ACTIVITY-BASED MANAGEMENT

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During the 1980s, many businesses started to introduce activity-based costing (ABC) systems. The aim of these
was to achieve a more accurate calculation of product costs. However, it soon became apparent that the
information that had been produced for activity based costing had much wider use than just calculating the cost
per unit of a product or service.

Activity-based management (ABM) can be defined as the entire set of actions that can be taken on a better
informed basis using ABC information. The aim is to achieve the same level of output with lower costs.

STAGES IN ABM
The initial stages in ABM are the same as for ABC, so these should be familiar from earlier studies:
1. Identify the activities that the organisation performs
2. Calculate the cost of each activity
3. Identify the activity cost driver for each activity.
Identifying the activities
Organisations perform hundreds, if not thousands, of different activities. It would not be feasible, or even
beneficial, to identify every activity that the organisation performs – so judgment will need to be used to identify
the significant activities; perhaps based on the amount of time that is spent performing them or based on the
expected cost.

Some organisations may try to define only high-level activities to keep the number of activities defined to less
than 30, while other organisations may define much more detailed activity lists. These activities may be
summarised in an activity dictionary.
The following list shows examples of some of the activities that may take place in a manufacturing organisation:

 Schedule production jobs

 Set up machines
 Receive materials
 Run machines
 Support existing products
 Introduce new products
 Calculate the cost of the activities
All indirect costs must be apportioned to the particular activities that they relate to using an appropriate basis.
Staff may be asked, for example, to estimate how much time they spend on each of the activities above so that
factory staff costs can be apportioned to the relevant activities. Other costs such as rent and heating and lighting
will also have to be apportioned. This is similar to the principle of allocating and apportioning costs to cost centres
in traditional absorption costing.

As far as ABM is concerned, simply having the information about the cost of each activity may be all that is
required. In the case of ABC however, it is then necessary to apportion the costs of each activity to the products
using the cost driver information.
Identifying the cost driver
The cost driver is the factor that causes the cost of an activity to vary. In traditional costing, it was always
assumed that the cost driver was volume of production, measured either in terms of the number of units, or a
proxy, such as the number of labour hours or the number of machine hours. In ABM however, it is recognised
that the cost of a particular activity may depend on something other than volume of output. In the case of sales
order processing, the costdriver may be the number of orders processed; so whether a sales order contains five
line items, or 10 line items, the amount of time to process it will be the same.
The cost drivers for the activities listed above may be as follows:

Activity Driver

Schedule production jobs Number of production runs

Set up machines Number of setups

 Activity Driver

Receive materials Number of receipts

Run machines Machine hours

Support existing products Number of products

Number of new products

Introduce new products introduced

ABC then apportions the costs of each activity among the different products that use them, based on the use of
the drivers by each product.
There are two main types of activity-based management:

1. Operational activity based management (doing things right) – this relates to making the organisation more
efficient by reducing the cost of the activities and eliminating those activities that do not add value.
2. Strategic activity based management (doing the right thing) – which essentially involves deciding which
products to make, and which customers to sell to, based on the more accurate analysis of product and
customer profitability that activity based costing allows.
OPERATIONAL ABM
One of the greatest advantages of ABM is that costs are categorised by activities rather than by traditional cost
categories. A simplified analysis of expenses from a traditional costing system may look something like this:

Cost of sales X

Staff costs X

Rent of factory X

Maintenance X

Depreciation X

Total costs X

ABM analyses costs by activity. For example:

Direct materials costs X

Direct labour costs X

Schedule production jobs X

Set-up machines X

Receive materials X

Support existing products X

Introduce new products X

 Total costs X

Having costs analysed by activity provides much more relevant information to managers. There may be activities
that are being performed that do not add value, so these can be stopped. Management may also identify
activities that cost more than expected, and can investigate these. Management might decide for example that
the cost of setting up machines is too high. Using their knowledge of the drivers of that activity, management
would realise that having longer production runs could reduce the cost of this activity as the number of set ups
would be reduced.

