Is your cost system a ripe candidate for a major overhaul? Here's how to determine if your company can benefit from an activity-based solution.
Cost systems have evolved substantially since Henry Ford divided his total expenses by the number of black Model A cars his company produced to determine his unit cost. Much later, standard costing and economic order quantity became prevalent. Then manufacturing resource planning came along, followed by the just-in-time concepts. These traditional cost systems reflect circumstances in which direct labor and materials are the dominant factors in production, technology is stable, overhead primarily supports production and companies have a limited range of products or services. The concepts predate high technology, income taxes, product diversity and depreciation.
The Model A is long gone, but many companies continue to use traditional cost systems that aren't helping them achieve the business efficiencies necessary to reach their goals. Although every financial manager has heard about activity-based costing (ABC) and activity-based management (ABM), why are so many reluctant to adopt an activity-based solution? Perhaps part of the reason is because they are unable to determine if their organization is a good candidate for implementing such a major change.
ABC is a tool used to assign costs to products or customers based on the resources they consume. It can be used to identify the cost of activities such as purchasing, set up, shipping and receiving, inventory control, and so on. Each activity is then traced back to the customer or product that caused the activity to be performed, rather than arbitrarily assigning such costs to products on a percentage basis. The objective is to create a clear picture of the activities that create cost so management can control the activities, and thus, control costs.
ABM is a companywide management system that uses ABC to improve a business. Its uses can be strategic, financial or operational. ABC is a tool. ABM is the use of that tool. ABC explains what goes on in a business. ABM uses the information to manage the business.
According to Steve Player, director of cost management at Arthur Andersen in Dallas, ABM allows the company to focus on profitable growth rather than haphazard growth. It is a tool that makes the invisible visible and shows which growth area will be most profitable.
Is ABM Right for You?
If your company has relatively low overhead, produces a limited number of products and has little diversity in volume relative to those product lines, then you probably will not achieve significant benefits from ABM, says Rich Bilancia, president of Colorado-based Computer Guidance and Support.
On the other hand, according to Jeff Williams, IBM Consulting Services Principal, Resource Management Division in New York, your company is a prime candidate for ABM if it has high overhead, whether in a manufacturing or a service industry; diverse product or service lines; capital-intensive operations; vertically integrated processes; large distribution, sales, and/or marketing costs; or products with short life cycles.
OK, your company is a possible candidate. What next? Williams suggests that you ask yourself a series of questions:
- Is our pricing consistent with our costing?
- Do some products/services subsidize others? If so, is it intentional? /P>
- Do we know how much individual customers cost us?
- Can we identify any specific areas of waste or inefficiency relating to specific customers or product lines?
- Have we tried to implement effective cost-cutting measures?
- If we're outsourcing any operations, are they the right ones?
If you answered no, maybe or I'm not sure, to any of these questions, then ABM deserves serious consideration.
A possible first step, if you decide to consider ABM, is to assess the ability of the company and key individuals in the company to accept change and commit to continuous improvement (see the questionnaire, Rate Your Readiness for Continuous Improvement, below), a key element in determining whether an ABM project is likely to succeed. For change to be successful and sustainable your employees must be open-minded to new ideas, closed-minded to old practices and single-minded about the future, says Tom Pryor, president of Integrated Cost Management Systems Inc. (ICMS) in Arlington, Texas.
Assuming that you believe your company can change, the next step might be to discuss your answers to the questionnaire with others in your department and with senior management. Pryor suggests that you personally contact every functional manager and ask what information is needed to identify and evaluate opportunities for an ABM solution and how that information can be obtained. Then show examples of ABM and link them to managers' needs.
Significant education may be necessary, starting, Pryor suggests, with a half-day workshop for senior management, before and after piloting ABM, to ensure proper use of the data. Executives, according to Pryor, should be taught how to use ABM for strategic planning and be provided with an ABM coach to call upon when they have questions or concerns. A number of companies, colleges and associations offer workshops designed to help managers decide if ABM is right for their company.
Ernie Halperin, manager of marketing communication at Oregon-based ABC Technologies Inc., also recommends that prospective users of ABM attend a workshop. ABC Technologies offers a one-day workshop, priced at $495 per person, to help people explore ABC. According to Halperin, the workshop gives a feel of what ABC is all about. It is investigatory in nature. The workshop is offered around the country on a rotating basis. It can also be held in-house if a company so desires. Attendees are supplied with software for a 30-day free trial; Peter B.B. Turney's book Common Cents; a video, Understanding Activity-Based Management; a workbook; and an ABC model on diskette. The objective is to enable the attendee to go back home and demonstrate what ABC/ABM can do.
Sapling Corp., Toronto, offers a two-day workshop usually co-sponsored with an association, college or accounting firm, at a cost that varies between $895 and $1,035 per person. The workshop focuses on a process-based approach to ABC. A case-study oriented workshop answers the question, how might the theoretical notions of ABC/ABM apply to a particular company? says Bruce Hadley, vice president of corporate marketing.
At the workshop, the attendees are given modeling software intended to show operational and senior management how ABC can help solve specific problems. The primary benefits of the workshop are to teach attendees hands-on modeling; provide the opportunity to talk to others at the same point in their investigation; and to supply modeling software to be used to convince senior management to commit a budget and implement a pilot, Hadley says. Workshops are offered around the country, and each workshop features a case study unique to a particular industry.
Finally, it may be appropriate to design a one-time pilot project to solve a specific problem that has been identified and to take the idea and the results of your meetings to senior management. According to Bilancia, The controller must sell the idea to senior and middle management and have the project initiated by someone outside of accounting.
Arthur Andersen's study on best practices of activity-based management underscores the need for a cross-functional team. Putting someone from marketing, operations or engineering in charge of the project will help ensure that activities and costs are viewed horizontally. Thus, ABM will be perceived as a management tool necessary for management decision-making. In addition to the project team, company employees must be involved in creating, implementing and continuously improving the ABM system. Identification of activities and cost drivers must be defined by the employees who do the work.
The Controller's Role
Controllers must add value to the company, and to add value, accountants must understand operations and supply operations people with useful information to speed the organization toward success. Producing statements according to GAAP is not enough. Even FASB is studying recommendations on changing from reporting focused on information about the past to a balance of reporting between past and forward-looking information.
Del Hock, chair of the board of Public Service Company of Colorado, in a speech at a CPAs in Industry Conference, said, Unless you are a CPA in an accounting firm, bank or other financial institution, you are not involved in the core business of your company. If you want to advance your career beyond the accounting or finance function, you have to find a way to become an important part of that business.
Anyone in the company can introduce ABM. But, according to Bilancia, The two areas where people intuitively understand costs are engineering and accounting. The controller is going to be involved at some stage. Why not at the inception?
The process is not cheap and it is not quick. Basically, ABM is a proactive initiative that takes a lot of work. But results can be dramatic.