATIONAL ABC/M FOR PRODUCTIVITY

Managers and employee teams are seeking more transparency and visibility of their costs. Just
reliably knowing ABC/M’s per-each-unit costs of their outputs of work is useful for
benchmarking to search for best practices or monitor trends to measure performance

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improvement. ABC/M removes the illusion that support overhead (i.e., indirect) expenses are
necessary and, therefore, appear to be free—they are not free.

The costs of an output, product, or service (i.e., a final cost object) can be reduced by:

• Reducing the quantity, frequency, and/or intensity of the activity driver (e.g., fewer
inspections reduces the “inspect product” activity cost);
• Lowering the activity driver cost rate from productivity improvements (e.g., shorten the
time for each “inspect product” event); and
• Understanding the sources and causes of waste leading to nonvalue-adding activities to
reduce or eliminate them (e.g., solve the problem that requires an inspection in the first
place).

These three are examples of how ABC/M data leads to cost management for productivity
improvement. The idea is to do more with less (or at least with the same). That is, produce
more outputs with the same amount of resources or the same amount of outputs with fewer
resources.

ABC has a bonus referred to as ABC/M “attributes.” It can report another dimension of
costs—the “color of money” spent. It applies cost attributes, usually to an activity, by
tagging or scoring each activity with a code. This dimension of cost does not exist in
general ledger accounting systems because attributes are tagged to activities or to cost
objects, not to resource expenses.
• An example of a tag would be if an activity is deemed as value-adding or nonvalue-
adding.
• Another example is the five sequential “cost of quality” (COQ) categories of work that
increase in their severity: error free, prevention related, appraisal related, internal
failure work, and external work.

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 • Attributes do not alter the cost of anything calculated by ABC/M. Costs remain
unaffected.
• Attributes facilitate in grouping of activity costs into various categories that in turn help
focus (e.g., nonvalue-added costs) and can suggest actions. This insight could never be
detected using general ledger cost reporting or traditional broadly averaged cost
allocations.

Above figure illustrates multistage activity-based costing. The activity labelled ‘support
activities” provide services to other activities later in the value chain—product/service activities,
customer activities, and infrastructure-sustaining activities. The exhibit illustrates how a total of

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$70 of resource costs are assigned in multistage ABC costing. After multistage allocations, $25
is assigned to products, $20 is assigned to customer related activities, and $25 is assigned to
infrastructure related costs (computer equipment and software, buildings and other equipment,
etc.)

RESOURCE CONSUMPTION ACCOUNTING

Resource Consumption Accounting (RCA) is a management theory describing a dynamic,

integrated, and comprehensive management accounting approach that provides managers
with decision support information for enterprise optimisation. RCA is a relatively new
management accounting approach based largely on the German management accounting
approach (GPK)and also allows for the use of activity-based drivers.

RCA emerged as a management accounting approach beginning around 2000, and was
subsequently developed at CAM-I (The Consortium of Advanced Management
International) in a Cost Management Section RCA interest groupcommencing in December
2001.

In 2008, a group of interested academics and practitioners established the RCA Instituteto
introduce Resource Consumption Accounting to the marketplace and raise the standard
of management accounting knowledge by encouraging disciplined practices.

By July 2009, Professional Accountants in Business (PAIB) Committee of International

Federation of Accountants (IFAC) recognized Resource Consumption Accounting in the
International Good Practice Guidance (IGPG) publication called Evaluating and Improving
Costing in the Organisation. The guide focuses on universal costing principles and with the
Costing Levels Maturity Modelacknowledges RCA attains a higher level of accuracy and
visibility compared to activity-based costing for managerial accounting information when the
incremental benefits of RCA's better information exceed the incremental administrative effort
and cost to collect, calculate and report its information.

As stated in the International Good Practice Guidance,

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"A sophisticated approach at the upper levels of the continuum of costing techniques provides
the ability to derive costs directly from operational resource data, or to isolate and measure
unused capacity costs. For example, in the resource consumption accounting approach, resources
and their costs are considered as foundational to robust cost modeling and managerial decision
support, because an organization’s costs and revenues are all a function of the resources and the
individual capacities that produce them."

— International Federation of Accountants, 2009

THE CORE ELEMENTS OF RCA:

There are three core elements that enable RCA to lay a very different foundation for its cost
model.

• The view of resources – resources and their costs are considered foundational to proper cost
modeling and decision support. An organization’s cost and revenues are all a function of the
resources that produce them.
• Quantity-based modeling – the entire model is constructed using operational quantities.
Operational data is the foundation of value creation and the leading indicator of economic
outcomes.
• Cost behavior – value is added as a veneer to the quantity-based model and costs/dollars
behavior is determined by the behavior of resource quantities as they are applied to value
creating operations within an organization.

PRINCIPLES OF RCA

CAUSALITY

The principle of causality is the most important concept covering cause and effect relationship.
Causality requires resource flows and their costs to be modelled from resource to consumers
(support and direct) through the value chain on strict cause and effect basis. It means the final
product and service will not reflect full cost as defined by generally accepted accounting
principles. Full cost requires non-causal allocation of costs to the unit level of a product or
service. The term was established in 1963 by Professor Gordon Shillinglaw.

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RESPONSIVENESS

The principle of responsiveness ensures the compliance with the principle of causality in
modelling the resource consumption with main focus on cost behaviour. Responsiveness governs
the fixed and proportional costs relationship between resource pools. The principle of
responsiveness has a number of advantages –

• Allowing inverse relationship between total cost and total volume when manufacturing more
complex products.
• Providing managers specific insights into resources when they relate them to changes in
product output.
• Enabling the accurate modelling of an organization’s economic flow of goods and services
regardless of its complexity.

