Make  Decisions That Count

Good managers focus on developing and implementing successful strategies. They don’t take high performance for granted. They ask the right questions, test the best ideas, and make only those decisions that are proven to improve the bottom line.

Testing and adopting the best ideas is dependent on use of performance tools and the quality of the analysis using these tools.  Some organizations lack a culture and tradition of fact-based analysis and decision making. Others rely on outmoded approaches to decision making that are inaccurate and may result in missed opportunities or decisions that appear profitable but in reality reduce the bottom line. Our experience shows that the “profit gap” left on the decision table is 400% or more of current profits.

The Five Steps to Profitable Decisions

1.      Identify the top sources of increased profits

The first step is to identify the biggest potential sources of increased profit. These are the areas where good decisions count. Specific areas for each company will vary depending on the nature of the business, current business performance, competitive conditions, and the strategic direction of the business. They include lines of business, market segments, channels of distribution, customers, product mix, pricing, marketing initiatives and buckets of cost.

In some cases the areas of greatest decision impact will be easy to identify. High level analysis of current performance versus strategic goals will find some obvious targets. This analysis can be done very quickly. If information is required to pinpoint action areas, more analysis is necessary. This additional analysis will reveal hidden opportunities to increase profits. For example, a high level profitability model can reveal market segments that are destroying profits. This profitability model can be built in 60-90 days and may lead to immediate decisions that increase profits.

2.      Evaluate how decisions are made

Effective decision making is dependent on the sources of decision information and the ease of making decisions using this information. It is heavily influenced by the use of performance measures to guide and reward decisions.

If the primary (or exclusive) source of financial information is the accounting system, decisions will likely result in significant profit destruction. This is because the primary purpose of an accounting system is financial reporting. Accounting was not designed to provide information about the sources of profits. Here are some examples of the negative impact on decisions:

• Decisions on product and service mix and price are affected by inaccurate and incomplete product costs. This is because manufacturing companies use standard costs as the measure of product cost, and standard costs are notoriously inaccurate. Service companies are not required by generally accepted accounting principles to have product costs, so often have no cost measures to use in decision making. 
• Except in aggregate, financial systems do not report the cost of market facing activities such as customer acquisition, advertising and channel support costs. Decisions regarding market segments, channels and customers therefore lack relevant cost information. Customer relationship management (CRM) systems include lots of information about customers, but usually do not report the cost to serve each customer or customer group. 
• Financial systems report cost by account by not by process or objective. Accounts—such as depreciation, salaries, office supplies etc.—provide no information about the state of the underlying business purpose. If salaries are decreased in an effort to improve profits, will this benefit the business or hurt the business? Does spending contribute to the accomplishment of strategic objectives? It is not possible to answer these questions using cost information from the financial system.

The ease of making decisions is dependent on the availability of decision tools and timely access to decision information. For example, in a company with several distribution centers, an important decision is the choice of the distribution center to serve a particular customer. This complex decision may involve manufacturing costs, shipping costs, material handling costs, taxes and tariffs, and the costs of meeting customer requirements. In the absence of an optimization model that takes each of these cost elements into account and determines the correct solution, it will be difficult if not impossible to determine the lowest cost alternative.

Difficulty obtaining information can have a negative impact on decisions. Relying on out-of-date information in a rapidly changing business environment may result in the wrong decision. Delays obtaining information will lengthen the time it takes to make a decision, increased analytic effort will increase cost, and decisions may be made by necessity without the insights derived from the information.

3.      Close the decision gap

Closing the decision gap, and focusing decision outcomes on profit improvement, requires ready access to decision relevant information and tools. Such a system typically includes cost and profitability management models, decision analysis and optimization tools, and desk top access to up-to-date relevant information and tools. 

Cost and profitability models are designed to report the exact information needed to make critical profit enhancing decisions. They differ from financial accounting by their use of activity-based costing (ABC) modeling techniques and scope of analysis. They also leverage the billions of transactions in computer systems to create a rich repository of cost and profit information. When fully automated using data integration tools, these models allow decision makers to focus their time on decision analysis rather than data entry and spreadsheet manipulation

Decision analysis and optimization tools help decision makers derive meaning from the information in the cost and profitability models, and determine the decision outcomes with the highest likely profitability.  For example, using analytics it is possible to determine which customers are the most profitable over an extended period of time and when adjusted for risk. Based on this analysis, marketing initiatives for customer acquisition and retention and up sell can be targeted to these profitable customer groups.

Desk top access to decision relevant information and tools increases the impact of decisions on profitability. In such a system each decision maker uses a portal to access the information he or she needs for decision making. Standard reports, refreshed to reflect the most recent information, are supplemented by queries into the profit information data bases to combine and report specific types of information. Projections of profitability, pricing models, cost minimization and other optimization techniques are available as needed from the portal.

4.      Change the performance measurement system

In a perfect world managers would automatically change their approach to making decisions based on the availability of information about the sources of profitability and use of decision making tools. In reality, lack of enthusiasm for analytic approaches and inappropriate measurements may be barriers to adoption and execution.

Analytic approaches to decisions that focus on profitability benefit from management commitment. Sometimes this comes down to culture—some organizations are immersed in fact-based decision making, while others follow a more intuitive approach. If top management incorporates analysis in key decisions, it is likely that the rest of the organization will follow their example.

The availability of information about the sources of profitability will not be enough if managers are evaluated and rewarded based on non-profit measurements.  For example, one company implemented a profitability management system but found that sales did not use the system to determine what to sell and how to price the product. This was because the sales force was compensated based on sales revenue.  A change to compensation based on net profit margins saw an immediate response, with product mix changing dramatically in the month following the change.

Adding objectives and measures of profitability to scorecards is a great way to focus attention on making profitable decisions. In a balanced scorecard, measures of customer, segment and channel profitability can be added to the customer dimension. Measures of cost can be added to the process dimension to focus cost improvement efforts. The balanced scorecard also helps focus decisions on improving long-term profitability rather than actions that favor short term profits.

5.      Track the results

It is important to measure the success of profitability management. Tracking results reinforces the emphasis on fact-based decision making and the positive impact of decisions on the bottom line. It also encourages improvements to the profitability management system to strengthen the program.

While it may not be possible to track the impact of every decision, it is feasible to measure the success of the key profit initiatives that account for 80% or more of the improvements in profitability. What was the increase in segment profits resulting from a new negotiating strategy using accurate measures of customer profitability? What was the return from investing in customer retention activities? What were the cost savings from replacing vehicles in the fleet based on minimizing the lifetime cost of equipment ownership? The returns from these and other initiatives can be accumulated to provide an overall measure of success of profitability management. For most companies the return will be significant.

Conclusion

Twenty five years of research and implementation of profitability management systems confirms that many companies have hidden pockets of unprofitability and profit opportunity. With the right information and tools, and systems to support and motivate profitable decision making, it is possible to increase profits by 400% or more. This increase is derived from making smarter decisions. It is possible without the heavy lifting and cost associated with initiatives to increase sales or reduce costs.

There are five proven steps to smarter and more profitable decisions. The first step is to understand where the profit increases will comes from and focus efforts on those areas. The second step is to assess how decisions are made and identify gaps in the type of information and tools that are used to make decisions. The third step is to implement a profitability management system that makes it possible and easy for managers to find and exploit the hidden opportunities to increase profits. The fourth step is to bring the performance measurement system into line with the new emphasis on profitable decisions, providing managers the motivation to make decisions that increase the long-term profitability of the company. The fifth and final step is to score the results of the new profitability management system and decision emphasis. This reinforces the success of the program and provides impetus to continue and improve profitability management.

Together, the continuous improvement of products and processes and the financial insights that can be gained from activity-based costing (ABC) have become widely recognized as important ways to gain competitive advantage. Continuous-improvement programs are multifaceted, but they usually include steps to eliminate waste, reduce response time, simplify product design, and improve quality. To support these efforts, ABC provides valuable economic information to guide product strategy and process change.

Early examples of ABC demonstrated a superior ability to report more accurate product costs in environments characterized by product variety and batch-size diversity (i.e., in settings where large numbers of different products are manufactured in a wide range of production lot sizes).

The Schrader Bellows case
The Schrader Bellows case, for example, described an ABC system for a plant with over 2,000 products (representing about 20,000 components) and batch sizes that varied from one to tens of thousands. Schrader Bellows committed resources toward many activities supporting the production of batches of product, such as setup, first-piece inspection, and material movement. The traditional standard cost system failed to attribute cost to batches of products. Therefore, the conventional system reported product costs that were markedly different from those reported by the ABC system.

The ABC system provided insight into Schrader Bellow’s strategic capabilities. The company did not have the capability to manufacture many end items in small lots. Like most firms, Schrader Bellows had two basic alternatives in response to this type of insight. One was to drop or re-price unprofitable products and the other were to reduce the cost of producing these products.

Specifically, the company could either change its product strategy or change its strategic capability. Changing product strategy requires either increasing prices or narrowing the scope of products offered. Changing strategic capability, on the other hand, requires continuous process improvement of the value chain or improvement of product design.

Unfortunately, adapting product strategy to competitive pressure is much easier than altering strategic competitive pressure is much easier than altering strategic capability. One of major lessons of the continuous process improvement is that altering product strategy competitive pressure is a short-term solution at best. A firm can give up markets or increase prices. By doing so, the firm may benefit in the short run, but the wellspring of a firm’s strength lies in a superior ability to contribute value to customers. This ability comes from constantly increasing strategic capability.

Impact of Continuous Improvement
Increasing strategic capability through continuous improvement reduces the importance of the factors that made ABC successful at Schrader Bellows. Continuous-improvement programs include actions that reduce or eliminate batch-level activities, reduce batch size, and diminish nonfunctional differences between products.

Continuous process improvement yields reductions in the time required to perform batch-level activities. The length of time required to set up a machine, for example, may be reduced from many hours to just several minutes. This task can be accomplished by doing the following:

• Improved training;
• Eliminating conflicts in workers’ assignments;
• Driving setup time off-line; and
• Placing tools and dies in more convenient locations.

Such efforts can be extremely successful at reducing setup time and costs. Over a five-year period, for example, Toyota reduced the setup time for 800-ton stamping presses from more than one hour too less than 12 minutes.

Some batch-level activities, such as those associated with incoming materials, may be completely eliminated by continuous improvement. The inspection of materials for quality defects, for example, may be eliminated if the vender is able to deliver materials exhibiting statistical control. The following may also eliminate receiving, moving, and storing activities:

• Having venders deliver materials directly to where they are used on the production line; and
• Reducing the distances between adjacent work centers from hundreds of yards to a few feet.

