Do you know what we think of our cost accounting system? It is a bunch of fictitious lies -- but we all agree to it."

That's a complaint an operations manager of a Fortune 500 company made to me recently. Unfortunately, his tale of woe -- that his company uses flawed and misleading cost data for price quoting, profitability analysis, and justifying improvement projects -- is more the rule than the exception. And using faulty data diminishes the value of the business performance management (BPM) systems and processes many companies are considering, and implementing, today.

Misleading managerial accounting data and management's lack of deep visibility into what causes costs -- that is, their drivers -- prevent an organization from achieving a full vision of its integrated BPM system. An increasingly accepted solution to this problem is activity-based costing (ABC), which computes the cost data, combined with activity-based management (ABM), which applies the ABC information for better decision-making.

All ABM activities are supported by ABC calculations that provide visibility into the work activities that belong to business processes, particularly those indirect expenses (commonly referred to as "overhead") that are hidden in traditional cost reporting. ABC also provides substantially improved accuracy by tracing and assigning expenses to the calculated costs of outputs, products, service lines, channels, and customers rather than applying arbitrary allocations that use broad-brush averages such as sales dollars or number of labor hours.

ABM is an integral component of an effective performance measurement and management system. ABM information assists managers strategically by informing them (with much greater accuracy than traditional accounting) about which products and customers are profitable. ABM also explains what drives operational costs and how to improve them. Organizations with ABM systems, for example, are discovering that the output of their ABM systems provides excellent, highly accurate key performance indicators (KPIs) for their Balanced Scorecard systems.

ABM Changes Decision-Making Processes

When managers combine ABM with other components of BPM, such as strategy maps and scorecards, employees better understand what their organization's priorities should be and can change their behavior to focus their work efforts on strategic and operational issues. BPM becomes more powerful when managers and employee teams have access and visibility to fact-based intelligence. The fact-based intelligence provided by ABC data increases the likelihood that correct strategies will be formulated and enables employee teams to analyze what is happening and what might happen through what-if scenarios.

In addition to improving corporate decision-making, an ABM system accelerates profit and productivity improvement. Managers can use its repeatable and reliable information to both assess past progress against plans and support future decisions. Exhibit 1 illustrates a generic ABM cost-assignment system. This diagram is not as complex as it initially looks; it is a logical representation of how costs flow from resources. Note how the demands on work move from bottom to top, with the costs reflecting back, measuring the effect. ABM is a consumption model and not a flowchart, although the activity costs do belong to processes, which is an alternative view for displaying ABM cost information.

Executives are trained to focus on financial accounting data, such as period-end reported sales, balance sheet ratios, profits, and spending. But BPM encourages managers to broaden their focus to include profit margin and computed cost data from ABM that can be useful as KPIs found in most scorecards. Regulatory compliance dictates financial accounting, but the issue here is managerial accounting for internal purposes.

The belief that organizations can set up only a single enterprisewide ABM system is a common misconception. In fact, companies can construct multiple ABM systems to suit the needs of their enterprise. In practice, two broad types of users and decision-makers view ABM data: strategic and operational users. A different type of ABM model design serves each type of user, but both types of ABM systems follow the same cost-assignment principles. The difference between them is the scope of organizational expenses included plus the inclusion or exclusion of pricing or revenue data for calculating profit margins.

Are All of Your Customers Profitable?

Strategic ABM supports an organization's BPM by measuring which products and customers are profitable so that it can apply its resources to the highest returns. If some customers are excessively high-maintenance, then those customers erode profit margins. Is the extra work worth it? Who are the troublesome customers, and how much do they drag down profit margins? More important, once these questions are answered, what corrective actions should managers and employees take?

Some customers purchase a mix of only low-margin products. After adding the costs-to-serve for those customers apart from the profits (or losses) from the products and service lines they purchase, a company may determine that these customers are unprofitable. Other customers who purchase a mix of relatively high-margin products may demand so much in special services that they, too, could potentially be unprofitable. What kinds of customers are profitable? How does an organization properly measure customer profitability? With that information, how and when does a company deselect, or fire, a customer? The concern here is not only determining the profit contribution of customers, including accurate costs for the products and service lines they buy, but also understanding the elements of customer-specific work that make up the entire costs to serve each customer.

Strategic ABM information builds business cases for actions that management would usually take based on intuition or hunches. With more accurate and robust profit and cost data, a company can answer questions about its customers, such as "Do we push for volume or for margin with a specific customer?"; "Are there ways to improve profitability by altering the way we package, sell, deliver, or generally service a customer?"; "Does the customer's sales volume justify the discounts, rebates, or promotion structure we provide to that customer?"; and "Can we realize benefits from our changing strategies by influencing our customers to alter their behavior to buy differently (and more profitably) from us?"