Many writers discuss using ABM to eliminate non-value added activities. Cooper and Kaplan claim that it is not
always clear whether an activity is value added or not. It might be argued for example that setting up the
machines is a non-value added activity, as customers do not value it. However, without setting up machines,
there can be no production. Instead, Kaplan and Cooper suggest discussing how efficient an activity currently is,
and therefore how much opportunity there is for improvement.
Use of ABM with other performance improvement strategies
ABM does not have to be used in isolation, and can be used alongside performance management improvement
strategies, such as Total Quality Management, Six Sigma and Business Process Reengineering, where the
information provided can support the projects.

In Total Quality Management, costs are analysed into costs of conformance (appraisal and prevention costs) and
costs of non conformance (internal and external failure costs). The aim of TQM is to reduce the costs of non-
conformance. Activity-based management enables organisations to more accurately calculate these quality
related costs and to monitor improvements.
Six Sigma, Business Process Improvements and Business Process Reengineering aim to achieve large one off
(discontinuous) improvements in particular business processes relating to efficiency and better customer
satisfaction. ABM can support these methodologies in several ways:
1. Identifying processes that need improvement and establishing priorities
2. Providing cost justification for proceeding with the project
3. Monitoring the benefits of the projects.
As far as establishing priorities is concerned, ABM enables management to identify which activities or processes
it is spending the most on, and where the biggest financial savings can be made. It can also identify activities
where management believe big improvements can be made. Typically these are the processes that are highly
fragmented, and involve people from many different departments.

Many business improvement projects may require considerable capital expenditure, and it will be necessary
therefore to do a cost benefit analysis to establish whether it is worthwhile going ahead. ABM can provide more
accurate information about the potential savings from a particular project, therefore leading to a more accurate
assessment.
After completion of a business process improvement project, many businesses do not measure the benefits
achieved by the project, and in some cases fail to take full advantage of them. For example, the project may have
reduced the amount of time spent on dealing with customer complaints, but have the excess staff members
whose time has now been freed up been re-deployed in other departments?

ABM models also provide information about cost incurred on the various activities, so it is easier to monitor how
much the costs of an activity have been cut by a particular project.
Example
A case described by Kaplan and Cooper related to a producer of technical manuals for the computer industry.
The company had run out of storage space in their main factory in South Street, due to a large amount of slow
moving inventory for their biggest customer, IBM. So additional storage space was rented in Elmore Street,
several kilometres away from South Street. After production, the manuals for all other customers were
transported to Elmore Street for storage. They would then be returned to South Street for despatch to the
customer when required. This was often only two or three weeks later.
The management knew that this movement of finished goods to and from Elmore Street was
inefficient. However, since the company used a traditional cost accounting system, the only visible cost relating
to this was the cost of transport – this was $200,000 per year. A solution to redesign the storage process in the
South Street factory for the fast moving goods, and to move the slow moving inventory to Elmore Street (or
destroy it entirely) was estimated to cost $600,000. It did not seem worth investing in this, given that the annual
saving would be only $200,000.
Activity based management was then introduced, and this identified that fact that the actual costs of operating the
inefficient system were much higher than expected. The annual savings of the proposed solution analysed by
activity were:
 $

Reduced rental expense 128,000

Reduced transport costs 271,000

Reduced costs of moving WIP within factory 38,000

Reduced costs of moving finished goods within factory 91,000

Reduced costs of finding materials 88,000

Equipment savings 27,000

Reduced cost of managing WIP 44,000

Reduced cost of managing finished goods 68,000

Eliminated use of outside warehouses 53,000

Total annual savings 808,000

This activity based information clearly gave management a much more accurate idea of the savings that could be
made by going ahead with the proposed solution, and since the required investment was $600,000 it was clearly
worthwhile.