Reductions in batch size. The reduction or elimination of batch-level activities creates opportunities for a reduction in batch size. It is no longer necessary to maintain large batch sizes to spread the high cost of batch-level activities over a large number of units. In the extreme, it is possible to produce and sell in lot sizes of one at the same unit as with lot sizes of one at the same unit cost as with lot sizes of 1,000 or more. This change is a positive development because small-lost sizes lead to improved quality, flexibility, and responsiveness to customers. Process changes can, therefore, have a significant impact on the design of ABC systems, which is a subject discussed in the following pages.

Eliminating nonfunctional design differences. Continuous improvement not only improves processes by eliminating the economic significance of batch size but also improves products. This improvement is accomplished by reducing differences between products that are not the result of functions that customers define as critical. The objective is to design products with minimal nonfunctional differences. Products may be designed, for example, to eliminate nonstandard components and subassemblies that do no add features required by the customer. As a result, imposing a common basic design across product lines can eliminate many individual parts.

As another example, package goods manufacturers produce products in a number of sizes. These varieties of size are customer-driven requirements, so they represent functional product differences. The package design engineer, however, can impose commonality in packaging specifications by using with common rounds. Common rounds refer to the diameter of the container bottom: The key is to accommodate size differences in the height of the container, not the diameter, because package lines must be set up a given diameter. Size changes by diameter necessitate expensive line changeovers whereas size changes by height are relatively simple.

The reductions in nonfunctional product differences simplify the entire production process. Products that are functionally different but virtually identical from a design standpoint share process and support activities. Economies of scale on common activities are realized as production is organized around “families of products” or common subassemblies.

Low-cost product variety. Firms whose continuous-improvement programs are well advanced may increase the variety of their products. The ability to produce in small lot sizes and the simplification of product design reduce the cost of producing a wide range of products. Low-cost product variety (which is essentially the ability to provide customers with virtually customer products) is the ultimate strategic capability derived from continuous improvement.

Having identified the impact of continuous-improvement activity on the firm’s processes and products, how does the ABC system respond to these changes? Does the firm move toward simplified systems in which the cost of identifying activities outweighs any perceivable benefits? These questions can be answered by addressing the impact that continuous improvement has on the following:

• The type of cost driver required;
• The number of cost drivers required; and
• The changes in the cost object.

Type of Cost Driver
One of the fundamental characteristics of ABC systems is the distinction between activities at the unit, batch, and product levels. Figure 1 illustrates the hierarchy. Unit-level activities occur each time that a unit is produced, while batch-level activities occur every time that a transaction affecting more than one unit occur. Product-level activities affect a complete product line and vary in accordance with product code (part number) proliferation.

The cost of batch-level activities must be divided by the batch size to determine unit cost. Similarly, the volume of the product line to determine unit cost must divide the cost of product-level activities. Similarly, the volume of the product line to determine unit cost must divide the cost of product-level activities. For example, the cost of a setup must be divided by the production lot size, and the cost of engineering a new-part drawing must be divided by the part’s volume to determine unit cost. As a result, batch-size diversity and total product volume diversity become important reasons to have an ABC system since the denominators are different across products.

Continuous improvement reduces the importance of batch-level activities and also reduces batch-size diversity (the ratio of batch sizes). These changes eliminate the need for batch-level cost drivers in the ABC system. Cost drivers associated with production batches (e,g., the number of setups or the number of production runs) will ultimately disappear because the cost traced will be insignificant. Likewise, cost drivers associated with orders of components or materials (such as the number of inspections or the number of receipts) should also disappear with the implementation of continuous-improvement strategies.

Product-level activities. Even a firm that has removed batch-level activities will still have product-level activities, which are needed to service an entire product line. If product-level costs exist, ABC systems will be superior to conventional cost accounting systems when the following conditions exist:

1. There is activity diversity across the product line. That is, products consume relatively different amounts of product-level activities. Activity diversity can be thought of as a numerator effect from the point of view of determining product cost.
2. There is total volume diversity across the product line, which is a denominator effect.

The presence of either of these two types of diversity suggests a need for an ABC system to prevent distorted product cost.

Product diversity. Examples of product diversity in the numerator occur if some products require more engineering attention than others do. For example the drawings for recently released parts habitually need greater engineering support than the drawings for mature parts. As a result, the ABC system should trace the engineering effort to the newer parts so that mature parts are not forced to cross-subsidize the recent releases.

In this way, the benefits of the learning curve are related to products according to actual engineering change experience, as illustrated in Example 1.

Example 1. A medical equipment company manufactured and sold two different types of wheelchairs. One wheelchair was sold to individuals who were permanently disabled, and the other was sold to individuals who needed them for temporary use (e.g. for the elderly). The premium for liability insurance represents a product-level cost because the liability exposures differ for these two difference products. The wheelchair for the permanently disabled poses a higher risk because of the more intense and longer-term use of these two different products. The ABC system should, therefore, assign more liability insurance cost to wheelchairs for the permanently disabled to reflect the activity differences.

Vendor-related activities. Some components require more vendor-related activities than others do. Again, activities to establish and prove vendors are usually concentrated on specialized components or new part numbers. These costs should be assigned to the products that require this additional activity. Product-level drivers, such as the number of engineering changes or the estimated effort by vendor, should reflect these differences in the cost of the products.

Denominator effects. Even in the absence of significant batch-size and product diversity, there may still be volume diversity across the products (part numbers); the result will be denominator effects, as illustrated above.

Example 2. Products A and B are members of the same product family. They are quite similar in design and are produced in lot sizes of one. They consume virtually identical types and amounts of activities. (The effort required to maintain the bill of materials and routing sheets, for example, is the same for each product). However, the sales volumes of the two products are quite different, because A is a high-volume and product B is a low-volume product. The cost per unit of B for product-level activities, therefore, exceeds that of A because of these volume differences. This difference will not be reflected in the reported costs of A and B unless a product-level cost driver (such as the number of products) is used.

Unit-level activities: “Superunit”cost drivers.
Advanced manufacturing settings are characterized by a variety of unit-level activities, which are activities performed on the product unit itself. In a printed circuit board plant, for example, these activities include photoimaging, creating multiple layers, drilling holes, and plating. Each of these process activities is used to a different degree by each product, depending on the design of the product.

ABC systems use “superunit’ cost drivers to reflect the different use of these unit-level activities by the products. Examples include the number of holes or number of layers of a printed circuit board. They also include the number of axial insertions, the number of radial insertions, and the number of manual insertions in a circuit board assembly.

Superunit cost drivers replaces traditional unit drivers, such as direct labor hours and machine hours. Direct labor cost often falls to such a low level under continuous improvement that it is no longer even measured in some plants. Machine hours can be used in lieu of direct labor hours but may require developing a system to measure it. In contrast, Superunit cost drivers are usually stored in the manufacturing database and are, therefore, readily available for use by the ABC system at no additional cost.

Superunit cost drivers is common in plants that produce custom products. Superunit cost drivers provide the link between the different characteristics of the products and the multiple processes in the plant. They enable design engineers to model the economics of alternative product and process designs. A printed circuit board, for example, places different demands on process activities, depending on the number of holes or the number of layers.

Number of Cost Drivers
It is reasonable to believe that an ABC system should have fewer cost drivers as a result of implementing a continuous-improvement program. Even in cases where superunit drivers are required, the reduction of batch-level activities eliminates a whole class of cost driver.

Furthermore, reductions in product diversity reduce the need for product-level cost drivers to achieve improved accuracy of product cost.

In cases where the factory is focused on one product or on a small number of similar products, it is common to find product-costing systems that use a single cost driver. These systems rely on the direct tracing of overhead cost to product cells. A single cost driver (such as cycle time) is then used to allocate the cost in each cell to the products manufactured. It has been argued that such a simple system can still report accurate product costs because of the lack of product diversity within the cell.

One concern with a system that has only a few cost drivers is to be certain that it encourages the right behavior and does indeed report accurate product cost. The Portable Instrument Division of Tektronix, for example, implemented a system with two drivers: the number of part numbers and direct labor hours. The purpose of the driver “number of part numbers” was to focus the attention of the design engineers on the cost of part-number proliferation. The engineers responded by increasing the commonality of new products and reducing the division’s part count.

While this initial response was appropriate, it was clear the commonality was only one of several important engineering objectives. Reducing the part count did not necessarily reduce the number of process steps required; not did it necessarily increase the quality of the product. A subsequent version of the system expanded the number of drivers in the cost system to supply the engineers with the more detailed information that they required.

Potential for inaccurate product costs. A system with only a few drivers may also report inaccurate product cots and thus lose credibility. Zytec, a manufacturer of power supplies, used cycle time and supplier lead-time in its new cost system. Cycle time, which is the elapsed time from the arrival of raw material in the plant to the shipment of the product, was used to trace manufacturing overhead to the products. Supplier lead-time, which is the time that elapses from when an order for a component is placed until when it is delivered, was used to trace material overhead to the products.

The objective was to make the cost system consistent with the company’s continuous improvement program. Cycle-time reduction was intended to reduce cost and improve quality and service. Reduction in supplier lead-time was intended to reduce cost and improve flexibility.

The system failed, however, because it did not report accurate product costs. Both drivers measure elapsed time, yet components and products consume activities in ways that are not reflected by time. For example, a vendor with a long lead-time may deliver high-quality components, whereas a vendor with a short lead-time may deliver low-quality components. Similarly, a product with a long cycle time may require little engineering attention, while a product with a short cycle time may require substantial engineering time.

The response to Zytec’s system was quite negative. The cycle time portion of the system confused managers, who were unable to explain the differences in cost from one product to another. Managers also had difficulty understanding the relationship between supplier lead-time and cost. Finally, customers were unwilling to rely on prices based on costs that were reported by the new system.

One-product plants. Even if a plant makes only one product, it may still be necessary to have an ABC system with several cost drivers. For example, an ABC system was introduced in a defense plant that produced “only one product.” However, this “one product” actually consisted of many subassemblies and thousands of components. Subassemblies were sold as spares and for use in customers’ products. In addition, subassemblies were ongoing candidates for outsourcing. In reality, therefore, the plant had many products and required accurate costs for each of these products. A multidriver system was required to provide this accuracy.

Changes in manufacturing strategy. A one-or two-driver system may be vulnerable to changes in manufacturing strategy. One plant, for example, was organized by product cell. The costing system traced costs directly to each cell and used direct labor hours to allocate cost to the products produced in the cell. This design reported accurate product cost as long as only one type of product was produced in each cell.

Recently, however, losses in sales volume had forced the plant to emerge several product cells. The system was too simple to accurately cost cells with multiple products.

