Here is a simple way to understand the basic principles of activity-based cost management (ABC/M). Imagine that you and three friends go to a restaurant. You order a small salad and they each order the most expensive item on the menu and a glass of wine. When the waiter or waitress brings the bill the others say, “Let’s split the check evenly.” How would you feel? You would feel this is unfair and inequitable.
This is similar to the effect on many products and service lines in the cost accounting system when the accountants take a large amount of indirect and shared expenses (i.e., overhead) and allocate them as costs without much logic. There is little or no relationship to how the products or service lines uniquely consumed the expenses. This is inequitable and unfair to each product’s or service’s cost. It is somewhat like taxation without representation.
ABC/M gets it right. In the restaurant example, ABC/M is equivalent to the waiter or waitress providing four individual checks—you are charged for only what you individually consumed.
Allocating costs using broad averages is flawed, inaccurate, and misleading. The calculated costs of outputs will accurately reconcile in total for the organization, but not for individual pieces. Unfortunately managers have little choice but to go along with these flawed costs. ABC/M resolves this problem by proportionately tracing activity costs to outputs, products, or services using factors, referred to as activity drivers, that reflect cause-and-effect relationships.
From the spending view to the activity and output view
When managers receive their monthly responsibility cost center report, they are either happy or sad but they are rarely any smarter! ABC/M extends the minimal information in the departmental spending reports to make managers and employee teams smarter. This extended information is then used for making decisions—better decisions than are made without the ABC/M information.
Let’s add some more realities to this description of government and defense organizations as service providers by including the key players:
- The civil service employee or military member might simply prefer the status quo
or whatever may be a little bit better for him or her; - The taxpayer prefers to be taxed less;
- The user of government services desires more and higher quality service; and
- The functional manager is defending the existing level of his resources and fiscal budget.
It is a no-win situation. Something has to give. The combination of these disparate interests creates tension and conflict. How does one untangle the knots? Untangling is difficult when the primary financial view that is used by management only shows spending for resources. There must also be an equivalent financial view of the outputs. Questions and discovery begin when the costs of outputs, including their per-each-unit cost, can be made visible and compared. A more reasonable discussion about spending levels occurs when you can equate the spending and what the service recipients get for the spending with the costs of outputs and outcomes.
Outputs are the linkage to the external recipients, such as citizens, as well as to the internal work activities. An ABC/M information system provides visibility to all of these relationships (and even more with the additional capability to score or tag costs with ABC/M’s “attributes”, such as value-added versus non-value-added costs, which will be described in a following article).
ABC/M is a cost assignment network
Many accountants are satisfied if the input spending expense reconcile in total with calculated output costs. To them the total cost is all that matters, and any arbitrary cost allocation can tie out to the total.
Figure 2 describes how ABC/M solves this problem. The left side shows the classic monthly report that responsibility cost center managers receive from the general ledger accounting system. Note that the example used is a back-office department of a license bureau, such as for driver or hunting licenses. It is a factory, too, only its outputs are not tangible products but documents. This is to demonstrate that, despite misconceptions, indirect white collar workers produce outputs the same as factory workers do. You can substitute any department, government or commercial, for the license bureau department in the example and the lessons will hold.
Copyright 2013 Analytics-Based Performance Management LLC
Figure 2 – The language of ABC/M
The cost center expense report provides no insight to what managers can control or influence. It only displays what they spent. However, when you translate those “chart-of-account” expenses shown under the general ledger or fund accounting system into the actual work activities that consume these expenses, a manager’s insights begin to increase. The right side of Figure 2 is the ABC/M view. It is the starting point for calculating the costs for diverse outputs, such as services. ABC/M resolves the deficiencies of traditional financial accounting by focusing on work activities and their outputs as costs.
Another key difference lies in the language used to depict cost allocations (i.e., absorption costing). ABC/M describes activities using an action verb-adjective-noun grammar convention, such as “process building permits” or “open new taxpayer accounts.” This gives ABC/M its flexibility. In contrast to a general ledger’s spending accounts, ABC/M’s wording is powerful because managers and employee teams can better relate to these phrases. ABC/M’s wording implies that the work activities can be favorably affected through change, improvement, or elimination.
The structure of the general ledger and fund accounting system is restricted by cost-center expense mapping to the hierarchical organization chart. As a consequence, this type of reported information drives vertical and hierarchical behavior, not the much more desirable process behavior that customers and citizens consume. In effect, with traditional accounting systems, public sector managers cannot see the costs that belong to their end-to-end workflow processes—and what is driving those costs.
How do cost drivers work?
Additional information about what drives costs can be gleaned from the right-side view of Figure 2. Look at the second activity—“analyze licenses,” at a total cost of $121,000—and ask yourself what would make that cost significantly increase or decrease. The answer is the number of licenses analyzed. That is that work’s activity driver. Figure 2 illustrates that each activity on a standalone basis has its own activity driver. At this stage, the costing is no longer recognizing the organization chart and its artificial boundaries. All the incurred expenses, regardless of their department, have been combined into the work performed. The focus is now on the cost of that work and on what influences and affects the level of workload on the activity.
The right side of Figure 2 then completes the costing of the final cost objects (e.g., products, services, and citizens) similar to my restaurant example of ABC/M. Each final cost object proportionately consumes each activity cost based on the volume or quantity of the activity cost driver. The total $914,500 of inputs is translated into $914,500 of outputs. This reassignment of the resource expenses is much more accurate than with traditional accounting systems that use broad averages. This is because ABC/M complies with costing’s causality principle.
To summarize, the general ledger and fund accounting chart of accounts view only answers “what was spent?”, whereas by transforming expenses into calculated costs in the next two views, there are more valuable and useful answers to the questions “why was it spent?”, “what caused the rate of spending?”, and “who or what was it spent for?”
ABC/M’s cost assignment network demonstrates that all costs actually originate with the ultimate end user, service recipient or beneficiary of the work. Examples of the origin of costs could be a citizen, welfare recipient, new homebuyer seeking permits, or another government agency relying on those services. This is at the opposite end from where accountants who perform “cost allocations” think about costs. The destinations, usually outputs or people, place demands on work, and the work in turn then draws on the resource capacity (i.e., the spending)—hence the costs measure the effect by reflecting backwards through the ABC/M cost assignment network. When expenses are expressed as activity costs, they are now structured in a different format that enables them be traced into output costs.
The modern movement toward managing with a process view has created a growing need for better managerial and costing data. Managing processes and managing activities (i.e., costs) go together. By current definition, a workflow process comprises two or more logically related work activities intended to serve end-receivers and beneficiaries; thus, a means of integrating processes, outputs, and measured costs has become an even more important requirement for managers and employee teams. ABC/M data provides a logical way to visualize and report on these linkages.
ABC/M resolves the structural problems inherent in the general ledger and the fund accounting system by first converting account balances into activity costs. ABC/M then assigns the activity costs to cost objects or reassembles the activity costs across processes. This new and transformed cost data can be used to identify operating relationships that are key to making good decisions affecting products, service lines and customers.
This is the second article (Part 2 of 4) in a four-part series based on the book, Activity-Based Cost Management in Government by Gary Cokins (Second Edition; Management Concepts, 2006, ISBN 978-1-56726-181-3).