Traditional methods of costing products result in under- and overcosting from flawed, volume-based averaging methods of cost allocation. The profit margin math subtracts the true ABM product and service-line costs from the revenues. The profit margin is always a derivative -- it is the money that is left over. With ABM, product and service-line costs shift from what the company believed them to be, while the price and volume do not shift but remain unchanged. As a result, the profit margins are also revealed to be substantially different than what the organization had believed. This result is also due to the fact that margins are usually very thin, so even slight changes in costs make a large difference in profits.

Exhibit 2 is a graph that shows how unrealized profits can be hidden because of inadequate costing methods. The accountants are not properly assigning the expenditures based on cause-and-effect relationships. The graph -- often referred to as a profit cliff -- displays the result of the cost subtracted from its sales to reveal each product's and service line's profit.

The products are rank-sorted, left to right, from the largest to the smallest profit margin, and then cumulatively added. The very last data point equals the firm's total net profit, as reported in its company P&L statement. For this organization, total revenues for the period were $20.0 million, with total expenses of $18.2 million -- a $1.8 million net profit. But the graph reveals the distribution of the product mix of that $1.8 million net profit. It shows that roughly $8 million of unrealized profits came from the most profitable three-fourths of the products and roughly $6 million was lost on the remainder. This revelation can be shocking to the management team.

Think of the last data point, the one that ties to the P&L, as being on a vertical metal track; it can only slide up or down. Looking at the graph this way reveals that products and service lines to the left of the profit cliff's peak (where an item's sales amount exactly offsets its costs at the peak) are also fair game for increasing profits. Many managers focus only on the losers to the right, but increased profits can also come from up-selling and cross-selling the most profitable products located to the left of the peak. When the cost-to-serve for each customer is combined with the unique P&Ls of the product or service-line mix that the customer purchased, then a P&L statement for each customer (or typically customer segment) can be reported and analyzed. This adds power to BPM and links it to customer relationship management programs.

What does a commercial organization do with the customer profit information? In other words, what actions can an organization take to increase its profits? Some customers may be so unprofitable that the company will conclude that it is impractical to try to achieve profitability with them. These customers should be terminated. After all, the goal of a business is not to improve customer satisfaction at any cost but rather to attempt to manage customer relationships in order to improve long-term corporate profitability.

ABM-Calculated Outputs Provide a Subset of a Scorecard's KPIs

Operational ABM supports an organization's BPM system by measuring the costs of the output of processes. Management uses it to drive productivity and improve asset utilization. Most organizations have very little insight about their outputs -- not the obvious products and standard service lines they deliver to end customers, but rather the internal "outputs" of the work their organizations perform. For example, internal outputs reflect the work effort and cost to generate sales calls, processed invoices, processed customer complaints, returned goods, etc. These examples are not the "work activities" that employees perform. They are descriptions of the results after the activities have been performed; in other words, they are the outputs of work. A collection of outputs leads to "outcomes" -- products, services, and the like -- a more macro result for which cost can also be calculated.

So where does ABM fit in? ABM can assign attribute tags to activity costs, such as cost of quality measures or valued-added codes, to focus on what activities need attention. ABM also does a great job tracing resource expenses to all sorts of internal outputs. This does not mean that the work processes producing these outputs are unimportant. It simply means that many people react more to the visibility of output costs than they do to the process costs to which the work activity costs belong.

In short, when unit costs are trended or compared with other unit costs, employees and managers gain more insight. They can benchmark to deduce whether they have a best or worst practice. Per-unit-of-each costs should not only be included as KPIs in the balanced scorecard's financial perspective but should also appear in the other perspectives as well. While unit costs represent dollar figures, they are much more like a representation of the equivalent resources the unit measure consumes, in this case stated in terms of money.

ABM Converts Data Into Business Intelligence

When used in conjunction with a BPM system, ABM should not be promoted as an improvement program, or users may perceive it as a temporary fad or "project of the month." Instead, ABM simply reflects the economics of how an organization behaves and consumes its expenses as calculated costs, such as for products, services, processes, channels, and customers. The information the ABM calculation engine reports should always be the input for something else, such as for performance measurement scorecard systems. Exhibit 3 illustrates from an IT perspective how an ABM system developed by SAS imports data from transactional financial and operations systems and then pushes the data into other business process systems, including a scorecard and customer relationship management system.

For example, within a large mutual fund company, management recognized that it is much more costly to acquire new customers than to retain existing ones. Knowing it must efficiently utilize its already-scarce resources, the company decided to deploy them to serve its more profitable customers. Its marketing and sales personnel shifted from pursuing increased sales volume at any cost to pursuing profitable sales volume. And the chief marketing officer (CMO) now requests customer profitability data from the CFO to target marketing strategies to microsegments of customers and optimize the company's increasingly targeted marketing campaigns -- regardless of the communication channel (e.g., e-mail, call center, mailing brochures) -- to achieve the highest ROI per campaign. This is another example of integrating the solution suite of BPM methodologies.