Cost Objective
Continuous-improvement programs typically start in a plant with the elimination of batch-level activities and nonfunctional product differences. As the plant becomes more efficient, plant overhead goes down, and opportunities for improvement become smaller. The next step for some firms is to move outside the plant to improve postplant activities, such as marketing and logistics.

Postplant activities. This shift in emphasis outside the plant recognizes the growing importance of postplant activities. In some cases, the cost of these activities equals or exceeds plant costs. Consequently, there are opportunities to target these resources more effectively, to adjust prices to reflect the use of postplant activities, and to continuously improve the performance of these activities.

To take advantage of these opportunities, an ABC system must be reoriented toward a different cost object. The costs of plant activities are traced to the product in ABC systems. Many postplant activities, however, focus on the customer, rather than the product, as a cost object.

Customer-level activities. The postplant costs, therefore, give rise to a new activity level: the customer-level activity. These are activities that do not support units. Batches, or products but that does support customers. In a sense, the cost system is turned on an axis toward this new cost object: The product cost in the plant is the platform to which the customer-level costs are added. The total cost of serving a customer, therefore, is the cost of the products purchased plus the customer-level costs. The result is a cost, system that provides information on the relative profitability by customer or customer segments not just by product.

Customer-level activities are activities unique to serving specific customers or customer segments. Examples include the following:

• Specialized service;
• Logistics support;
• Merchandise support;
• Special receivables terms;
• Inventory buffering;
• Cash incentives;
• Packaging;
• Palletizing; and
• Engineering support.

These support activities act many like product-level activities, except the cost object is the customer rather than a product.

Customer-level cost drivers. Customer-level activities require customer-level cost drivers, which can include the following:

• Number of customers;
• Service level;
• Marketing effort; and
• Specific inventory and receivable requirements.

Naturally, high levels of activity investment in a customer for small volumes result in low profitability. In a sense, the ABC system brings intelligence that has generally been lacking to the continuously improving firm. The question is not what does the customer want from the, but what does the customer value-in other words, what is the customer willing to pay for products and services to make them profitable to both parties.

The extended value chain. A realignment of the cost object toward the customer is entirely consistent with the direction of any continuous-improvement effort: The effort is an extended value-chain perspective. The hallmark of continuous improvement is to provide value to the customer. Increasing value to the customer may require strategic changes as well as continuous improvements in the activities serving the customer.

Customers that demand high postplant activities should not be cross-subsidized by those that do not. If a company maintains its focus only on product cost, it forces an averaging of different customer activity intensities across the product line. Therefore, cost should include both product costs from the plant plus customer-level costs of support provided outside the factory walls. This information can provide insight into marginal opportunities and vulnerabilities in the customer base, as illustrated in Example 3.

Example 3. To illustrate, a small machine shop with numerical control (NC) equipment was operating three shifts per day, seven days per week, but was making very little profit. The major customer-a Fortune 100 companies that the machine shop considered its bread and butter-provided 50 percent of the machine shop’s volume. But the reality was far different, as a careful examination of customer-driven activities revealed. The major customer ordered high-precision machined parts in low lot sizes. The jobs for this customer, therefore, required long setups, intense engineering support, intense NC programming support, intense sales support, high order activity, higher scrapped units, high inspection intensity, and high inventory for this firm. Rather than assigning these incremental costs to the products manufactured for the major customer, however, these costs were spread across the machine shop’s complete product line. As a result, this major customer enjoyed subsidized pricing; the machine shop’s number-one customer was actually its number-one loser.

Strategic and operational changes. The firm’s response to this information was both strategic and operational. The strategic response was to increase price to offset part of the high cost of serving the customer. The operational response was to reduce the cost of serving the customer via continuous improvement. The information to support both of these responses came from the ABC system, as illustrated in Example 4.

Example 4. When a trucking firm looked at services from a customer perspective, its freight rates did not reflect activity differences by customer. The firm developed an ABC system that used the customer as the primary cost object. Examples of customer-level cost drivers used included were pickup-drop off efficiency, backhaul opportunities, number of stops along a single haul, extend of prior notice by the customer, and extent of surge capacity needs by the customer.

The trucking firm uses the information from its ABC system to change the way it prices its services. The traditional approach to pricing was to set a standard rate to haul freight from one location to another. Under this approach, the rate from city X to city Y was the same regardless of activity intensity.

The new approach to pricing is based on customer-service requirements as defined by the ABC system. The new rates ensure that customers that receive low-cost service pay only for a share of the activities they use. Customers that are expensive to serve share the cost of the additional activities used.

Conclusion
ABC systems in traditional batch-oriented manufacturing environments are likely to report large shifts in the cost of the products. This additional accuracy is a major source of value of these systems because it reduces the cost of strategic errors. For example, more accurate product costs reduce the likelihood that prices will be set incorrectly or the unprofitable products will be sold aggressively.

However, continuous-improvement programs reduce the scope for improving the accuracy of product cost because overhead associated with batch-level activities goes down, batch size diversity is reduced or eliminated, and product diversity may initially be reduced. These changes affect the design of ABC systems in terms of the type of cost drivers used; the number of cost drivers used, and evens the cost object.

Continuous improvement changes the type of cost driver found in ABC systems. Batch-level drivers are not used because of the absence of batch-level activities and batch size diversity. Product-level drivers are prominent because of either continued product diversity or sales volume diversity. Superunit drivers are found in advanced manufacturing settings where custom products are produced on multiple processes.

Continuous improvement also changes the number of cost drivers found in ABC systems. The number of cost drivers may go down because an entire class of cost driver-the batch-level driver-is eliminated. It also may go down because, in some cases, product diversity is reduced. It is common, therefore, to find product costing systems, in continuous-improvement situations that use as few as one or two cost drivers.

It may still be necessary, however, to use multiple cost drivers: Too few cost drivers may focus attention on an incomplete set of improvement requirements and, therefore, interfere with the improvement process. Too few cost drivers may also result in inaccurate product costs and may be vulnerable to changes in manufacturing strategy.

As continuous improvement proceeds, the focus of improvement extends down the value chain from the product in the plant to the customer. This extension recognizes the significance of postplant, customer-level activities and their associated cost. The ABC system, therefore, uses a new cost of customer-level activities consumed to the cost of products.

Under a continuous-improvement program, the need for ABC systems to support marginal evaluation of customers and customer segments becomes increasingly important. Customer cost provides new insights into both customer segments become increasingly important. Customer cost provides new insights into both customer and segment strategy and leads to improvements in the performance of customer-level activities.

About Cost Technology

Cost Technology designs and implements solutions to support fact-based decision making.  These solutions transform existing data into strategically meaningful and actionable insights in areas such as cost and profit management, financial forecasting, analytics, and performance management.  Since 1991, the firm has helped public and private sector organizations across the world improve performance by creating the knowledge needed to make every decision count.

Over the course of the past several years, Dr. Turney has delivered a multitude of presentations and webinars focused on successful ABC implementations.  This article is a compilation of questions submitted on this topic.

Question:
How do you sell the proposition to management to continue developing ABC in their organization when they want a pay back on the initial ABC implementation?

Answer:
The answer is to give them an initial payback and, in doing so, inspire them to continue with ABC long-term. This is why at Cost Technology, Inc. we emphasize rapid results in phase one of the implementation, and sustainable results in phase two. Our experience is that when you can demonstrate results that more than pay for the cost of the first round, senior management are able to reassess the project risk and are very confident about moving forward. However, you need to plan the implementation carefully and ensure that the results are realized. We use our Value Creation methodology to ensure this happens.

Question:
What are some of the specific capabilities that the existing tools provide that allow you to develop models so much quicker?

Answer:
Cost Technology’s assessment exercise helps us frame the issues and scope out the model in terms of decisions that need to be addressed by it. The ability to develop models quickly comes from the quality of modern tools and the learning curve we have gone through over more than two decades of ABC implementations. ABC software is a specialized tool for ABC—everything is designed to support model building. The ABC technician can focus on the model-build rather than customizing the tool (as he or she would have to do if using, say, Excel). Also, the use of storyboards and web-based tools speed up data capture and analysis (including on-line real-time validation of the model), whereas old-fashioned interviews are very time-consuming and repetitive. In addition to the quality of the tools, we are just much better at implementing ABC. What used to take 6-9 months now takes 2-3 months for the initial project.

Question:
Are there any examples of insurance companies that have successfully used ABC/M for cost reduction?

Answer:
There are several case example of the use of ABC in insurance, and we have developed ABC successfully in insurance companies. The biggest difference is not technical—implementation is very similar—rather it is the change management issues. Change in insurance has historically been glacial and you may need significant effort to successfully foster change around ABC. In the insurance industry, the practice of analyzing customer behavior – tends to support the use of ABC. For example, you can now use ABC to supplement your intelligence about customers and derive the cost to acquire, cost to serve and cost to retain your customers.

Question:
Why is it so hard for service companies to see ABC as a perpetual cost system as manufacturing companies do? There is no manufacturing company without a cost system, but there are a lot of service companies without them.

Answer:
I suspect that one of the reasons is that ABC is often still sold as a costing system, and manufacturing companies are the only ones with costing systems. The reason for this is that manufacturing companies have inventory, and, according to Generally Accepted Accounting Principles (GAAP), the inventory must be valued. This involves determining how much cost goes into cost of goods sold and how much remains in inventory in the balance sheet. Service companies do not carry inventory and therefore have no reporting or regulatory need for a costing system.

In its earliest days, ABC was developed—and pitched—as a better cost accounting system. We quickly learned, however, that ABC is really an analytic tool that provides support for management decision-making. And service companies need ABC the analytic tool just as much as manufacturing companies do. I personally would not sell anyone on ABC as a costing tool. The lower percentage of service companies with ABC may also be due to getting started later—the earliest ABC implementations were largely in manufacturing organizations. But they will catch up soon.

Question:
What are some ways ABC can help in CRM? Like profitability, what are other areas?

Answer:
Great question! CRM can provide a lot of useful data about customers, but, without ABC it cannot inform management on the relative profitability of customers. Nor can it provide diagnostic information about the source of cost, nor support the analysis needed to identify ways of improving profitability and reducing customer cost. As we mentioned in a previous answer, you can combine ABC with CRM to derive the cost to acquire, cost to serve and cost to retain individual customer categories. You can also use this and customer profitability intelligence to make decisions about price-service-support-technology offerings to different customer categories.

Question:
I am working towards developing an ABC process and am anticipating resistance by production management. Does a small project pilot on a department for purposes of selling the concept make sense?