WORK (OR PROCESS) VISIBILITY

The principle of work (or process) visibility is adopted from Activity-Based Costing (ABC) and
is applied with quantity based drivers when needed for decision support or process
improvements. Sometimes tracing resource flows between cost objects does not yield sufficient
information for managerial decisions while it is necessary to know what activity is executed in
the resource consumption between resource pools. This principle applies to activity modelling by
including such activities in the model which add critical and ongoing information that managers
need frequently.

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CASE STUDY CLOPAY

CLOPAY PLASTICS COMPANY

Headquartered in Cincinnati, Ohio, Clopay has U.S. film manufacturing operations in Augusta,
Ky., and Nashville, Tenn., as well as others in Germany and Brazil. The company manufactures
plastic products, such as film, that are sold to consumer product companies for use in hygiene
and healthcare products. In addition to providing innovation in the plastic film industry, Beyond
the manufacturing area, there are five departments that support the Augusta operations, including
shipping, materials management, quality assurance, plant maintenance, and administration.
Before the RCA pilot, the Augusta Clopay plant used a traditional standard costing system and
generally based their standard product costs on planned machine hours and sales in pounds. They
allocated support department costs to the production departments using the direct method based
on various allocation bases including machine hours, pounds produced, purchased pounds, and
headcount in each production department.

These costs consisted of indirect labour, support labour, office supplies, and other depreciation.
Production departments then added their own overhead costs to the fully absorbed support costs
in creating a standard cost for overhead.

PROBLEMS WITH CLOPAY’S PREEXISTING PRODUCT COSTING METHOD

Clopay’s pre-existing costing system was a classic example of a full-absorption method creating
the potential for fixed-cost death spiral effects.

• The primary issue was that costs for individual products changed based on unrelated changes
to other products or resource costs associated with other products.

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• The second was costing issue related to assigning depreciation costs based on financial
accounting. Where two machines differ in terms of age and cost, the pre-existing Clopay
system allocates higher costs to products made on the new machine, even though the
products made on the old machine could be very similar.

• Third, cost assignment affects customer and market issues as well. When product managers
realized Clopay was going to eliminate or phase out a product, they lowered the selling price
on alternate products or increased the volume of low-priced commodity products to increase
volume for the remaining products. Given an expected decline in volume, managers knew
those overhead cost dollars would be spread over a decreasing number of units and, in turn,
would cause the cost per unit to increase, making the profit per unit decline.

Clopay management recognized that they were relying on inaccurate cost information and
intuition that unfortunately provided a poor substitute for strategic cost information. Moreover,
the current system couldn’t simulate cost results given changes in resources such as an additional
machine or upgrading an existing one. As a result, Clopay agreed to serve as an RCA case study
to investigate the differences between RCA and its current system.

Clopay used RCA to create 23 resource pools for costs in two categories: general support and
production departments. Using 23 resource pools as opposed to eight support and six production
departments offered the opportunity to better trace costs by type into resource pools. More
resource pools provided more detailed information, which made for more accurate data to use
when making strategic decisions. This approach provided greater homogeneity than Clopay
could achieve by using departments that contained a diversity of costs. RCA assigns costs based
on causality but doesn’t insist on using activity drivers for cost assignment where such drivers
are either unnecessary to achieve accuracy or aren’t desired for some other purpose, such as
achieving a greater understanding of processes or how to manage them. RCA excluded fixed
costs that couldn’t be traced based on causality— the largest of these costs were due to idle
capacity, which resulted in a total of 6% fewer conversion costs assigned by RCA than with the
pre-existing Clopay cost system. Clopay implemented additional RCA features by using

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replacement cost depreciation for productcosting purposes and theoretical capacity for
denominator volume.

RCA BENEFITS CLOPAY REALIZED

• Properly attributing costs to specific production processes and their outputs resulted in more
accurate cost assignment and a better understanding of resource consumption patterns.
• The achievement of more accurate cost assignment provided the ability to conduct resource
planning using only relevant costs.
• The use of replacement cost depreciation eliminated the issue of unequal cost assignment for
similar products that consumed the same resources and support activities.
• Product costs included only the cost of resources used.
• The amount of excess/idle capacity was made available to managers based on unconsumed
theoretical capacity.
• Cost assignment based only on causality eliminated costs that were previously assigned
based on unrelated changes to other products.
• Incentive to non-strategically lower selling prices to artificially manipulate cost allocation
amounts to specific products was eliminated.

CONCLUSION

RCA is a very emerging and productive cost accounting method which is well suited for today’s
contemporary and complex business activities. As with any new system, there are some
drawbacks to RCA. RCA is expensive to implement. There is significant planning time required,
and an integrated ERP system must be implemented as well. This will prove to be difficult
because RCA is very new and very few companies around the world have implemented these
methods. Also, RCA may not be a good fit for companies with nonroutine activities. Causal
relationships will be hard to define for non-routine activities.

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Overall, Resource Consumption Accounting is emerging cost management methods that may
help managers make better decisions. By separating cost behaviours, RCA highlights idle
capacity and reduces fixed cost distortions. These features are critical to help solve the pandemic
of inadequate management accounting systems. Thus, it is hoped that with further research and
development to eradicate the shortcomings in this useful accounting based system, we can see
high prospects of the implementation of the RCA in various diverse businesses in the future.

