The Waste of Activity-Based Costing (ABC) in the Service Sector
- October 26th, 2009
- Posted in Systems Thinking Concepts
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During my lifetime I have witnessed two attempts at Activity-based Costing (ABC). For those unfamiliar this is an approach that flowcharts processes (activity) and then totals the costs of these activities. Seems a reasonable approach to anyone trying to manage costs and productivity.
The method deployed is to interview workers involved with the process and find out how long each activity takes and what percentage of their time is attributable to each activity. Each worker is allocated indirect costs (overhead) for things like lease expenses, information technology, human resources, etc. The result is an activity cost.
The flaw of ABC is to assume that being active is being productive. As managers like the idea that workers being active 100% of the time is to be efficient. Such thinking brings the human robot to mind.
My personal experience has been attempts by accounting organizations coming in and doing organization-wide ABC. The problem was at the end of the ABC exercise, I summed up the activity costs multiplied times the volume of actual activity and the costs did not come close to the organization’s total costs. This was problematic, but by no means the end.
ABC treating all activity as work to be done ignores failure demand (demand from customers caused by failure to do something or do something right for a customer), duplication, errors, etc. This is to manage costs instead of the causes of costs.
Where costs are high to deliver service, organizations still need to understand customer demand and the reasons for waste before making changes to the organization Or they run the risk of making things worse. To set targets for a piece or function of the process ignores the understanding of the end-to-end system and purpose.
If a function or process is deemed too expensive it stands to be paid attention to by looking for cheaper outsourcing or shared services opportunities. These also lead to increased costs as it disregards the end-to-end costs and waste that are not seen in the activity as already illustrated above.
My Vanguard partners in the UK found that the inventor of ABC Thomas Johnson changed his mind about the benefits of the technique after spending time at the Toyota plant in Georgetown. He came to his senses regarding the foolishness of managing through costs. My hope is that the US government and other private sector businesses will come to the same conclusion. Millions are being wasted by conducting and taking action on the ABC approach.
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Tripp Babbitt is a speaker, blogger and consultant to service industry (private and public). His organization helps executives find a better way to make the work work. Download free from www.newsystemsthinking.com “Understanding Your Organization as a System” and gain knowledge of systems thinking or contact us about our intervention services at [email protected]. Reach him on Twitter at www.twitter.com/TriBabbitt or LinkedIn at www.linkedin.com/in/trippbabbitt.
I couldnt agree more BUT… you have not mentionned the new way of doing ABC and that is the Time-Driven Activity-Based Costing methodology which basically eliminates most of the previous ABC pitfalls and add the possibility to replicate a dinamic and in constant change enviroment. I did apply it to the project I am currently working with sucess and we are now for the first time able to measure and control our cost-to-serve and price non-compliance to our clients. If you find the time have a look to the new forum on the TDABC methodology – http://timedrivenabc.com Best regards, Miguel
Miguel: Thank you for the comment I think you are missing the point here. The focus on costs, increases costs. A management paradox. Costs are in the flow, economies of flow (http://bit.ly/3xSOSh). Regards, Tripp
Tripp, You’ve missed the point completely. ABC, done right, isn’t about a new/different way to manage costs. It’s a very effective way at measuring and managing value tied to customers. Research from Harvard, as well as others, shows that 20% of customer accounts now contribute 250%+ of EBITA (has been getting worse not better over the last 30 years). That’s a massive problem. Organizations can not manage margin on customer accounts if it is not being effectively measured. Activity tracking should be automated and not a one time event. Ongoing automated, measurement of activities (and inactivity) in business processes tied to customer interactions allows an organization to proactively manage margin against individual customers as the revenue to cost mix changes. How’s 350% increase in profitability in less than year for effective? This increase was through smarter business management, not the short-term slash and burn techniques that cost consultants have been recommending for years, which, in turn, have been destroying the long-term business success and survival of organizations. Who was the rocket scientist that every came up with the business strategy of shrinking to greatest anyhow? If the data is looked at careful, it is very clear that shrinking to greatness has destroyed many more businesses that it has saved. And, even those that are saved, less than 1% reclaim their glory – the tail is wagging the dog. Jeff