Turney’s Answer:
Yes it does, but I would make sure that the pilot is a “proof of concept” pilot. This means it will provide results that will ensure enthusiastic support for ABC amongst the production management. You will need to carefully pick the target area and method to provide the required results. We use often the storyboarding method in situations where realized cost reduction will close the sale.

Question:
Can you be more explicit about storyboarding being the primary method used by Johnson & Johnson?

Answer:
Johnson & Johnson Medical used storyboarding in to identify non-value added activities. This was very successful, and prompted our efforts to design an ABC-solution using storyboards. We added discipline and additional information to the storyboarding method. For example, the Johnson & Johnson method did not involve costing the activities, which is critical to prioritization decisions and removing resources from the process.

Question:
We have implemented ABC, yet our management suggests that we don’t have “True” ABC because we haven’t captured every operational activity via bar coded transactions or similar means. Are there ABC implementations that you know of that capture and manage that level of detail? How do we respond?

Answer:
Your answer has to be that implementing ABC is a process that goes on over time. Your initial implementation must have provided a lot of good information that is useful to management. I would expect your ABC cost to be quite accurate even without the use of bar coding. However, management may want ABC to provide more detailed operational cost data that can only be provided with bar coding.

Question:
Could you explain the key aspects of implementing storyboard methodology?

Answer:
Planning is a key issue in storyboarding. Proper planning will ensure the selection of the right areas for storyboarding as well as provision of the right data. As far as method is concerned, we use a structured method that is proven to provide results. A key factor here is to combine the structured method with a group of knowledgeable people from the work area. Another key factor is to use experienced facilitators. Always work towards realized cost savings in the region of 20-30% of the analyzed cost.

Question:
Can you give me the name of your latest book?

Answer:
Common Cents (Second Edition) is the latest book. This is published by McGraw-Hill and is available on our web site. I also contributed a Chapter in Jonathan Hornby’ recent “Radical Times Requires Radical Action” which focuses on the value of ABC in surviving and recovering from the current economic recession.

Question:
Can you identify any special problems related to service type industries such as banks, hospitals, schools, etc.?

Answer:
Regardless of the type if business you work in, it is important to develop an understanding of the industry you are in and the specifics of your company (processes, systems, products, services, customers, markets, business issues etc). This is particularly true in health care where specific experience and knowledge is often considered important. Beyond this I consider ABC to be a fungible method that works pretty much in the same way in any type of industry. One common problem in most industries is that the true profitability of customers is not known and support costs are not traced logically to services.

Question:
I wonder how you explain to top management that every time you make a process improvement from ABC, you should be able to reduce the unit cost of products and services?

Answer:
If the changes to the process reduce activity requirements and therefore cost, one would naturally expect the cost of products that use the process to go down. The only way that the cost of other products could go up is if the resources freed up in the first process are redeployed to other processes without a commensurate increase in volume through those processes. The cost increase may be due to a technical error where resources freed up as a result of the ABC analysis are not treated as temporary excess capacity. Your ABC software tool is an ideal vehicle for doing the analysis to provide the understanding for these changes.

Question:
Can you address the role of combined drivers?

Answer:
Activity drivers must accurately measure the consumption of activities by cost objects. In some cases accuracy is best reflected by combining two measures.

Question:
How to integrate ABC with other enterprise wide initiatives like Six Sigma, etc.?

Answer:
The key here is to recognize that ABC in support of Six Sigma will be quite different from a strategic model that supports, say, customer profitability. ABC can significantly help Six Sigma by providing cost information which helps set priorities (choosing Six Sigma projects) as well as providing supporting analysis (such as cost driver analysis of problem areas). I recommend using the ABC model to set targets, and the storyboarding method to provide the detail, analytical support, and team-based method to fit best with Six Sigma, continuous improvement, business process reengineering etc.

Question:
What platform do you recommend SAS ABM software? Why?

Answer:
SAS ABM works on any system platform—SAP, Oracle and many different ERP systems. The software comes with a variety of data tools and choices for data integration. The goal for a sustainable system is to create full automation to reduce on-going maintenance effort and cost.

Question:
I have not had any measurable success in full implementation but am now developing resource modules across my organization for use in current budget management. I am hoping success and visibility in this area will get buy in from the various managers. Are there any dangers in this approach that I may be overlooking?

Answer:
If you are able to simplify the budgeting process you will have accomplished something value added. However, I am not sure that success in budgeting translates into buy-in to ABC. You will need to build on your credibility in budgeting and deliberately cultivate an interest in ABC.

Question:
Do you have any examples/cases from forecasting/short term planning ABC models? And how these are linked to continuous planning and scorecarding?

Answer:
ABC is a complementary tool for scorecards. Our experience is that as many as 25-30% of measures in a balanced scorecard are derived from ABC. If you wish to do more research into this area, I recommend a case study that explains and describes the process of linking of ABC to scorecards (the ABC Technologies case study available from the University of Virginia).

Question:
I am trying to do an ABC model for a contracting office. As of now, we are more cost focused than customer focused in our measures. Are there any bench marks in industry that you could recommend to help establish better performance measures for customer service in contracting? To clarify, we are concerned with cost, obviously. However, if our mission is to improve customer service, how do we measure for this effectively?

Answer:
The heart of an ABC model is, of course, the activity. And the activity can be measured in more ways than just cost. In addition to cost, you might consider measuring lead time—the elapsed time from the start of the work to the completion of the work and the forwarding of the output to the customer—and also quality—a measure of how well the output meets the requirements of the customer. When we do storyboarding we routinely measure cost, time and quality measures for each activity and process. In terms of customer focus, ABC allows you to measure customer profitability and use measures like cost to serve, cost to acquire and cost to retain with a goal of improving customer service and provide more value to them.

Question:
Is ABC an appropriate method to compare costs in government to private companies? Can ABC be used to justify not out-sourcing?

Answer:
This is one of the most useful applications of ABC in government at this time. A good ABC model can provide all the cost information you need to measure the cost reduction associated with outsourcing a process. Make sure your analysis includes the reduced cost of support by secondary activities as well as the direct cost savings of the outsourced process. Don’t forget that none of your cost savings assumptions will be correct unless management follows through and redeploys the freed-up resources. We have success stories from government where ABC resulted in insourcing work rather than outsourcing work.

Question:
Which would be the best approach to go from Activity Based Costing to Activity Based Management and have the top management support?

Answer:
The best approach is to include Value Creation in the ABC implementation. We recommend an initial phase that yields rapid results, and then a more extended implementation that will provide sustainable results. This captures management’s immediate attention and support, and then successfully builds on it leading to a truly successful performance management system.

Question:
Question a little out of the main subject but if it is possible, I would like to know if you suggest implementing ABC/M prior to VCA or VCA prior to ABC/M.

Answer:
I recommend implementing ABC before doing an application such as Value Chain analysis. It is critical that you have the ABC information available from the beginning for use in the application.

Question:
FTE’s or time spent in each activity is an important driver in ABC implementation. How do you obtain good information from employees when they think the information they offer may be used against them?

Answer:
The key to obtaining accurate measurements of time is to use a collaborative group technique in the context of proper leadership and communication. A collaborative group technique—such as storyboarding—does not have the fear and mistrust that is typically associated with interviewing. Strong leadership and the communication of why the employees are participating in the initiative are critical. Sometimes accounting can be regarded as the “enemy” and care may be needed in defining roles and establishing purpose and motivation. Technology also has a role to play in reducing the time and effort required for on-going data capture.

Question:
How to avoid the impact from bad accounting practices?

Answer:
Accounting limitations can be important, but, given time, a workaround can usually be found. For example, if the model is organized by function or process, and the general ledger is not, it will be necessary to break out the resources using estimated data. Inaccuracies—such as in the fixed assets—are more difficult to correct. Missing data—such as in the overhead areas in government agencies—can also be problematic.

Question:
Do you know of any ABC implementations in which the volume of data that bar coding every transaction is being done and/or is justified?

Answer:
Bar coding can be very useful at providing operational data that can be used for activity drivers and performance measures in the ABC system. It may be essential in a manufacturing setting for use of a planning model.

About Cost Technology
Cost Technology designs and implements solutions to support fact-based decision making.  These solutions transform existing data into strategically meaningful and actionable insights in areas such as cost and profit management, financial forecasting, analytics, and performance management.  Since 1991, the firm has helped public and private sector organizations across the world improve performance by creating the knowledge needed to make every decision count.

Over the course of the past several years, Dr. Turney has delivered a multitude of presentations and webinars focused on maximizing the value generated by ABC implementations.  This article is a compilation of questions submitted on this topic.

Question:
Have any of your efforts to implement ABC at a company failed? If so, what was the key cause of failure?

Answer:
I can’t think of any of our efforts that have failed, but we have worked for organizations who have failed with ABC for reasons beyond our control. The reasons are many, but are predominantly organizational—e.g., lack of leadership, financial distress etc. This experience has led us to be “smarter” in the way we orchestrate our client work—for example, by utilizing collaborative methods that require leader participation.

Question:
What is a typical time frame for an assessment?

Answer:
An assessment can last from a few days to 90 days, depending on the scope and complexity of the organization, the scope of the assessment, and the desired results. The 90 day time frame—called Profit Reveal 90—delivers rapid results and a positive ROI on the project.

Question:
Do you find the ABM sites, using ABC for cost reduction, run models on a monthly or quarterly schedule? How would you respond if management sponsors are asking for your ABC model?

Answer:
The primary reason for running frequent model updates in a cost reduction environment is to reflect the changes in resource deployment and activities resulting from cost reduction efforts. Quarterly updates are probably sufficient, but if the model is fully automated, monthly updates will be no more costly than quarterly updates.

Question:
What are some examples/case studies for service industries?

Answer:
You will find several service case studies in the Performance Center at www.costechnology.com. My preferred service case study is the Deluxe series. While this is a manufacturing company, the case focuses on the service side and illustrates a thoroughly modern ABC system that delivers results.

Question:
How do you address a large R&D operation that works on numerous one-time projects and does complex research that often produces an output that is difficult to measure?

Answer:
Very carefully! We find the storyboarding technique works well because the key is to understand and analyze the processes and the cost associated with the processes.

Question:
I can see a business case for ABC in manufacturing. What about for software firms? Do you recommend or know of many cases where ABC systems exist here? We also provide BPR services…do you foresee any benefits?

Answer:
We have done a number of ABC applications in software companies. The revelations—such as in the actual versus perceived profitability of products, services and customers—is just as stunning in software as it is in manufacturing. ABC also helps with high cost processes, which seem to be a problem in software companies.

Question:
Is the assessment different for a Government agency?