TIME DRIVEN ACTIVITY BASED COSTING

TDABC simplifies the costing process by eliminating the need to interview and survey
employees for allocating resource costs to activities before driving them down to cost objects
(orders, products, and customers).

The new model assigns resource costs directly to the cost objects using an elegant framework
requiring only two sets of estimates, neither of which is difficult to obtain.

• First, it calculates the cost of supplying resource capacity.

• For example, consider a department or process for handling customer orders. In
this first step, the TDABC model calculates the cost of all the resources
personnel, supervision, occupancy, equipment and technology supplied to this
department or process. It divides this total cost by the capacity the time
available from the employees actually performing the work of the department to
obtain the capacity cost rate.
• Second, TDABC uses the capacity cost rate to drive departmental resource costs to cost
objects by estimating the demand for resource capacity (typically time, from which the
name of the new approach was chosen) that each cost object requires.
• Staying with the same example of the customer order department, the model
requires only an estimate of the time required to process a particular customer
order. But TDABC does not require that all customer orders be the same.

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 • It allows the time estimate to vary on the basis of the specific demands by
particular orders, such as manual or automated orders, expedited orders,
international orders, orders for fragile or hazardous goods, or orders from a new
customer without an existing credit record.

The TDABC model simulates the actual processes used to perform work throughout an
enterprise. It can therefore capture far more variation and complexity than a conventional ABC
model, without creating an exploding demand for data estimates, storage, or processing
capabilities.

Using TDABC, a company can embrace complexity rather than being forced to use simplified,
inaccurate ABC models of its complex businesses.

COMPARISON OF CONVENTIONAL ABC AND TIME DRIVEN ACTIVITY

BASED COSTING

• Conventional ABC starts with a project team interviewing supervisors and departmental
personnel to learn about the various activities they perform.

• To keep the example simple, let's assume that the ABC team determines that the department
performs the following three activities:
o Process customer orders
o Handle customer inquiries and complaints
o Perform customer credit checks

• In the next step, the team interviews and surveys the employees, asking them to estimate
the percentage of their time spent (or that they expect to spend) on these three activities.
This part of the analysis is generally time consuming and difficult for people to respond
to. A typical employee question is, "Do you mean what I did yesterday?" The reply is,
"No, I would rather that you think about an average three- or six-month period and
estimate the proportion of time you are processing customer orders, dealing directly with
customer questions or complaints, and checking and maintaining customer credit reports
during this extended period."

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 • The ABC team cannot really validate employees' subjective time distributions unless it is
prepared to spend weeks observing the actual mix of time spent among the three activities.
Let's assume that interviews and surveys reveal that the time mix among the three
activities is 70 percent, 10 percent, and 20 percent, respectively.

• The ABC team assigns the total cost of the department ($567,000) to the three activities
using these time percentages.

• The team also collects data about the actual (or estimated) quantities of work for the
quarter in these three activities, as shown below:
➢ 49,000 customer orders
➢ 1,400 customer inquiries
➢ 2,500 credit checks

• The project team makes an additional assumption to keep the analysis simple: all orders
take about the same quantity of resources (time) to process, all customer inquiries take
about the same amount of time, and each customer credit check also takes about the same
level of effort. The ABC system now calculates the following average cost driver
rates:

• The ABC project team uses these cost driver rates to assign the customer service
departmental expenses to individual customers on the basis of the number of orders
handled, complaints processed, and credit checks performed for each customer.

Activity Time spent Assigned cost Cost driver Cost driver rate
quantity
Process 70% 396900 49000 $8.10 per order
customer orders
Handle 10% 56700 1400 $40.50 per
customer inquiry
inquiries
Perform credit 20% 113400 2500 $45.36 per credit
check check
Total 100 567000

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 • The ABC project team uses these cost driver rates to assign the customer service
departmental expenses to individual customers on the basis of the number of orders
handled, complaints processed, and credit checks performed for each customer.

• TDABC skips the activity-definition stage and therefore the need to allocate the
department's costs to the multiple activities the department performs.

• The time-driven approach avoids the costly, time-consuming, and subjective activity-
surveying task of conventional ABC.

• It uses time equations that directly and automatically assign resource costs to the
activities performed and transactions processed.

• Only two parameters need to be estimated:

• The capacity cost rate for the department
• The capacity usage by each transaction processed in the department.
• Both parameters can be estimated easily and objectively.

• The capacity cost rate is defined below:

Cost of capacity supplied ÷ practical capacity of resources supplied
• The cost of capacity supplied is, of course, the $567,000 per month.

To estimate the practical capacity: -

• The TDABC team identifies the quantity of resources (typically, personnel

or equipment) that actually perform work.

EXAMPLE

Assume that the department employs 28 frontline people (this doesn't count supervisors or
support staff).

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Each frontline employee works an average of 20 days per month (60 days per quarter) and is
paid for 7.5 hours of work each day.

Each employee shows up at work, therefore, for about 450 hours, or 27,000 minutes per quarter.
Not all the time paid for is available for productive work.

Employees in the customer service department spend about 75 minutes per day in breaks,
training, and education.

Thus, the practical capacity for each employee is about 22,500 minutes per quarter (375 minutes
per day multiplied by 60 days per quarter).

With 28 frontline employees, the department has a practical capacity of 630,000 minutes.

The cost rate (per minute) of supplying capacity, the first estimate for a TDABC model, can now
be calculated:

Capacity Cost Rate: - $ 567000 ÷ 630000 minutes = $0.90 minute

Estimating the practical capacity for an employee or a piece of equipment should be

straightforward.