On the one hand you are entirely correct. If you invest time to look at costing, you have incurred costs. If you don’t subsequently make savings to at least equal the investment then it was a waste of time. But this is trivial and applies to any efficiency initiatives. Just because you analyse something does not mean you do it differently. Ten years ago I was shown some statistics showing customer satisfaction after implementation of IT solution driven efficiency tools. ABM tools were a subset. There was an across the board 60-70% dissatisfaction rate, which does not mean that these were all a disaster – only that the expected returns did not materialise. I’m curious about the following comment: -”The problem was at the end of the ABC exercise, I summed up the activity costs multiplied times the volume of actual activity and the costs did not come close to the organization’s total costs.” First let me say that I’m sure you know that the ABC model is a fully costed modelling system. I know this because later you mention the fact that ABC model disguise the inefficiencies. If you built an ABC model using the standard methodology and failed to reach the organisations total costs then you either failed to account for all the activities or all the costs. Now I’m not too bothered by this because most ABC modellers will take steps to identify controllable costs. Techniques include 1. Identifying fixed and variable 2. Identifying mandatory and discretionary expense 3. Identifying spare capacity (assigned or not) (structural, maintenance, quality etc) 4. Identifying consumption differences (eg. Cooper Kaplan hierarchy of cost – Unit Batch Product etc) 5. Fault ratios/rejection rates etc. All of these techniques being designed to go beyond understanding what things cost to understanding which costs can be managed down. The quote above hints that you deliberately built your model to ignore the inefficiencies. That instead of building a full absorption you only assigned costs to activities if that cost could be justified by optimum operation. Perhaps I read too much into the statement but certainly that is the way to progress. ABC can capture the cost of waste and inefficiency within a process. Frankly I can’t understand how you would begin to eliminate this without understanding how costs are absorbed (wastefully or otherwise). I do understand that many ABC models are not fit for purpose. Many times I have seen models that are built without an understanding of what they were supposed to achieved. We all know the “so what model”. Most clients are completely unaware that a model intended to facilitate process improvement will not be the same as a model designed to assist product rationalisation, or a model to support CRM. Mostly importantly, having a model is no guarantee that the organisation will actually take steps to change itself. Change after all is difficult but that’s a different subject. PS: Some people including Mr Kaplan might wonder at the solo credit you grant Thomas Johnson regarding the invention of ABC
All: You miss the point. Let’s be clear, I did not build any of this where ABC was used . . . I was a participant and/or observer To focus on costs is to increase them, no matter what action you take. In fact, you would be better off taking no action or better never starting the project as I outline in the post. Costs are in the flow, and to understand the flow is to get to the design and management of the work . . . the causes of costs. The point here is that there is a more effective way than focusing on costs. PS. I am sorry for leaving Mr. Kaplan out as I am sure he will be happy to take credit for a bad idea.
I would like to say that i have implemented ABC rather TDABC in service industry and its very much successful. i have answer to all of your queries that you have raised in the discussion. 1.Talking about 100% efficient. In TDABC approach, i calculated the time utilized and time unutilized cost center wise. This can be done by calculating available time of the cost center by summing up every one’s available time. Then find out the time utilized by the employee’s of the cost center in the tracking of the activities. By this way u can find out time remained un-utilized. I have done it for company wise by FTE concept and utilization rate for almost 30 cost centers through out the company. 2. Cost of calculating activity wise total cost which is not equal to the company’s total cost According to your concept, u r missing the shared services and services utilized by all the departments which are provided by shared services to all other departments. 3. Ignoring failures, damages and other non value addition activities In this case, u r still missing the concept of clean cases and rework cases. A clean case is a case where the activity is being done at once. If the activity is being repeated then its a rework. Its a non value addition to the organization and time spend on the rework can be evaluated in calculating cost available to use. Also there r many failure stories where the concept is not being implemented properly or not understood properly.Not to blame the failure and celebrate about the success stories. Regards Jitesh [email protected]
I am not interested in doing ABC better or new methods (TDABC), The problem here is the focus is on costs and activity. To focus on costs increases them. We need to focus on the causes of costs and they are in the flow end-to-end from a customer perspective.