Answer:
The process you go through in a Government agency is exactly the same as in a manufacturing company. The issues, processes, and products and services are quite different, but these are identified and analyzed as part of the assessment. Our experience is that Government agencies can realize significant benefits from an assessment—the design of the ABC is such that it addresses the major goals, the storyboarding sessions provide some significant cost savings and the value creation process assigns responsibilities to teams to achieve the cost savings. So the basics are still the same as manufacturing, and realized savings should be part of the program.

Question:
How are ABC and ABB connected?

Answer:
Very closely. ABB is really a forward looking version of ABC. It is used for resource planning (based on a sales forecast), capacity analysis, and scenario analysis to support decision making. It is important not to make it too complex, and use analytics in combination with ABC to deliver the forecast information cost-effectively..

Question:
Is it essential to use an ABC/M software during and after implementation? If so, what software would you recommend?

Answer:
Yes, yes and yes. If you don’t believe me, step into a time machine and return to 1986 and experience the pain yourself. During the initial model build, and then going forward into systems integration, maintenance, and web delivery of reports and information, you will give thanks every day that you use ABC software. We use SAS ABM, SAS Profitability Management and MyABCM. The choice of a software tool is specific to a particular organization, its business needs, complexities, systems requirements and budget.

Question:
In my company, I feel that ABC is a “nice thing to have” but is not used to help make good business decisions. I think that this is because the company did not complete the proper assessment but went forward with the implementation process. How do we now make the adjustments so that ABC is a valuable process in the business?

Answer:
I am glad you are asking this question because it means it is not too late to salvage ABC. The exact answer will depend on an assessment of the reasons for failure, and the requirements going forward. A common problem is failure to define the business purpose and to design the ABC system specifically to meet this purpose. Other problems are tactical and usually fixable.

Question:
What sort of dialogue with a prospective client typically precedes the conclusion or suggestion that ABC is needed? As an adjunctive question, what are the indicators of an organization in need of ABC?

Answer:
There are two types of dialogue. One type is with financial or accounting people who know about ABC and will be responsible for implementing it. Here the discussion usually centers implementation issues such as the approach to implementation, the  choice of software tool, budget etc. The other type is a dialogue with the management who own the business problem such as pricing, supply chain or customer profitability. Here the issue is what is happening because of the absence of ABC, and how ABC can correct the problem.

Question:
We can see how ABC can assist private industry, how can ABC be applied to government entities to increase efficiency?

Answer:
Every organization has processes with activities (mostly with significant degrees of misalignment and inefficiency), resources deployed to do the work (with alignment and capacity issues), and outputs and customers of the outputs. A government entity is no different in this regard than any other organization. Like private industry, government entities have strategic and operational issues that require ABC, such as budget shortfalls, pressure to outsource, etc. Our assessment determines the design of the ABC and identifies the specific areas that need to be analyzed. Our experience is that government entities can experience significant savings from ABC when using the storyboarding method.

Question:
Are there any best-practice ABC models available for specific industries? Which industries?

Answer:
Best-practice models provide good illustrations of industry-specific models. With one exception, it is unusual for these models to form a template for model implementation. This is because organizations differ significantly in business need, organization structure etc, so the ABC model will be different. The exception is in large organizations that have similar businesses or processes in different geographic locations. In these cases a best-practices model will be cost-effective in model ABC system role out.

Question:
What is the biggest opposition to the implementation of ABC in both the public and commercial sectors?

Answer:
Anyone can oppose ABC, and opposition may come from accounting or from operations. The root causes of opposition are FEAR. IGNORANCE and the ABSENCE OF LEADERSHIP. These causes can be addressed through the use of change management, effective implementation techniques and training. .

Question:
Do you have any experience performing ABC activities for Federal Agencies and or Department of Defense Organizations (DoD)?

Answer:
Yes, we have had many very positive experiences in Federal Agencies and the DOD. It may take longer than in the private sector, but with the right methods, ABC can be very successful. We have had particular success with storyboarding to identify cost savings in the US military sector both in the USA and overseas.

Question:
Building on the earlier question regarding frequency of running the model, if supply chain management sponsors are asking for the ABC model to provide detailed cost of jobs, which ran on, say, nightshift this past weekend, is it best to say ABC does not provide such real-time job costing information, and other systems such as shop floor control should be developed to get such detailed cost?

Answer:
This is a challenging question that raises philosophical as well as systems issues. My answer depends on what your sponsors want to use the information for. If the purpose is real-time operational control—such as adjusting the temperature of the process to keep it within specifications—there may not be any value to real-time cost information. On the other hand, if your sponsors want to price the jobs to the customer, then you want real-time ABC cost. This real-time cost should be up-to-date from a process standpoint, but not real-time process cost (this may not be possible to compute). However, you can apply activity driver rates to each job to get a real-time job cost which can be used for pricing purposes.

Question:
Thanks for the great information! How easy/common is it to integrate ABC with business intelligence applications or solutions?

Answer:
You will need to be more specific in your question. What type of business intelligence applications do you have in mind? ABC is an analytic solution that sits in the same domain as business intelligence and should be fully compatible with any form of business intelligence. For example, ABC could fit well with data mining products to generate intelligence on customer profitability. Reports can be surfaced via portals and performance measures can be surfaced on maps. Cost measures can be routed to scorecards which can also be integrated into the business intelligence framework.

About Cost Technology
Cost Technology designs and implements solutions to support fact-based decision making.  These solutions transform existing data into strategically meaningful and actionable insights in areas such as cost and profit management, financial forecasting, analytics, and performance management.  Since 1991, the firm has helped public and private sector organizations across the world improve performance by creating the knowledge needed to make every decision count.

A Q&A WITH DR. PETER TURNEY

Over the course of the past several years, Dr. Turney has delivered a multitude of presentations and webinars focused on maximizing the value generated by ABC implementations. This article is a compilation of questions submitted on this topic.

Question: Have any of your efforts to implement ABC at a company failed? If so, what was the key cause of failure?

Answer: I can’t think of any of our efforts that have failed, but we have worked for organizations who have failed with ABC for reasons beyond our control. The reasons are many, but are predominantly organizational—e.g., lack of leadership, financial distress etc. This experience has led us to be “smarter” in the way we orchestrate our client work—for example, by utilizing collaborative methods that require leader participation.

Question: What is a typical time frame for an assessment?

Answer: An assessment can last from a few days to 90 days, depending on the scope and complexity of the organization, the scope of the assessment, and the desired results. The 90 day time frame—called Profit Reveal 90—delivers rapid results and a positive ROI on the project.

Question: Do you find the ABM sites, using ABC for cost reduction, run models on a monthly or quarterly schedule? How would you respond if management sponsors are asking for your ABC model?

Answer: The primary reason for running frequent model updates in a cost reduction environment is to reflect the changes in resource deployment and activities resulting from cost reduction efforts. Quarterly updates are probably sufficient, but if the model is fully automated, monthly updates will be no more costly than quarterly updates.

Question: What are some examples/case studies for service industries?

Answer: You will find several service case studies in the Performance Center at www.costechnology.com. My preferred service case study is the Deluxe series. While this is a manufacturing company, the case focuses on the service side and illustrates a thoroughly modern ABC system that delivers results.

Question: How do you address a large R&D operation that works on numerous one-time projects and does complex research that often produces an output that is difficult to measure?

Answer: Very carefully! We find the storyboarding technique works well because the key is to understand and analyze the processes and the cost associated with the processes.

Question: I can see a business case for ABC in manufacturing. What about for software firms? Do you recommend or know of many cases where ABC systems exist here? We also provide BPR services…do you foresee any benefits?

Answer: We have done a number of ABC applications in software companies. The revelations—such as in the actual versus perceived profitability of products, services and customers—is just as stunning in software as it is in manufacturing. ABC also helps with high cost processes, which seem to be a problem in software companies.

Question: Is the assessment different for a Government agency?

Answer: The process you go through in a Government agency is exactly the same as in a manufacturing company. The issues, processes, and products and services are quite different, but these are identified and analyzed as part of the assessment. Our experience is that Government agencies can realize significant benefits from an assessment—the design of the ABC is such that it addresses the major goals, the storyboarding sessions provide some significant cost savings and the value creation process assigns responsibilities to teams to achieve the cost savings. So the basics are still the same as manufacturing, and realized savings should be part of the program.

Question: How are ABC and ABB connected?

Answer: Very closely. ABB is really a forward looking version of ABC. It is used for resource planning (based on a sales forecast), capacity analysis, and scenario analysis to support decision making. It is important not to make it too complex, and use analytics in combination with ABC to deliver the forecast information cost-effectively..

Question: Is it essential to use an ABC/M software during and after implementation? If so, what software would you recommend?

Answer: Yes, yes and yes. If you don’t believe me, step into a time machine and return to 1986 and experience the pain yourself. During the initial model build, and then going forward into systems integration, maintenance, and web delivery of reports and information, you will give thanks every day that you use ABC software. We use SAS ABM, SAS Profitability Management and MyABCM. The choice of a software tool is specific to a particular organization, its business needs, complexities, systems requirements and budget.

Question: In my company, I feel that ABC is a “nice thing to have” but is not used to help make good business decisions. I think that this is because the company did not complete the proper assessment but went forward with the implementation process. How do we now make the adjustments so that ABC is a valuable process in the business?

Answer: I am glad you are asking this question because it means it is not too late to salvage ABC. The exact answer will depend on an assessment of the reasons for failure, and the requirements going forward. A common problem is failure to define the business purpose and to design the ABC system specifically to meet this purpose. Other problems are tactical and usually fixable.

Question: What sort of dialogue with a prospective client typically precedes the conclusion or suggestion that ABC is needed? As an adjunctive question, what are the indicators of an organization in need of ABC?

Answer: There are two types of dialogue. One type is with financial or accounting people who know about ABC and will be responsible for implementing it. Here the discussion usually centers implementation issues such as the approach to implementation, the choice of software tool, budget etc. The other type is a dialogue with the management who own the business problem such as pricing, supply chain or customer profitability. Here the issue is what is happening because of the absence of ABC, and how ABC can correct the problem.

Question: We can see how ABC can assist private industry, how can ABC be applied to government entities to increase efficiency?

Answer: Every organization has processes with activities (mostly with significant degrees of misalignment and inefficiency), resources deployed to do the work (with alignment and capacity issues), and outputs and customers of the outputs. A government entity is no different in this regard than any other organization. Like private industry, government entities have strategic and operational issues that require ABC, such as budget shortfalls, pressure to outsource, etc. Our assessment determines the design of the ABC and identifies the specific areas that need to be analyzed. Our experience is that government entities can experience significant savings from ABC when using the storyboarding method.