But don't confuse ABM with performance measures. ABM is not the measurement system. The output of ABM can be an important input of performance measurements in a scorecard system, and the presence of ABM data can stimulate greater numbers of actions.

Certainly, ABM is not a prerequisite for designing and using a BPM scorecard system. Scorecards are much more about communicating strategies to employees and increasing alignment of the work with overall corporate strategies. But the introduction of ABM data can populate the scorecard framework with robust and high-octane information that can give executives a much better sense of how well the organization is aligned with its strategies right now and how this information will influence the bottom line down the road.

With fact-based, relevant cost data from ABM systems, managers and teams can see things they've never seen before, and some of it might not be pretty. Often organizations are surprised when they realize the consumption patterns from their cost structure. As with scorecards, finding someone to blame or punish is not the point of having ABM data. It is important to treat ABM data responsibly. The key is to use the ABM data as a guide to better decisions, and the data for performance measures as a valuable benefit. Senior management's attitude is critical in successfully implementing a balanced scorecard. They should view the strategy map, scorecard, and ABM as supportive tools for remedies, not for punishment or embarrassment.

ABM Is a Cost-Reassignment Network

In complex, support-intensive organizations, there can be a substantial chain of indirect activities prior to the work activities that eventually trace into the final cost objects. These chains result in activity-to-activity assignments, and they rely on intermediate activity drivers in the same way that final cost objects rely on activity drivers to reassign costs into them based on their diversity and variation.

Given the existence of integrated activity-based costing/management (ABC/M) software, the direct costing of indirect costs is no longer -- as it was in the past -- an insurmountable problem. ABM allows intermediate direct costing to a local process, an internal customer, or a required component that is causing the demand for work. ABM software is arterial in design. Eventually, via this expense assignment and tracing network, ABM reassigns 100 percent of the costs into the final products, service lines, channels, customers, and business-sustaining costs. In short, ABM connects customers to the resources they consume -- and in proportion to their consumption.

The ABM cost-assignment network in exhibit 1, on page 37, consists of three modules connected by cost-assignment paths. This network calculates the cost of cost objects (e.g., outputs, product lines, service lines, customers). It is basically a snapshot view of the business conducted during a specific time period. (Life-cycle costing is associated with a customer relationship management topic, customer lifetime value.)

Resources, at the top of the cost-assignment network, enable the company to perform work because they represent all the available means that work activities can draw on. Resources can be thought of as the organization's checkbook; this is where all the period's expenditure transactions are accumulated into buckets of spending. Examples are salaries and operating supplies. These are the period's cash outlays and amortized cash outlays, such as for depreciation, from a prior period. During this step, the applicable resource drivers are developed as the mechanism to convey resource costs to the activity.

"Expenses" and "costs" are not the same thing. All costs are calculated costs. Recognize that assumptions are always involved in the conversion and translation of expenses into costs. The assumptions stipulate the basis for the calculation. Expenses occur at the point of acquisition with third parties, including employee wages. This is when money (or its obligation) exits the company. At that moment, "value" does not fluctuate; it is permanently recorded as part of a legal exchange. However, all costs are calculated representations of how expenses flow through work activities and into outputs of work.

In sum, resources are traced to work activities. During this step, the applicable resource drivers are developed as the mechanism to convey resource expenses into the activity costs. A popular basis for tracing or assigning resource expenses is the length of time that people or equipment spend performing activities. Note that the terms "tracing" or "assigning" are preferable to the term "allocation," because many people associate allocation with a redistribution of costs that have little to no correlation between source and destinations. Thus, some firms cynically view overhead cost allocations as arbitrary.

The activity module is where work is performed,where resources are converted into output. The activity cost-assignment step contains the structure to assign activity costs to cost objects or other activities, utilizing activity drivers to accomplish this assignment.

Cost objects, at the bottom of the cost-assignment network, represent the broad variety of outputs and services where costs accumulate. The customers are the last final-cost objects; their existence creates the need for a cost structure in the first place. Cost objects are the persons or things that benefit from incurring work activities -- the "what" or "for whom" work is performed. Examples of cost objects are products, service lines, distribution channels, customers, and outputs of internal processes.

Once established, the cost-assignment network is useful in determining how the diversity and variation of things, such as different products or various types of customers, can be detected and translated into how they uniquely consume activity costs.

Gary Cokins is global product marketing manager for performance management solutions at SAS and a well-known expert in performance and cost management.