• Calculate how many days per month, on average, employees and machines
work, and how many hours or minutes per day employees or equipment are
available to do actual work, after subtracting time for scheduled breaks,
training, meetings, maintenance, and other sources of downtime. This
amount need not be calculated precisely; an error of a few percentage
points will rarely be fatal, and major errors will be detected through
unexpected shortages or excesses of capacity.

The second estimate required for the TDABC model is the capacity required in this and most
cases, time to perform each transaction.

Conventional ABC uses a transaction driver whenever an activity such as set up machine, issue
purchase order, or process customer request takes about the same amount of time.

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TDABC, instead of using such transaction drivers, simply has the project team estimate the time
required to perform each of these transactional activities. The time estimates can be obtained
either by direct observation or by interviews. As with the estimate of practical capacity, precision
is not critical; rough accuracy is sufficient. And unlike the percentages that employees
subjectively estimate for a conventional ABC model, the capacity consumption estimates in a
time-driven model can be readily observed and validated. Returning to the numerical example,
suppose that the TDABC team obtains estimates of the following average unit times for the three
customer related activities:

• Process customer orders: 8 minutes

• Handle customer inquiries: 44 minutes
• Perform credit check: 50 minutes

The team now simply calculates the cost driver rate for the three types of activities performed in
the customer service department by cross multiplying the capacity cost rate with each activity's
estimated unit time:

TDABC
ACTIVITY Unit Time (minutes) Rate (at $ 0.90/minute)
PROCESS CUSTOMER 8 7.20
ORDER
HANDLE CUSTOMER 44 39.6
INQUIRY
PERFORM CREDIT 50 45
CHECK

Alternatively, we can replace the three customer service activities in the conventional ABC
model with a single time equation for the department:

Equation:

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 𝑪𝒖𝒔𝒕𝒐𝒎𝒆𝒓 𝒔𝒆𝒓𝒗𝒊𝒄𝒆 𝒕𝒊𝒎𝒆 (𝒎𝒊𝒏𝒖𝒕𝒆𝒔)
= 𝟖 × 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒐𝒓𝒅𝒆𝒓𝒔 𝒑𝒓𝒐𝒄𝒆𝒔𝒔𝒆𝒅
+ 𝟒𝟒 × 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒄𝒖𝒔𝒕𝒐𝒎𝒆𝒓 𝒊𝒏𝒒𝒖𝒊𝒓𝒊𝒆𝒔
+ 𝟓𝟎 × 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒄𝒖𝒔𝒕𝒐𝒎𝒆𝒓 𝒄𝒓𝒆𝒅𝒊𝒕 𝒄𝒉𝒆𝒄𝒌𝒔

The TDABC cost driver rates are somewhat lower than those estimated by the conventional ABC
model. The reason for this discrepancy becomes obvious when we recalculate the cost of
performing the three activities during the recent quarter.

Activity Unit Time Quantity Total Minutes Total Cost

Process 8 49000 392000 352800
Customer Order

Handle 44 1400 61600 55440

customer
inquiry
Performed 50 1500 125000 112500
credit check
Used capacity 578600 520740
Unused capacity (8.2%) 51400 46260

Total 630000 567000

The analysis reveals that only about 92 percent of the practical capacity (578,600 ÷630,000) of
the resources supplied during the period was used for productive work; hence only 92 percent of
the total expenses of $567,000 is assigned to customers during this period.

The conventional ABC system overestimates the costs of performing activities because its
distribution-of-effort survey, while quite accurate (the estimated percentage mix of 70, 10, and
20 is quite close to the actual mix of 67.7, 10.6, and 21.6 percent of the productive work across
the three activities), incorporates both the costs of resource capacity used and the costs of unused
resources.

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By specifying the unit times to perform each instance of the activity, the organization gets a
more valid signal about the cost and underlying efficiency of each activity as well as the quantity
(51,400 hours) and cost ($46,260) of the unused capacity in the resources supplied to perform the
activity.

While the TDABC model is initially estimated on historical data, its main power is to help
predict the future.

Suppose, in the next period, the quantity of activities is expected to be 51,000 customer orders,
1,150 customer inquiries, and 2,700 credit checks.

During the period, the company can operate the TDABC model as a standard cost model though,
of course, with many more cost drivers than a traditional standard cost model and assign costs to
orders and customers on the basis of the standard rates, calculated at practical capacity: $7.20 per
order, $39.60 per customer inquiry, and $45.00 per credit check.

This calculation can be performed in real time to assign customer administration costs to
individual customers, as their transactions occur. The standard cost rates can also be used in
discussions with customers about acceptance and pricing of new business.

Activity Unit Time Quantity Total Minutes Unit Cost Total Cost
Process 8 51000 408000 $7.20 367200
Customer
Order
Handle 44 1150 50600 $39.60 45540
customer
inquiry
Performed 50 2700 135000 $45 121500
credit check
Used capacity 593600 534240
Unused capacity (8.2%) 36400 32760

Total 630000 567000

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It reveals the time required to perform the three activities, as well as their resource costs. It also
highlights the difference between capacity supplied (both quantity and cost) and capacity used.
Managers can review the $32,760 cost of the unused capacity and contemplate actions to
determine whether and how to reduce the costs of supplying unused resources in subsequent
periods.

TIME EQUATIONS

• Time-Driven ABC easily incorporates variation in the time demands made by different
types of transactions.

• It does not require the simplifying assumption, made so far, that all orders or transactions
are the same and require the same amount of time to be processed.