Question: Are there any best-practice ABC models available for specific industries? Which industries?

Answer: Best-practice models provide good illustrations of industry-specific models. With one exception, it is unusual for these models to form a template for model implementation. This is because organizations differ significantly in business need, organization structure etc, so the ABC model will be different. The exception is in large organizations that have similar businesses or processes in different geographic locations. In these cases a best-practices model will be cost-effective in model ABC system role out.

Question: What is the biggest opposition to the implementation of ABC in both the public and commercial sectors?

Answer: Anyone can oppose ABC, and opposition may come from accounting or from operations. The root causes of opposition are FEAR. IGNORANCE and the ABSENCE OF LEADERSHIP. These causes can be addressed through the use of change management, effective implementation techniques and training. .

Question: Do you have any experience performing ABC activities for Federal Agencies and or Department of Defense Organizations (DoD)?

Answer: Yes, we have had many very positive experiences in Federal Agencies and the DOD. It may take longer than in the private sector, but with the right methods, ABC can be very successful. We have had particular success with storyboarding to identify cost savings in the US military sector both in the USA and overseas.

Question: Building on the earlier question regarding frequency of running the model, if supply chain management sponsors are asking for the ABC model to provide detailed cost of jobs, which ran on, say, nightshift this past weekend, is it best to say ABC does not provide such real-time job costing information, and other systems such as shop floor control should be developed to get such detailed cost?

Answer: This is a challenging question that raises philosophical as well as systems issues. My answer depends on what your sponsors want to use the information for. If the purpose is real-time operational control—such as adjusting the temperature of the process to keep it within specifications—there may not be any value to real-time cost information. On the other hand, if your sponsors want to price the jobs to the customer, then you want real-time ABC cost. This real-time cost should be up-to-date from a process standpoint, but not real-time process cost (this may not be possible to compute). However, you can apply activity driver rates to each job to get a real-time job cost which can be used for pricing purposes.

Question: Thanks for the great information! How easy/common is it to integrate ABC with business intelligence applications or solutions?

Answer: You will need to be more specific in your question. What type of business intelligence applications do you have in mind? ABC is an analytic solution that sits in the same domain as business intelligence and should be fully compatible with any form of business intelligence. For example, ABC could fit well with data mining products to generate intelligence on customer profitability. Reports can be surfaced via portals and performance measures can be surfaced on maps. Cost measures can be routed to scorecards which can also be integrated into the business intelligence framework.

About Cost Technology

Cost Technology designs and implements solutions to support fact-based decision making. These solutions transform existing data into strategically meaningful and actionable insights in areas such as cost and profit management, financial forecasting, analytics, and performance management. Since 1991, the firm has helped public and private sector organizations across the world improve performance by creating the knowledge needed to make every decision count.

This article examines ten myths of product costing identified from the comments of managers and academics. Each myth was heard several times from different sources. Each myth also appeared to have a kernel of truth, but had been generalized to apply to all activity-based systems. This article describes each of these ten myths and identifies the conditions under which they are true and those under which they are not.

Activity-based cost (ABC) systems maintain and process data on activities and products. These systems trace costs to products according to the activities performed to produce them. ABC systems are an important source of information on overhead activities and remove much of the distortion in product costs that is inherent to conventional unit-based systems.

Mythical beasts
This article examines several myths about ABC systems. The word “myth” as it is used here means a commonly stated view that is accepted without critical analysis. In fact, myths of this type are sometimes true – but only under certain limited conditions. It is this limited truth that gives them their persuasive force.

It is therefore important to understand when myths are true and when they are not. When viewed as rules of general applicability, the myths discussed in this article could lead to incorrect designs of cost systems. An incorrect cost system design could report inaccurate product costs and could provide a distorted view of the performance of activities. Either deficiency could cause management to make wrong decisions.

Common themes
The myths examined in this article contain certain common themes about ABC systems. One theme is that these systems are too difficult to implement and use. The second theme is that improving conventional systems makes ABC systems redundant. The third theme is that more accurate product cost information is unnecessary. The forth theme is that ABC systems play a limited role in managing a firm. The myths for each theme are as follows:

• ABC systems are too difficult to implements and use:
  • ABC systems are too costly; and
  • ABC systems are too complex to understand.
• Improving our existing system will do the job:
  • All that we need are more cost centers;
  • Machine-hour systems save the time; and
  • A cost system should be kept simple.
• We do not need more accurate product costs:
  • We know what our products cost; and
  • The market sets prices, so we do not need product costs.
• Cost systems play a limited role:
  • We cannot do anything about fixed costs;
  • Only manufacturing costs are product costs; and
  • Product costs are not useful for managing overhead activities.

The following sections provide a more detailed examination of each theme and its related myths.

ABC systems are too difficult to implement and use. Managers often express a concern that ABC systems are too difficult to implement and use. There is certainly a cost associated with designing and implementing a new cost system that has a different architecture and different data requirements than conventional cost accounting systems. There is also a cost to users of ABC systems who must adapt to the new cost information. Managers are therefore justified in questioning these costs, because they affect the net value of a shift to an ABC system.

Myth 1: ABC systems are too costly. A common response to ABC systems is to say that they cost too much. According to this myth, the additional cost drivers used in ABC systems increases the cost of system design, implementation, and maintenance to an unacceptable level.

In fact, ABC systems are more costly than unit-based systems. By design, an ABC system identifies activities and cost drivers, traces costs to each activity, and then traces the cost of the activities to products by means of the cost drivers. Cost driver usage is estimated for each component or products by means of the cost drivers. Cost driver usage is estimated for each component or product that consumes that driver. The driver “number of receipts”, for example, requires that the number of receipts be estimated for each component. Each time the ABC system is revised, this estimate must be updated.

Experience shows, however, that most people overestimate the incremental costs of tracking and data gathering for ABC systems. Mush of the data required by an ABC system already exist in the plant or can easily be captured. In a high-technology environment, for example, the number of insertions in an integrated circuit insertion machine or the number of holes punched in a printed circuit board are likely cost drivers for an ABC system that would already be stored in the manufacturing data base.

Even if data that a cost driver uses are unavailable, the data can be estimated from available data, or replaced with an equivalent measure. For example, the number of machine hours does not have to be measured directly; it can be estimated from the number of direct labor hours combined with the average number of machines worked on by an operator, Similarly, if the number of setups is not recorded, the number of production runs can be substituted, because typically there is a one-to-one relationship between the number of production runs and the number of setups.

ABC systems often reduce the cost of special studies required to supplement the information reported by the product costing systems. There are many firms with conventional systems whose accounting departments spend over 50 percent of their time conducting special studies. After implementing an ABC system, this percentage drops substantially; fewer studies are needed and also less effort per study. This reduction in frequency and effort reflects the additional information and increased accuracy of information in the ABC system.

Several firms have implemented ABC systems at a cost that was considered acceptable to management. One form, for example, recently implemented a system with 44 cost drivers, 30-activity center, and over 2,000 cost pools. Although this system was fairly complex, it was designed and implemented in about nine man-months. The system runs on a PC and computes product costs in minutes.

Myth 2: Activity-based systems are too complex to understand. Managers often state flatly that ABC systems are too complex to understand. They believe that the additional number and type of cost drivers make an ABC system difficult to understand. As a manager of one form commented:

“The objective with the cost system was to change the behavior of the management of the division. We did not go to a more complex system immediately – say, an eight-driver system – because we wanted to take incremental steps and change behavior permanently. If we had tried to introduce a massive change we might have created such confusion that the benefit would have been lost.”

When pressed for examples of complex systems that they have encountered, managers describe accounting systems that generate large numbers of variances and transactions, but not the product costing system itself. For example, in the firm whose manager was just quoted, the accounting system generated twenty-one different cost variances each month and required as many as fifty performance measurements by each operator each day (totaling over 30,000 measurements per month on one product line alone). The system processed more than 25,000 inventory transactions per month and divided the plant into more than 100 cost centers. It is therefore not surprising that management had difficulty understanding such a complex system.

The firm’s product costing system, however, was not the source of confusion. Overhead was directly traced at the first stage to the production cost centers or allocated using direct labor hours. The second stage used direct labor hours as the only cost driver. This simple unit-based design was actually quite easy to understand.

Although ABC systems use more cost drivers than unit-based systems, ABC systems are easy to understand because these drivers describe the major factors that create the demand for activities. ABC systems therefore match mangers understanding of the economics of their plants.

The driver “number of engineering changes,” for example, conveys the message that the more engineering changes there are on a product, the more costly the product will be.

Similarly, the driver “number of purchase orders” implies that the cost of purchasing some item is a function of the number of times it is bought. In both cases, it is clear to management that the cost per driver unit is determined by how efficiently engineering change and purchasing activities are carried out.

Therefore, the perception that ABC systems are too difficult to understand and use does not reflect the experience of firms that have implemented such systems. Although ABC systems are undoubtedly more costly than conventional systems because they require more measurements, this additional cost is often modest. In any case, even if the additional measurements increase the complexity of ABC systems, the resulting systems prove to be easier to understand than conventional cost accounting systems because they reflect economic reality better.

Improving our existing system will do the job. Critics of ABC systems frequently point out that a better alternative to starting with a completely different cost accounting system would be to improve the existing system. These reminders are appropriate, because generally ABC systems are compared with poorly designed conventional systems. Many well-designed conventional systems exist: These systems use multiple cost centers, often incorporate machine hours as a cost driver, and tend to be simpler than ABC systems. The question, therefore, is whether improving a conventional cost system reduces the need for an ABC system. The next sections address this issue.

Myth 3: All that we need are more cost centers. Another often-stated myth holds that dividing a plant into multiple cost centers will eliminate most of the distortions in product costs.

It is true that increasing the number of cost centers leads to more accurate product costs. However, there is a limit to the accuracy that can be achieved by simply increasing the number of cost centers. Creating multiple cost centers where only one or two existed does reduce distortion when costs are consumed differently in different parts of the plant. A plating department, for example, may have expensive equipment, whereas a painting department may have inexpensive equipment. Combining both departments into one cost center will result in inaccurate product costs if some products are routed through one department and some through the other.

The problem, however, is that activities that are not on the unit level cannot be handled by unit-based systems if multiple products pass through the cost centers. Instead, different types of cost drivers, such as those used in ABC systems, must be used.

Each batch of product passing through the plating department, for example, may require first-piece inspection. A unit-based driver, such as direct labor hours, attaches inspection cost to each product unit based on the amount of direct labor time required. This inspection cost results in inaccurate product cost when the batch size varies depending on the product inspected. A cost driver that would more accurately trace inspection costs to products, therefore, would be a batch-level driver, such as the number of inspections.