STRATEGIC ABM
The first application of strategic ABM is to help decide which products or services to make. The use of ABC
enables the cost per unit of a product or service to be measured accurately and therefore the profit per unit can
be predicted. Many organisations find that when they rank their products according to total profit, it is typical that
20% of their products generate 300% of the company’s profits.[1] This means that between them, the remaining
80% of products lose 200% of the company’s profits. The loss making products are normally those that are
produced in low volumes, or require a high level of customisation.
While it may be tempting to suggest that all such loss making products should be stopped, there are two possible
dangers to such a simplistic decision. First, if 80% of the products were stopped, demand for the remaining 20%
might fall, as many customers prefer to buy all their requirements from one supplier. A second danger is that
even if the business were to stop producing the loss making products, the costs associated with them would not
all be saved.
A more realistic approach that can be used is to adjust the price of the loss-making products, or to employ tools
such as target costing to reduce the cost.
A second application of ABM is customer profitability analysis where overheads are allocated to customers using
activity based management processes to obtain a more accurate analysis of the profit or loss generated by each
customer. In traditional costing it is assumed that if a customer generates positive contribution, then servicing that
customer must increase the profits of the company. This ignores the fact that many 'fixed' overhead costs are
customer specific – such as the time spent by customer service departments.

Using ABM, overhead costs are also apportioned to customers using appropriate cost drivers, giving a more
accurate picture of how profitable each customer is. Such exercises have produced surprising results for many
businesses, where the 'best' customers have often turned out to generate losses when ABM is employed.
Example
In Hometown, there are several providers of electricity, and domestic consumers can easily switch from one
provider to another.
One of the providers of electricity is First Electric. The company recently had an aggressive advertising campaign
and increased its customer base from 30,000 users to 40,000. Management was surprised to discover that this
led to a fall in profits.
The company introduced customer profitability analysis, using activity-based principles. The analysis identified
the following activities, along with their cost per unit of driver.
 Cost per unit of
Activity Driver driver

Meter reading Number of visits $20

Customer service Number of calls $30

Invoicing Number of invoices $10

Customer complaints Number of complaints $25

The meter reading took place every three months, after which an invoice was issued.

For an 'easy' customer, the overhead cost per quarter was $30, the cost of reading the metre, and issuing the
invoice. More difficult customers could cost much more. Many customers were out when the metre reader came,
so a second visit was necessary. Sometimes the customer was not home second time either, so was requested
to read their own metre and then call the customer service centre.
Using this information, First Electric was able to analyse accurately the profit per customer. The company was
surprised to learn that it made a loss on 20% of its customers and only broke even on a further 30%.

In order to remedy the situation, the company made a number of changes. First, it reduced the number of meter
readings to once per year, and issued invoices based on estimated consumption for the other quarters of the
year. It introduced a website where customers could enter their own meter readings if they were not home at the
date of the reading, thus reducing the amount of time used by the customer service department. These actions
are examples of operational activity-based costing as they relate to reducing the cost of existing activities.

The company also made attempts to stop supplying loss making customers by increasing prices above those of
competitors, encouraging loss making customers to switch to other providers, while offering big discounts to
profitable customers, encouraging them to remain loyal. This is an example of strategic activity-based costing, as
it focuses on which customers the company should supply to.
Evaluation of ABM
The benefits of ABM (and ABC) are greatest in organisations that have high indirect costs. A major reason for the
increase in the use of ABC in the last 30 years has been the fact that as manufacturing processes have become
more IT based and sophisticated, overhead costs have increased, while direct costs, particularly labour, have
fallen.

ABC is most useful in organisations with a wider range of products, as it is these organisations that will have the
most difficulty in allocating overhead costs among different products.