• It can allow the unit time estimates in a TDABC model to vary on the basis of order and
activity characteristics. Companies can usually predict the drivers that cause individual
transactions to be simpler or more complex to process.

• For example: -

• Consider the department of a chemicals distribution company that packages

customer orders for shipment. A standard item in a compliant package may require
only 0.5 minutes.

• If the item requires a special package, then an additional 6.5 minutes is required.

• If the item is to be shipped by air, an additional 0.2 minutes is required to place it

in a plastic bag.

• Rather than define a separate activity for every possible combination of shipping
characteristic, or estimate transaction times for every possible shipping
combination, the time-driven approach estimates the department's resource demand
by a simple equation.

• Packaging Time = 0.5 + 6.5(if special handling required) +0.2(if shipping by air)

• The accuracy of a TDABC model arises from its ability to capture the resource
demands from diverse operations by simply adding more terms to the departmental

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 time equation. Returning to the packaging department, let's say that the chemicals
company wants to offer a new differentiating feature by giving its customers access
to hazardous materials. To capture the cost of this feature, packaging personnel do
not need to be reinterviewed to learn what percentage of their time will be required
for packaging orders for hazardous chemicals. The TDABC model manager simply
adds one more term for this possible variation in the packaging activity.

• The new equation becomes: -

Packaging time =0.5+6.5(if special handling required) +.2(if shipping by air) +30(if
hazardous material)

• In contrast, conventional ABC requires a geometric expansion to capture the

increase in complexity. The packaging department's work would be decomposed
into four distinct activities:
o Packaging standard product
o Packaging product with special handling requirements
o Packaging product for air shipment
o Packaging hazardous material
• Each period (e.g., month), personnel in the packaging department would be surveyed for
estimates of what percentage of their time is spent with each activity. This survey is time-
consuming and subjective.
• The TDABC model allows all these activities to be combined into one process, with one
equation.
• A typical TDABC model requires fewer equations than the number of activities used in a
conventional ABC system, while permitting much more variety and complexity in orders,
products, and customers.
• Complexity in the process, caused by a particular product or order, may add terms, but
the department is still modelled as one process with one-time equation. This feature adds
accuracy to the model at little additional cost and effort.
• Once a time equation is built for each process, through interviews and time studies, the
model dynamically reflects the actual activity in each period. The time equations in a
TDABC model also provide managers with a capability for simulating the future.

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 • The equations capture the principal factors that create demands for process capacity,
including changes in process efficiencies, product volume and mix, customer order
patterns, and channel mix. Managers can use their TDABC model to perform dynamic
what-if analysis of various scenarios.
• The model can easily be incorporated into a new budgeting process that analytically
calculates the required supply and spending on resource capacity that is needed to deliver
on future periods' sales and production plans.
• For example, at Citigroup, managers use the TDABC model for business planning,
determining the level of staffing necessary to deliver anticipated customer service
demands.

MODEL UPDATING

• Managers can easily update a TDABC model to reflect changes in their operating
conditions. As already noted, they don't have to reinterview personnel when more
activities are added to a department. They simply estimate the unit times required for
each new activity identified. Managers can incorporate the effect of complex versus
simple orders by estimating the incremental unit time required when a complex
transaction must be handled.
• For example, one food service company modified the algorithm for customer service time
to reflect the additional time required to process special orders and those that required
credit memos. The algorithm subtracted time if the order came via an electronic data
interchange (EDI) connection.
• In this way, TDABC models evolve seamlessly as managers learn more about additional
variety and complexity in their processes, orders, suppliers, and customers.
• Managers can also easily update cost driver rates. Two factors cause a cost driver rate to
change.
• First, changes in the prices of resources supplied affect the capacity cost rate.
• For example: -
✓ If employees receive an 8 percent compensation increase, the cost rate increases
from $0.90 per supplied minute to $0.97 per minute.

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 ✓ If new machines are substituted or added to a process, the analyst modifies the
capacity cost rate to reflect the change in operating expense associated with
introducing the new equipment.
• The second factor affecting the cost driver rate is a shift in the efficiency of the activity.
Quality (six sigma) programs, other continuous improvement efforts, reengineering, or
the introduction of new technology can reduce the time or resources needed for the same
activity. When permanent, sustainable improvements in a process have been made, the
TDABC analyst modifies the unit time estimates (and therefore the demands on
resources) to reflect the process improvement.
• For example

• If a computerized database is made available to the customer administration

department, the people may be able to perform a standard credit check in 12
minutes rather than 50 minutes.

• The improvement is simple to accommodate; just change the unit time

estimate to 12 minutes, and the new activity cost driver rate automatically
becomes $10.80 per credit check (down from $45.00).

• The new rate may be somewhat higher than $10.80 after the unit cost rate
has been increased (above $0.90 per minute) to reflect the department's cost
for the newly acquired database and computer system

RESEARCH PAPER

Time-Driven Activity-Based Costing for Inter-Library Services: A Case Study in a

University by Eli Pernot, FilipRoodhooft, and Alexandra Van den Abbeele

TIME-DRIVEN ACTIVITY-BASED COSTING FOR INTER-LIBRARY LOANS

• In this part of the paper, they thoroughly explain the inter-library TDABC analysis. To
that end, they first briefly describe ILL at the KuleuvenArenberg library.

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 • Then, they present a thorough activity analysis and derive time equations for each request
activity. Third, they provide an overview of all related ILL costs and identify the different
costs per minute.
• Based on these time equations and costs per minute, they finally calculate the cost of
different outgoing and incoming requests. The activity data for this study were gathered
through direct observation and multiple interviews with both the library manager and the
ILL responsible
• Cost data were obtained from the library accountant and other information was found by
means of archival research, which included inter alia the annual report. All observations
were made during 2006 and all financial data (like wages and overhead costs) are from
2005.