Myth 4: Machine-hour systems would save the day. Machine-hour systems are often proposed as solutions to the problems of unit-based systems. The belief is that replacing the cost driver direct labor with machine hours will result in more accurate product costs in today’s manufacturing environment.

Advantages of using machine hours. Using machine hours has two major advantages over direct labor; First, machine hours may provide more reasonable overhead rates. In many firms, the proportion of manufacturing cost attributable to direct labor has fallen below 20 percent; in some cases, it is as low as one percent. In these firms, the overhead rate per labor dollar may be 200 percent or more. Managers have trouble understanding the meaning of such high rates and question whether diminished use of direct labor can really account for such huge overhead rates. Since most companies now use more machine hours than labor hours, the use of machine hours as a cost driver generally makes overhead rates fall to a more reasonable level.

The second advantage of using machine hours instead of direct labor hours is that machine hours trace machine-related activities to products more accurately than direct labor hours when machine-base diversity exists. Machine-base diversity exists when the number of machines that an operator runs varies according to the product produced. A relatively complex product, for example, may need four machines to be produced, while a relatively simple product may be produced on only two machines. In a case such as this, the ratio of machine hours to labor hours differs from one product to another, and direct labor hours will not capture this variation.

Machine hours will not produce accurate product costs if much of a company’s costs is incurred by activities that are not at the unit level, because both machine hours and labor hours are unit-based cost drivers. Machine hours capture work performed on a unit of a product and therefore do not do a good job of tracing the cost of activities that are not at the unit level to products.

Example: Products A and B, for example, may require the same number of machine hours. Even if A has quality problems and requires twice as many engineering hours as B, an equal amount of engineering hours as B, an equal amount of engineering cost will be traced to each product if machine hours are the cost driver used. The reported costs of the products will therefore be inaccurate, because A actually consumes twice the engineering costs that B consumes.

Ten Myths that Create Barriers to the Implementation of Activity-Based Cost Systems
By Peter B. B. Turney, PhD
Journal of Cost Management

Myth 5: A cost system should be kept simple. Managers and academics often state that a cost system should be kept simple-that is, relatively few cost drivers should be used.

If the products in a plant are homogeneous, even a unit-based system with only one or two cost drivers produces accurate product costs. (Note that, in the extreme case, a plant that produces only one product does not need a product costing system in the first place. To assign costs to products would simply require dividing all costs of the plant by the output during the period.) In plants where product homogeneity exists, therefore, there is no need to install an ABC system with multiple cost drivers to improve the accuracy of product costs.

Product diversity. But using only one or two cost drivers may result in inaccurate product costs when product diversity exists in multiple product facilities. Product diversity exists, for example, when products are manufactured in batches of different sizes or when product differences affect how intensely activities are performed. When product diversity exists, more – and different – types of cost drivers are needed to capture the impact of the product diversity on the cost of the products.

The cost of machine setup, for example, is a batch-level activity. If setup cost is traced to products via a unit-based cost driver and if batch sizes vary, the result will be inaccurate product costs. In contract, a batch-level driver, such as the number of setups, traces setup cost to products based on their use of the activity in question. Changing the engineering specifications of a product is a product-level activity. Product costs will be inaccurate if the cost of engineering changes is traced using a unit-level driver. This results because engineering effort usually varies from product to product. To accurately assign this product-level cost, a cost driver such as the number of engineering – change notices would have to be used.

The belief that improving conventional cost accounting systems will increase the accuracy of product cost is correct, but the increased accuracy may still be insufficient. Increasing the number of cost centers separates unlike activities. Using machine hours helps reduce burden rates and copes with machine-based diversity. These changes, however, do not improve the ability of conventional systems to handle activities that do not occur at the unit level, nor do they account for differences caused by product diversity. Therefore, companies may need an ABC system to provide accurate product costs if the following situations apply:

• They have product diversity; or
• They incur significant costs in activities that are not at the product level.

We do not need more accurate product cost. Some people retort that conventional systems report product costs that are sufficiently accurate. Some add that additional accuracy is unimportant, because managers know intuitively what products cost. Others believe that accuracy is unnecessary on the ground that the cost to produce a product is not used to set prices. These beliefs are important because they challenge one of the major benefits of ABC systems-more accurate product costs. The following sections address this issue.

Myth 6: We know what our products cost. Many people believe those managers easily estimate product costs without the help of a cost accounting system. If this belief is true, why incur the cost of developing and maintaining a cost system when managers can estimate product costs to an acceptable degree of accuracy using their intuition? In other words, such managers only need a cost accounting system to value inventory to the satisfaction of the auditors and the taxation authorities.

Managers may be able to identity products that are overcosted or undercosted. These managers use their knowledge of the products and processes to identify inaccurately costed products, These managers know, for example, that a product that is difficult to manufacture must cost more than one that is easy to manufacture. They will understand this fact even if their unit-based cost accounting system reports that the two products the same.

Managers do not realize the size of the problem. Experience has shown, however, that managers are unable to estimate the size of product cost distortions. The controller (who chose to remain anonymous) of one plant that had designed an ABC system commented on this tendency:

“The cost of some products turned out to be close to what we had predicted, but the cost of others was quite different. The cost of prototypes, for example, turned out to be far less than we had anticipated. Prototypes required extensive discussions with customers, engineering time, and different handling. They were regarded as nuisance items. But when we quantified this nuisance factor, it turned out to be more emotion than reality. At the extreme, the cost of setups was far higher than we anticipated. We had failed to include the cost of inefficiencies in the process flow in the cost of the setups. These costs were not visible to us and were not clearly attributable to the setups.”

Myth 7: The market sets prices so we do not need product costs. Many managers believe they do not need product costs because the market sets prices. Since one of the main reasons for having product cost information is to set prices, managers in firms whose prices are set by the market often feel that product costs are unnecessary.

Pricing to market is common in several industries, which means that the role of product costs in setting prices is, therefore, limited. Pricing to market is common, for example, in high-technology industries, because product life cycles are short and margins are high relative to manufacturing cost. Pricing to market is also common for commodities and when market prices are readily available. Finally, pricing to market is also used when product costs are difficult to determine.

However, it is dangerous to believe that product costs are unnecessary even if they are not needed for pricing; Managers chase profits, and profits can be phantoms of the cost system. It is only natural that managers should devote attention and resources to the products they perceive to be the most profitable, and it is the cost system that reports the absolute and relative profitability of products.

The business of one company, for example, was to combine two products – attaching machines and fasteners – and market them to customers as a package. The firm rented the machines out at a deliberately low price and priced the fasteners to cover their cost and the remaining cost of the machines. The cost system, however, traced all costs to the fasteners and none to the machines. On the surface, the system worked fine. Customers were happy and loyal. But when the company redesigned the cost system so that it separated the costs of the two types of products, it became clear that the cost system was sending highly distorted signals. Since some of the fasteners were labor intensive, the old system had attributed a disproportionate amount of overhead (including the cost of the attaching machines) to them. Over the years, the company had put little effort into these product lines and consequently walked away from attractive markets.

Experience has shown, therefore, that improved accuracy is an important benefit of ABC systems. Managers may be able to identify products that are incorrectly costed, but they may not be able to judge the size of the distortion. Thus, even firms that do not use product costs to set prices should still devote attention and resources to products based on relative profitability.

Cost systems play a limited role. Another school of thought maintains that ABC plays a limited role in managing a firm. One related belief is that improved information about overhead cost is unnecessary because little can be done about this “fixed” cost. A second belief excludes non-manufacturing activities from the focus of ABC systems. A third belief grants that ABC systems can help in making improved strategic decisions but does not acknowledge their usefulness in helping to manage overhead activities. If these beliefs are true, they clearly diminish the value of ABC systems. Each of these issues is discussed next.

Myth 8: We cannot do anything about fixed costs. Many people believe that little can be done to reduce fixed costs. (Fixed costs are costs that remain constant during a limited period despite fluctuations in volume. This assumption of constancy is relaxed only if the time period is long enough and if the change in volume is sufficiently large.)

The source of this myth is the belief that most costs can be divided into the categories of variable and fixed. Managers and academics a like observes that the cost of certain activities, such as the cost of connecting a power supply to a chassis, varies with the number of product units produced. Such activities are unit-level activities because they are performed each time a unit of the product is produced. Both other activities, such as engineering change activities, are not performed each time that a unit is produced and are, therefore, fixed.

While the cost of these “fixed” activities does not vary with the number of batches and different products produced. Batch-level activities are performed each time a batch of the product is produced. Product-level activities support the production of a product type. The only activities that are not variable are those at the process level that relate to the entire facility. These are costs that support all the products produced within the facility.

Batch-and-product-level activities are common in many manufacturing settings. Example of batch-level activities include the following:

• Setting up a machine
• Scheduling the production of batches of products; and
• Issuing purchase orders to buy a batch of components or materials.

Product-level activities include the following:

• Making an engineering change to a product; and
• Establishing vendor relations for a new component.

A failure to recognize batch-and product-level activities diminishes the perceived benefit of ABC systems. Conventional systems are unit based. They recognize only one level of variability-the unit level-and use only unit-level cost drivers (traditionally, direct labor hours). ABC systems, however, recognize multiple levels of variability and use unit-level, batch-level, and product-level drivers to capture this variability.

Myth 9: Only manufacturing costs are product costs. Another widely held belief is that only manufacturing costs is product costs. Conventional product costing systems are consistent with this belief because they exclude the cost of activities performed outside the factory walls. These excluded activities include research and development, selling, and distribution.

The exclusion of non-manufacturing activities from product cost reflects the influence of generally accepted accounting principles (GAAP) on product costing systems. GAAP defines product cost to mean full manufacturing cost; non-manufacturing costs are classified as period costs rather than product costs. This bias reflects the importance of inventory valuation as an objective for unit-based systems. For some, this bias also reduces the perceived value of ABC systems is their ability to handle non-manufacturing activities.

While excluding non-manufacturing activities may make sense for inventory valuation, it is counter-productive for managerial purposes. It is an inevitable fact that products require many activities outside manufacturing including the following:

• Designing products;
• Processing customer orders; and
• Distributing products to customer.

The cost of these activities can be traced to products using drivers such as the number of customer orders. Failing to include the cost of these activities distorts product costs if the following situations occur:

• The cost of the activities is high; and
• The activities are consumed differently by different products.

Note that in many firms the cost of non-manufacturing activities exceeds 20 percent of total revenues.

