The New ABC

In theory, activity-based costing (ABC) appears to be a superior way of managing a company’s limited resources. But the tool has failed when applied to the real world scenario. Managers, faced with mounting costs had no other option than abandoning the tool. However, activity-based costing is again making a comeback in a new form. Robert S Kaplan, the brain behind activity-based costing along with Steven R Anderson, Chairman of Acorn Systems, a software and consulting firm based in Houston¹ has proposed a new version of activity-based costing called “Time-Driven Activity-Based Costing.” They have published a seminal article in the Harvard Business Review (November, 2004) providing insights as to how the latest version of the tool can be best used. They argue that the new model solves the implementation issues and also provides managers with a flexible cost model that captures the complexity of a company’s operations. The model is time-based, involving calculation of the cost of one minute of overhead, which is then used to decide how much of this time each activity uses.

Why Traditional ABC Failed

When activity-based costing was first introduced in the 1980s, it immediately caught the attention of corporates. Clearly, everybody was aware that the traditional approach to allocating overheads was defying rational thinking. In the traditional model, all the overheads were spread out over a group of products or divisions basing on rough estimates, which is clearly a flawed thinking. ABC then offered a perfect and logical solution to this problem. The overhead costs under ABC were allocated to different activities that use them. It came as a great relief for managers and there was a stampede among corporates to implement ABC in their operations. Corporates of the 1980s and 1990s were obsessed with the short-term improvements of the financials. Managers used ABC as a short-term application and failed to follow an ABC initiative till the end. They considered it as an improvement program like six sigma or business process reengineering. It became a sort of project-of-the-month. Gary Cokins, Director of Industry Relations at ABC Technologies comments1 that some organizations have dismissed ABC because, in their initial attempt, the accountants over-engineered the size and detail well beyond diminishing returns for the extra level of administrative effort.

Time-driven ABC

No matter what the critics of ABC say, no one can deny that ABC has helped many companies in identifying cost and profit enhancement opportunities. The traditional ABC requires managers to assign resource costs first to activities and then to products or customers. But under the new model, managers directly estimate the resource demands imposed by each transaction, product or customer.

Estimation of the Variables

While traditional ABC extensively used surveying method is to estimate the time spent by employees, under the new method, managers estimate the practical capacity of the resources supplied as a percentage of the theoretical capacity. Kaplan and Anderson propose various ways to do this exercise. One method is to apply the rule of thumb wherein managers assume that the practical capacity is 80 per cent to 85 per cent of the theoretical full capacity. For example, if an employee or machine is available to work 48 hours per week, which is the theoretical capacity, the practical capacity becomes 38 to 41 hours. Another approach, which is more systematic, is to review past activity levels and identify the best productive month. Time-driven ABC does not restrict the measuring of capacity in terms of time availability. The capacity of a warehouse can be estimated by the space provided and subsequently the cost per cubic meter.

Once the cost per time unit of various resources is calculated, the next task for managers is to determine the time it takes to carry out one unit of each kind of activity. The requisite data can be obtained through interviews with employees or by direct observation. Managers should note that what they have to determine is not the percentage of time an employee spends doing an activity but the time duration for the completion of the activity. After the estimation of the cost per time unit of capacity and the unit time of activities, the cost-driver rates can be calculated by multiplying the two variables. These cost-driver rates can be applied to assign costs to individual customers as and when transactions take place.

Analyzing and Reporting Costs

Kaplan and Anderson claim that the time-driven ABC enables managers in reporting their costs on a continuing basis by revealing both the costs of activities and the time spent on them. This, in essence means that the difference between capacity supplied

and the capacity used gets highlighted. Kaplan and Anderson argue that armed with this information, managers can review the cost of the unused capacity and initiate necessary actions to determine whether and how to reduce the costs of supplying unused resources in subsequent periods. The information in some cases can aid companies from making unwarranted investments in raising the capacity.

Conclusion

Although Kaplan and Anderson argue that this form of activity-based costing provides managers with meaningful cost and profitability information, quickly and without much expenses, if the tool fails to solve the practical problems of the initial version of ABC that may well mark the sad end of one of the supposedly brilliant management ideas of the 1980s.

References

“Time-Driven Activity-Based Costing” by Robert S Kaplan and Steven R Anderson, Harvard Business Review, November 2004.

“Easier than ABC”, The Economist, October 23, 2003

1 Activity-Based Costing: Optional or Required? By Gary Cokins. www.aacei.org