Inter-Library Loans (ILL) at the KuleuvenArenberg Library.

• The KuleuvenArenberg library’s mission is ‘‘to develop a well-balanced collection for

education and research, with extended opening hours for students, an electronic library
that can be consulted at individual workplaces and the facilities for guided self-
education’’ (Annual Report, 2005).
• The recent trends to automate standard processes, like lending and receiving books, and
to digitalize the library are aimed at attaining this goal at the lowest possible cost.
• Furthermore, the library is a member of the LIBIS-network, which manages the library
systems of the entire Kuleuven and LIBIS-Net.
• LIBISNet’s mission is to support participating libraries in their library management and
the services they provide, such as ILL. Like any other ILL system, LIBIS-Net. supports
on the one hand that the Kuleuven library borrows books and requests journal articles that
are not present in its collection, the so called outgoing requests, and on the other hand
that the library lends items to other libraries, the so-called incoming requests.
• Although ILL basically only refers to ‘‘loans’’, we will use the term in the remainder of
this paper to refer to both books loans and article deliveries.

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 • Fig. 1 depicts the relations between the three parties involved in an outgoing request,
which generally consists out of three flows. Only when a book is not returned within the
allowed borrowing period, the library sends a reminder for return, creating a fourth flow
(4). Obviously, when the request concerns a journal article, the ILL process stops after
flows 1 and 2, because a PDF file or a hard copy must not be returned. For most Belgian
libraries, payment for ILL is handled by the clearinghouse system of Impala, comparing
earnings and dues on a 1 to 1 basis. While libraries with a negative balance receive an
invoice from Impala, those libraries with a positive balance may send the clearing-house
an invoice. When payment is not handled by Impala, the Kuleuven library either receives
an invoice from the other library or settles the payment by means of an IFLA
(International Federation of Library Associations) voucher, the latter being utilized more
and more frequently for international ILL services. Obviously, the Kuleuven library
charges the reader for the ILL costs. All financial transactions follow flows (2) and (3) in
Fig. 1, but do not have to coincide with the physical flow of the book or article.
• From the perspective of the Kuleuven library, incoming requests involve only two
parties and consist of three flows when the ILL concerns a book loan, represented in Fig.

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 ACTIVITY ANANLYSIS AND TIME EQUATIONS

• To construct appropriate time equations, they performed a thorough activity analysis of

ILL at the Arenberg library.
• They identified four common ILL activities (process, deliver, close and invoice), each
implying several sub activities, which differ for outgoing and incoming requests. For

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 each of these sub activities, the ILL responsible at the Kuleuven library provided an
estimation of the time needed to perform this sub activity once.
• Based on these estimations, we derived eight-time equations, one for every main activity
of an outgoing and incoming request, which can be found in Table 1. The interpretation
of these time equations is similar for all equations.
• The total time needed – in minutes – for a certain activity is the sum of the times needed
to perform a certain sub activity, taken into account that certain request characteristics,
like the fact whether the request concerns a book or journal article, influence the presence
of certain terms in the equation.
• For that reason, these characteristics are included by dummy variables, which are equal
zero or one, the latter when the request actually shows this characteristic and its time
needs to be included in the time calculation. The role of these dummy variables needs to
be emphasized, as these variables are crucial in understanding the utilization of the time
equations.
• Furthermore, the time equations are set up chronologically, implying that both the main
activities and the sub activities occur in the order of the position in their time equation.

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TIME EQUATIONS

• Identification of the Cost Per Minute In this part of the TDABC analysis, we identify how
much one-time unit – 1 min – of every activity, defined in the previous step, actually
costs.
• All cost rates were calculated by means of data provided by the library manager.
According to him, the total number of personnel assigned to ILL represents 2.5 full time
equivalents.
• With a theoretical capacity of 38 h a week, a total of 95 h would be available for ILL
activities per week. Yet, instead of using this utopian kind of capacity, they base our
calculations on the more realistic practical capacity, which is set at 80 percent of the

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 theoretical capacity, a standard number in the management accounting literature (e.g.
Kaplan and Anderson6 ) and also the number given by the ILL responsible. Therefore,
the practical capacity for ILL activities is 76 h or 4560 min per week.
• The 2.5 FTE consist of six people, each working 100 percent (the ILL responsible), 75
percent, 37.5 percent, 25 percent, 6.25 percent, and 6.25 percent of their time on ILL.
• Based on their different gross wages, the total labor cost of these people is €1,521.56 per
week. Dividing this amount by the practical capacity of 4560 min per week, results in a
cost of €0.33 per minute.
• Besides these employees, the Arenberg library hires students to perform scanning and
copying activities for incoming requests. Based on their hourly wage, we calculated their
labor cost per minute as €0.28.
• Finally, the Arenberg library also employs an accountant, who books invoices to readers
and deals with the potential payments of supplying and requesting libraries.
• His monthly gross wage is €3,117.11, implying that his cost per minute amounts to o0.43.
According to the Arenberg library accountant, the ILL overhead costs concern equipment
and daily working costs. In the same way, so by dividing total costs by total number of
minutes (4560 per week), we calculated a general overhead cost of €0.03 per minute,
covering furniture, computers, computer supplies, and paper.
• In addition, article requests can require copying and scanning activities for which a
specific cost of €0.02 per minute is derived, covering the scanner/copier and all related
costs, such as paper and maintenance.
• Finally, we also distinguish a specific shipping cost of €0.02 per minute.