ABM can be criticised for being too inwardly focused. It aims to increase profits by reducing the cost of the
activities that it already performs. It does not consider external factors, such as changes in consumer demand for
its product.
Users of ABM and ABC often assume that all overhead costs are variable. This is not the case, and some
overhead costs will be fixed, so will not be saved if activities are reduced.
ABM is also complex and is expensive to implement. For small businesses, or businesses with narrow product
ranges, the benefits of implementing ABM may not justify the costs.
Question
Note – this question is an abridged version of a question that appeared in the June 2013 Paper P5 exam.
Navier Aerials Co (Navier) manufactures satellite dishes for receiving satellite television signals. Navier supplies
the major satellite TV companies who install standard satellite dishes for their customers. The company also
manufactures and installs a small number of specialised satellite dishes to individuals or businesses with specific
needs resulting from poor reception in their locations.
The CEO wants to initiate a programme of cost reduction at Navier. His plan is to use activity-based management
(ABM) to identify non-value adding activities. The first department to be analysed is the customer care
department, as management believe that the costs of this department are too high. The costs for the most recent
year from the existing accounting system are shown in Table 1.

TABLE 1: EXISTING COST DATA

 $000

Computer time 165

Telephone 79

Stationary and sundries 27

Depreciation and equipment 36

707

The cost accountant has gathered information for the customer care department in Table 2 from interviews with
the finance and customer care staff. She has used this information to correctly calculate the total costs of each
activity.

TABLE 2: ACTIVITY-BASED DATA

Total
Staff cost %
Activities of department time ($) Comments

Handling enquiries and

preparing quotes for potential relates to 35,000
orders 40% 282,800 enquiries/orders

relates to 16,000
Receiving actual orders 10% 70,700 orders

done once an order is

Customer credit checks 10% 70,700 received

Supervision of orders through

manufacturing to delivery 15% 106,050

relates to 3,200
Complaints handling 25% 176,750 complaints

707,000

The CEO wants you to consider the implications for management of the customer care process of the costs of
each activity in that department. The CEO is especially interested in how this information may impact on the
identification of non-valued added activities and quality management at Navier.
Required:
Assess how the information on each activity can be used and improved upon at Navier in assisting cost reduction
and quality management in the customer care department. (12 marks)
Solution
The information in Table 2 shows that the main cost activities of the CC department are pre-sale preparation
(handling enquiries and quotes) and post-sale complaints handling. Together, these activities consume 65% of
the resources of the customer care department.
The pre-sale work is essential for the organisation and the department converts 46% (16,000/35,000) of enquiries
to orders. It would be beneficial to try to benchmark this ratio to competitor performance although obtaining
comparable data will be difficult, due to its commercially sensitive nature.

However, the complaints handling aspect is one, which would be identified as non-value; adding in an activity-
based management analysis. Non-value adding activities are those that do not increase the worth of the product
to the customer; common examples are inspection time and idle time in manufacturing. It is usually not possible
to eliminate these activities but it is often possible to minimise them. Complaints handling is not value adding as it
results from failure to meet the service standards expected (and so is already included in the price paid).

Complaints handling links directly to issues of quality management at Navier as improved quality of products
should reduce these costs. These costs are significant at Navier as complaint numbers are 20% (3,200/16,000)
of orders. Complaints may arise in many ways and these causes need to be identified. As far as the operation of
the CC department is concerned, it may cause complaints through poor work at the quotation stage where the job
is improperly understood or incorrectly specified to the manufacturing or installation teams. This leads to non-
conformance costs as products do not meet expected standards and, in this case, complaints imply that these
are external failure costs as they have been identified by customers

Quality of the end product could also be affected by the supervision activity and in order to ensure that this is
functioning well, the CC department will need to have the authority to intervene with the work of other
departments in order to correct errors – this could be a key area for prevention of faults and so might become a
core quality activity (an inspection and prevention cost).

The other activities in the department are administrative and the measures of their quality will be in the financial
information systems. Order processing quality would be checked by invoice disputes and credit note issuance.
Credit check effectiveness would be measured by bad debt levels.
Bibliography
Kaplan and Cooper, Cost and Effect, Chapters 6 to 10, published by Harvard Business Press 1998.
Nick Ryan is lead tutor for performance management subjects for Becker Professional Education
(Europe)

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Last updated: 18 Aug 2015