Learning the ABCs of cost analysis

One way to make better business decisions is to view the costs of products and services with activity-based costing. Known as "ABC," this proven method may change the way you do business. This article will show you how it's done.

By Bradley S. Litt

Determining the costs of a project is no longer as simple as figuring out what you'll pay for parts and labor. For today's complex businesses, the bottom line is often difficult to draw—especially with traditional accounting processes.

Activity based costing (ABC) is an alternative accounting technique that utilizes cost attachment rather than cost allocation to determine the actual cost of products and services. While not a new concept, ABC is quietly changing the way organizations view and manage their business. Although ABC is only data, it has the ability to clearly define the critical attributes of today’s business processes. Through data, ABC is able to act as an enterprise-wide change agent, enabling organizations to build awareness, make better decisions, and effectively support enterprise-wide improvement initiatives.

By using this technique, you may find that ROI calculations and cost/benefit analysis are as easy as “A-B-C.” We’ll talk about how ABC works, and I’ll give a little background on why traditional accounting approaches fall short with today’s complex projects.

What’s wrong with traditional accounting approaches?
Until recently, corporate accounting was the last place an operational manager would look for help in accessing the health of a business process. Over the past decade, as the complexity, variety, and diversity of business has escalated, the cross-functional behavior of business processes and the shifting patterns of cost have left traditional approaches to process and cost/benefit analysis distorted and grossly inadequate.

In addition, traditional accounting systems generally exist to satisfy external reporting requirements, not internal project metrics, and usually fall short in helping project managers detect process-related problems or potential solutions.

As businesses have become more complex, the elements of cost/benefit have shifted and become mixed. Overhead costs are replacing the direct costs of labor and purchased materials. These overhead costs increasingly comprise technology and the specialists who are needed to sustain the gains in productivity and manage the complexity of production. As managers attempt to understand and manage cross-functional business processes, organizations are finding that traditional approaches for managing these costs are ineffective.
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Processes-oriented paradigm
The real beauty of an ABC model is that it forces organizations to adopt a cost-management paradigm that focuses on understanding their processes. Once an organization accepts this paradigm, they soon recognize that their products or services are produced through cross-functional business processes and not functional silos.

These processes contain a wide variety of activities that not only define the process, but more importantly, reflect how effectively the process performs. It is these activities that actually consume organizational resources (cost). They are the central focus and foundation of ABC.

Without an effective focus on activities, ABC would be just another cost accounting system.

Focus is on activities
Focusing on activities rather than departments or functions makes it possible for ABC to provide the information necessary to not only effectively manage business processes but also to improve them. Ensuring that a business process runs smoothly is critical in maximizing the perceived and actual value your customers receive.

As a result, it's not uncommon for organizations beginning an ABC implementation to simultaneously be involved with improvement initiatives centered on defining and measuring core business processes and related activities.

Another way ABC adds value is that it avoids two significant problems associated with traditional cost allocation methods:
  1. Misallocation of cost
  2. Masking of the true drivers of cost

Within an ABC implementation, business processes are mapped to ensure that the appropriate boundaries for each process are defined. Through this mapping process, activities and associated drivers are identified and their relationships tested. This verification process ensures a concise attachment and not an allocation of cost to processes and products.

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The values of ABC
While ABC can be complex and confusing, organizations can reduce the complexity by building a strong process orientation through the definition and mapping of core business processes prior to introducing ABC. Studies have found that companies with a strong cross-functional process orientation tend to experience fewer false starts and less anxiety with their ABC implementation. Not only are the implementations more successful, but the organization as a whole is better prepared to understand the basic structure of ABC.

From a strategic perspective, ABC’s value lies in its ability to correct product-cost distortions. Once product-cost distortions are corrected, organizations can better understand which products are actually profitable and adjust pricing and product lines accordingly to maximize profitability.

From an operational perspective, ABC’s value can be found in its ability to link up-to-date financial metrics of resource-cost consumption to improvement processes. Managers who understand ABC realize that accurate, relevant cost data enables them to identify and achieve innovation and continuous improvement.

The strength of ABC is its ability to measure and organize data at an extremely fundamental level where the resource consuming activities are actually performed. ABC also makes it easier to understand variable cost behavior and cost-of-quality for activities and processes. Finally, ABC can provide project managers with accurate cross-functional cost data ensuring reliable cost related decisions and consistent monitoring throughout their projects.

This article was originally published by gantthead on April 18, 2001.

Bradley S. Litt is a principal and founding partner of Strategic Business Solutions, Inc., an Iowa-based management consulting firm. Prior to forming Strategic Business Solutions, Inc., Litt worked with a number of national consulting firms, spending the last three years as a principal with the Business Process Reengineering Group (BPRGroup). He has provided consulting services to the financial services industry for the past 15 years.

Do you use ABC?
What results have you experienced using ABC? What’s the biggest drawback? Post a comment below or send us a letter.


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