TABLE SHOWING COST PER MINUTE

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OUTGOING REQUEST COST TABLE

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 • To calculate the total cost of a certain outgoing request, we first need to identify the type
of request – book, article in PDF, or article on paper – and the characteristics determining
the occurrence of certain activities. Then, we sum the costs of the identified activities into
two subtotals. Finally, these subtotals are added into the total cost. They explain this
approach by a thorough example.
• Assume that the Kuleuven library receives the request from a reader to order a certain
journal article via ILL. The reader did not find the journal article in the library collection
and asks for help at the library desk. After he hears about the possibility of ILL, he fills in
a request form and says he prefers an invoice to payment in cash.
• Yet, the journal article appears difficult to find, as the first supplying library negatively
responds to the ILL request. In addition, the second supplying library sends the article on
paper, so that a scan is performed.
• Yet, this scan appears unsuccessful, so that the hardcopy of the article is sent by postal
mail. Finally, the foreign supplying library requests payment by means of an invoice.
• In order to calculate the total cost of this request, they first need to identify its type and
characteristics. It is clear that this request concerns an outgoing request of an article that
is delivered on paper by the supplying library.
• That means that we consider the third main column of Table 3 and need to include the
standard activities of processing (€2.45), receiving (€1.08), and scanning (€1.14) in the
addition of the first subtotal. Furthermore, we know that the article is scanned
unsuccessfully, so that the hardcopy is sent to the reader by postal mail (€0.38).
• Hence, they select this activity of the fourth row. After closing (€0.25), this request is
paid via an invoice (€0.29 +€0.09).
• Therefore, the subtotal of standard activities amounts to €5.68. Additionally, this request
is hampered by a first negative request (€2.38) and requires feedback (€2.27), as well as a
supplier-invoice, since the payment is not handled by Impala (€0.29 +€0.09). This leads
to a second subtotal of o5.03 for optional activities.
• Hence, the total cost to handle this outgoing request amounts to €10.71. In the same way,
the subtotal of time needed for standard activities adds up to 15.5 min. As the optional

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 activities require 13.9 min, the total time needed to handle this outgoing request is 29.4
min.

• The cost table for incoming requests, shown as Table 4, is very similar to the one for
outgoing requests and can be used accordingly.

INCOMING REQUEST COST TABLE

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 • Two differences with the outgoing request cost table worth mentioning are the following.
First, this cost table includes an extra subtotal, named process, which separates the
standard activity of process from the other standard activities (the second subtotal). The
reason for this approach is the possibility that the Kuleuven library sends a negative
response to the requesting library.
• Second, an article on paper involves a second choice in the other standard activities
subtotal. As in the case of an outgoing request, the requested article found on paper is
scanned, so that it can be sent electronically. Hence, the first choice in the cost
calculation is the same, namely whether the scan is successful. Yet, if the scan appears
unsuccessful, the article is not immediately sent on hardcopy, but copied so that a second
scan can be made of the copied version. If this second scan is successful, the resulting
PDF file is saved and sent; otherwise the hardcopy is sent. Hence, in the incoming case a
second choice is needed, namely whether the second scan is successful, which implies the
addition of more time and cost and is indicated by ‘‘or’’ in the table.

THE BENEFITS OF TDABC: SOME MANAGEMENT IMPLICATIONS

• Therefore, they conclude that ILL earnings often do not cover ILL costs.
• The TDABC approach, with its time equations, offers some specific advantages, as these
equations create larger transparency than a traditional cost accounting system or an
ordinary ABC system.
• The time equations clearly show which activities demand more time, and thus lead to
higher costs.
• This way, the library manager can take appropriate actions to lower the time needed to
handle a certain request

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COMPANIES FOLLOWING TIME DRIVEN ACTIVITY BASED COSTING

Hunter Company

The Hunter Company (disguised name of actual company), a large, multinational distributor of
scientific products with over 20 facilities, 300,000 customers, and 460,000 product SKUs,
processes more than one million orders each month. Hunter already had an existing activity-
based costing model that had been built with the assistance of an external consulting team. The
insights revealed from the model were extremely informative but many in the company
questioned if the view was worth the climb.

Their main complaints can be summarized as follows:

• The model had been cumbersome to build and maintain. With more than 1,000 activities,
the monthly survey of department staff of where they had spent their time was complex
and costly. Also, tracking the driver quantities for each activity and customer was
difficult.
• The model did not reconcile with actual financials since activity cost driver rates had not
been updated recently.
• Despite the already large number of activities, the model was still not considered accurate
or granular enough. It did not reflect several important differences between orders. To
increase accuracy, more activities would have to be added, and employees would have to
be re-interviewed. Also, an additional data extract to track the quantities of the new cost
drivers would be required.

The existing ABC approach was not easily maintainable, and thus not sustainable. The company
called in a software/consulting company to help it implement the time driven ABC approach.

The time-driven approach led to the following changes:

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 • For a department, such as the inside sales department, the previous ABC model
required employees to estimate, each month, the percentage of their time spent on
their three activities: customer set-up, order entry, and order expediting.

• In the time-driven approach, the ABC team estimated the time required to perform
each activity.

• For example, the activity to set-up a new customer took 15 minutes. Since a field
already existed within Hunter’s ERP system that identified whether a customer was
new, assigning a customer set-up cost to a new customer became a simple
transaction.

