ABM – How it Works

1. Identification and Analysis

Identification refers to finding and listing a company’s significant business

activities – especially since companies are typically involved in hundreds of
activities on a daily basis. Identifying activities that have the most impact on
finances is an important step in activity-based management.

The next step involves identifying cost drivers for each activity, based on the
costs incurred during the activity. Cost drivers are the factors that cause the
cost of an activity to vary.

For example, if the activity is setting up new machines, the cost driver is the
number of machines set up – because that is what determines all the
associated indirect costs of labor, equipment, and the machinery itself.

2. Evaluation and Value-Chain Analysis

The manager also needs to calculate the cost of each activity by appropriating
all the indirect and direct costs related to the activity. This is known as activity-
based costing and is a method used to assign the costs of each activity
according to actual consumption, based on overhead expenses incurred
during the activity.

For instance, if a cloth manufacturer runs sewing machines all day for most of
the year, that will be considered a significant activity. The cost calculation of
this activity will include the cost of labor, electricity, and space required to run
the machines.

Along with activity-based costing, the value generated by each activity must
also be quantified so that it can be compared to the cost and allow for an
evaluation of the activity. This is called value-chain analysis, which is an
analysis of the value added by a particular activity.
For example, in the case of running sewing machines, the value generated will
be in terms of the value of clothes the machines generate over a certain
period. Then, the value added by running the machines can be weighed
against the cost of running the machines, and allow the company to identify
whether the activity is profitable or problematic.

3. Identifying Opportunities to Improve

The information analyzed and collected through activity-based costing (ABC),

and value-chain analysis can be used to identify and implement processes that
can improve the company’s operations and/or strategies. This divides ABM
into two potential sub-categories:

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.

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.
 

ABM – Advantages and Disadvantages

As listed above, activity-based management offers several advantages related

to improving the economic efficiency of operations, as well as the strategic
decision-making process of a company.

By allowing managers to enhance value-generating activities, it also offers the

potential to improve the experience of a customer, increasing profitability in
the long run. Furthermore, the costing information from activity-based costing
can be used to forecast and determine crucial financial information for future
fiscal years, enabling the company to plan a more accurate budget for
upcoming years.

However, one of the primary risks associated with using the ABM method is
that it ignores the intrinsic value of activities and focuses only on the
quantifiable and financial aspects of each activity.

For example, suppose a manager holds a lot of meetings with the company’s
primary supplier to establish a healthy relationship, and this builds up to make
a significant portion of weekly expenses due to transport costs. It may be seen
as a non-value generating activity simply due to the high costs, but the value
of the relationship being built between the company and the supplier is not
accounted for.

Therefore, although activity-based management comes with a few advantages,

it is important to also examine the non-quantifiable side of activities while
using the ABM approach to make operational and strategic changes.