• For order entry, the team learned that every order took about five minutes to enter
the basic order information, plus three minutes for each line item on the order.

• Again, this was a simple calculation to implement since the ERP system already
tracked the number of line items for each order. Finally, the team learned that order
expediting was triggered by a request by the customer to rush the shipment,
resulting in an additional 10 minutes of time to coordinate the expediting.

• The order included a field that identified it is a “rush order.” The project team could
write a simple equation to estimate the Inside Sales Department time required for
each order received:

Inside Sales Process Time = 15*[New Customer] + 5 + 3*[Number of Line Items] +

10*[Rush]

• The Inside Sales Department cost for the order was obtained by multiplying this time by
the cost per minute of Inside Sales Department resources.
• This process was replicated in each department to arrive at the total cost of producing,
handling, and fulfilling the order.
• Note that once the team had created the Inside Sales Process algorithm, it did not need to
continually re-interview personnel. Each period, the costs of the department would be
assigned based on the volume and nature of the transactions it handled.

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The Hunter Company identified the following benefits from shifting its ABC model to the time-
driven approach: -

• It reduced the number of activities to maintain. It transformed 1,200 activities (e.g., set-
up new customer, enter orders, expedite orders) to 200 department specific processes
(e.g., the equation used to estimate Inside Sales Department time). Also, it could easily
update the resource cost of each cost center and departments so that its process costs were
accurate and current.
• Its cost estimates were more accurate since they were based on actual observations of
processing time and actual transaction data, not subjective estimates on where and how
people spent their time
• It was easier to increase model accuracy and granularity, when wanted, for high cost and
heterogeneous processes. Adding more elements to the time equation enabled managers
to easily add more variety and complexity to the model when required. This enabled
managers to identify specific SKUs, customers, and processes where improvements could
be made.
• The model was easier to validate. The calculated total process time, based on all
transactions in a period, could be reconciled to head count (resources supplied during the
period). If the total process time exceeded the actual resources supplied, managers
received a signal that some of their unit times were likely too high. If total calculated
process time was well below the time supplied, but employees felt they were working at
or beyond capacity, managers learned that some of their unit times were under-estimated
or employees were working less efficiently than anticipated.
• The model provided explicit information on processes operating at or beyond capacity,
and those operating well below capacity. Managers could take action to relieve
bottlenecks expected to persist in future periods, or act to reduce capacity 14 in
departments where any unused capacity was expected to persist for several periods into
the future.

Today, it takes two people, two days per month to load, calculate, validate and report findings,
compared to the 10-person team spending over 3 weeks to maintain the previous model.

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Employees now spend time generating increased profits from the information rather than just
updating and maintaining the information.

Klein Steel

• Klein Steel, a steel service center in upstate New York, distributes more than 3,500
products at an average mark-up of 30%. Because of high handling and distribution costs,
however, its net margin was only 1%.
• It installed a time-driven ABC system that enabled it to see costs by distribution office,
by product, by customer, and by size of order.
• By working from an industry template, Klein had such accurate cost and profitability
information within 1-2 months.
• Among its findings were the following:
• twenty-five percent of its customers were unprofitable
• the company could not make a profit on any order selling for less than 20
percent gross margin – regardless of order size
• several entire distribution routes were unprofitable
• salespersons had been trying for years, unsuccessfully, to increase order volume
with some unprofitable customers.
• Klein acted quickly to establish new order acceptance guidelines, provide customer
incentives to consolidate many small orders into a few large ones to reduce handling and
shipping costs, enact a new sales commission plans based on net profitability of
customers, and improve processes revealed to be high cost.
• Klein enjoyed an initial gross profit improvement of 4% and recaptured the cost of
installing its new ABC system within six months. It was targeting a profit improvement
of more than $700,000 annually.

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Banta Foods

• Banta Foods is a Midwest food distributor with revenues of approximately $100 million
from 2,700 customers.
• Like Klein Steel, it operated with a razor thin net margin of about 1 percent.
• Historically, its profit drivers were increasing the number of orders per day, increasing
aggregate revenues, and controlling aggregate expenses.
• Its time driven ABC system, installed and running within a few weeks, revealed much
more granularity in its expense structure by tracking costs to products, orders, customers,
and territories.
• Sales managers learned that a $1,000 order, considered the smallest size to breakeven,
could either be quite profitable or a loss depending on distance to customer, location of
product in the warehouse, size of order, frequency of delivery, type of service, 15 and
credit worthiness of the customer – all of which were now incorporated in the algorithms
in its new time-driven ABC system.
• Chuck Banta, President and CEO, noted: Your cost to serve is a lot less 50 miles away
from your warehouse than it is 200 miles away. ABC allowed us to look at all our
expenses through that kind of lens.
• Based on the information in its ABC model, Banta instituted a non-negotiable minimum
order size, reduced the inventory of unprofitable products, promoted sales of high profit
products, negotiated with customers to either reduce or re-price the demand for high cost
services, and offered incentives to its salespersons to increase the net profits of their
customers.
• It also renegotiated with vendors to recoup the cost of processing customer rebates. The
general manager of sales used the information to transform his sales representatives from
order takers to consultants, helping their customers to become more profitable.
• He reported:
o Sales people can now increase their gross profit not by simply adding points to
their margin but by knowing which items to sell.

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 o By accurately projecting the cost and profits of proposed business, Banta has
been able to take on new business that increased revenues by 35% and net profits
by 22 % significantly outperforming its industry and garnering the distinction of
“Innovator of the Year” in its industry.
o With all its initial actions, Banta’s annual profits increased by 43%.

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