Tracing non-manufacturing costs. Several companies with ABC systems trace the cost of non-manufacturing costs to products. A manufacturer of printed circuit boards, for example, traces the cost of order entry, sales, and marketing activities to products using the number of customer orders as a cost driver. This tracing results in quite different product costs, because the size of customer orders varies significantly from product to product.

Under the firm’s old system, the cost of order entry, sales, and marketing activities was expensed and not traced to the products. All products were therefore under-costed; products ordered in small batches were significantly under-costed. This under-costing created an incentive to accept small customer orders. Management has since instituted a charge per customer order (using the ABC system as a guide). As a result, the average size of customer orders has increased.

Myth 10: Product costs are not useful for managing overhead activities. Some people maintain that product costs are not useful for managing overhead activities. For those who subscribe to this opinion, a decision to implement an ABC system must be based on strategic benefits from the system instead of cost reduction.

This belief stems from the experience of using unit-based product costs for cost reduction purposes. Unit-based systems use drivers such as direct labor hours that do not accurately measure the use of activities that are not at the unit level. Therefore, managers who use this inaccurate information to reduce cost may make changes (to products or processes) that increase rather than reduce cost. In one firm, for example, the redesign of the products to reduce direct labor cost actually increased total cost because of the increased demand for overhead activities.

ABC systems, however, provide useful information for cost-reduction programs. ABC systems use more and different types of cost drivers that enable them to determine product costs accurately. As a result, it is possible to manage these cost drivers and reduce costs. ABC systems also provide information on activities that facilitates managing those activities.

One firm, for example, used the number of part numbers as a cost driver in its ABC system. An important goal in this firm was a reduction in the numbers. Management believed that reducing the number of part numbers in new product designs would reduce the demand for material-related activities and thus reduce overhead. Management also felt that a reduced part count and the simpler product designs that resulted from using fewer parts would facilitate the introduction of just-in-time (JIT) manufacturing.

Another firm used its ABC system to determine the cost of engineering-change activities. Careful study showed that the engineering-change process could be redesigned to reduce the cost and time required completing an engineering change. The ABC system was used to model the change and to confirm the cost savings that resulted.

Overall, there is no justification to the belief that ABC systems play a limited role in reducing costs. ABC systems provide new opportunities for cost analysis by recognizing what proportion of supposedly “fixed” overhead is actually variable. Including activities outside the factory provides additional information on the cost of products that require these activities. Finally, ABC systems provide rich sources of information for managing overhead activities. In some cases, firms have implemented ABC systems solely for this reason.

Conclusions
The rapid emergence of ABC systems challenges forms to assess the value of ABC by carefully balancing the costs and benefits re-designing and implementing a new cost system. Many firms are likely to find that ABC systems provide a distinct advantage and should be implemented.

This article has explored a number of myths about ABC systems. These myths, each of which casts doubt about the value of ABC systems, actually represent only partial truths about ABC. The myths may be valid under limited circumstances, but they break down when they are extended to ABC systems at large. Companies that are considering the redesign of their product costing systems may, therefore, make the wrong decision if they accept these myths as always being true in all circumstances.

In sum, experience shows that ABC systems are not difficult to implement and use. There are also limits to how much improvement can be derived from conventional systems. In addition, companies usually benefit from an ABC system that reports more accurate product costs. Finally, the value of ABC systems is derived from a number of uses, including the management of overhead activities.

About Cost Technology
Cost Technology designs and implements solutions to support fact-based decision making.  These solutions transform existing data into strategically meaningful and actionable insights in areas such as cost and profit management, financial forecasting, analytics, and performance management.  Since 1991, the firm has helped public and private sector organizations across the world improve performance by creating the knowledge needed to make every decision count.

Question:
You mentioned trying your best to measure the outcome of administrative processes. Do you have an example of what you would recommend in order to translate the most value to the client in a situation where a straight quantitative answer is not available?

Answer:
I prefer to emphasize the positive. There is real value to identifying the activity, costing it, linking it to the goals of the department, and analyzing cost drivers associated with the activity. None of this information will be available about an administrative process prior to an ABC storyboarding initiative. It provides huge value to the client, even in the absence of other quantitative output measures.

Question:
What is a good business unit or department to target within an organization to run an ABC “Proof-of-Concept”?

Answer:
First, you need to identify areas where you are likely to gain results. For example, areas with cost or efficiency problems are good candidates. Second, you need to select areas that are technically feasible in a reasonable period of time. For example, a highly complex engineering area may take too long to provide results within the limited time-frame of a proof-of-concept initiative. Third, and lastly, you need to work in an area where you have the full and enthusiastic support and involvement of management. This is important because you will need to spend time with several members of the selected area during development of the storyboards, as well as during the follow-on value creation phase. For private sector companies, Profit Reveal 90 combines an assessment to target the highest business value, model building and profit realization and cost reduction to provide results within a fast 90 day period.

Question:
How can you measure the quality using the ABC Model?

Answer:
A measurement is an attribute of an activity or process. Just as cost is an attribute, so is quality. The challenge with quality is how to measure it, and how to determine specific measurements. In many cases, particularly in non-manufacturing settings, there may be no history of measuring quality, and therefore no data available. You must then start with estimates of quality measures, and set into motion the measurement of the quality of each activity.

Question:
For cost per unit of output, what capacity would you consider, particularly in the case of non-bottleneck resources?

Answer:
This is a great question and also a complex one to answer. Identifying capacity may not be necessary in a model that focuses on reducing cost or improving profits. If you wish to use the model to plan the use of resources, and to associate with activities only those resources that are used, then it is necessary to use modeling techniques such as time driven ABC or resource planning where the capacity of each activity is defined. From a reporting perspective, it is then possible to report the cost of excess capacity (for non-bottleneck resources).

Question:
In your experience, have you seen that in the operational ABC model, you could group multiple activities to an activity driver?

Answer:
For cost assignment purposes, you can group activities to a single activity driver in any type of ABC model. In an operationally focused ABC model, you will have more scope to do this because you will have more activities. You can also group individual activities into consolidated (or macro) activities prior to assigning their cost to cost objects using activity drivers. When you conduct a cost driver analysis in operational ABC (i.e. root cause analysis to find explanations of inefficiency and high cost), you will find that cost drivers are often common to multiple activities. This means that when you fix the problem associated with the cost driver, there will be improvement and cost reduction impact on several activities. You will aggregate these cost savings (plus time reduction and quality improvement) to determine the overall impact of fixing the cost driver.

Question:
How much participation is required by the business owners and stakeholders to conduct an accurate assessment?

Answer:
There must be enough participation to ensure that all the pertinent information they have is included in the assessment. Also, their participation will help achieve the buy-in and support necessary for the acceptance of the assessment recommendations and plan. From a practical standpoint, you will spend more time with those individuals whose knowledge, opinion and support are most critical to the success of the ABC assessment. Typically the assessment is completed in 2-4 weeks. We spend an average of 2 hours talking to the appropriate people and do some off-line analysis. If the assessment is extended to target results (such as in the Profit Reveal 90) it will last longer (say 90 days) but provide a positive return on investment.

Question:
Would the cost of maintaining the ABC model also be a factor to build a live ABC model? And for operational ABC purposes would one zoom in to the areas of interest by using this strategic model?

Answer:
My experience with ABC systems is that maintenance, if handled correctly, can be quite cost effective. You should look for opportunities to automate the maintenance process wherever possible, such as through bar coding or through computerized time collection, stored processes for analytics and queries, automation of data loads and the automated delivery of reports to portals. For the second part of your question, if you build the strategic model first, then you can use it to identify areas of high cost and improvement potential, and then “drill-down’” to get operational benefits in those areas through targeted ABC analyses.

Question:
In conducting the assessment, how much of the model can be defined through process/technology reviews versus business owner/stakeholder interviews?

Answer:
This is a great question. Our experience is that the mix is about 50-50. I would say that we get about 50% of the insight through process review and some analysis of financial and non-financial data. The remaining 50% comes from the interviews with stakeholders.

Question:
In any ABC adaptation, the results will point to non-productive activities and inadequate processes, i.e., someone is exposed. Therefore, whom do you target within an organization as your potential “sponsor”/”advocate”?

Answer:
The sponsor should always be the most responsible manager you can find. This may be the President, the Chief Executive Officer, or the Vice President or General Manager in the case of a division. It is also important to have a sponsor in each area where you are implementing ABC, such as the VP of Manufacturing, or the Head of the Department. The Chief Financial Officer or Controller also plays an important role, but generally as a champion and project leader. At Cost Technology, we have an established process for Value Creation, which includes titles, position descriptions and responsibilities of individual members of the team.

Question:
What is your advice to the people who do not want to be measured so they don’t cooperate to define the key activities?

Answer:
You have to minimize fear, distrust, and any belief that this is unimportant personally and to the organization. You can accomplish this with leadership, communications, and collaborative implementation methods (such as storyboarding) and other techniques.

Question:
How do you assign costs to processes (i.e. salaries, depreciation, cost allocations, etc.)?

Answer:
The costs of these resources are assigned using resource drivers. Resource drivers accurately measure the relative use of a resource by each activity. Please read the relevant Chapters in Common Cents for a more detailed explanation.

Question:
How do you ensure that outsourced options have costs that are aligned to your company’s costs or processes?

Answer:
Comparison will be difficult if the potential contractors do not report cost according to the activities in your ABC model. If you are large and powerful, or have a good relationship with your contractors, I suggest you ask them to report cost on an activity basis. You can always facilitate the process by offering to help. One of our consulting affiliates is a retired manager from Xerox who did this with over 70 suppliers to Xerox, and he did it very successfully, while achieving significant cost reduction.

Question:
Is it necessary to link the ABC model to the scheduling model?

Answer:
The scheduling model may provide certain data—such as the number of times scheduled per product—that may be useful for activity driver purposes.

Question:
If your first priority is to develop profitability for potential customers based on “unbundling” the company’s current and potential activities, should we implement the operational model first? Then implement the strategic model to develop customer specific ABC?

Answer:
No, if your first priority is customer profitability, you should develop a strategic model first. You can later create an operational ABC capability by drilling down into high cost areas revealed by the initial strategic model.

Question:
Collecting activity driver quantities for sales in an operational ABC is a huge undertaking because it is mostly based on time sheets. What would you recommend to reduce the cost of gathering the AD information?

Answer:
I would explore the possibility of automating the data collection. There will be some upfront cost and effort, but long-term it will be less time consuming. Software tools available today are capable of handling large quantities of data in short periods of time cost-effectively. Banks or telecoms, for example, have models that use billions of pieces of data associated with millions of customers and run in less than 10 minutes.

Question:
Does the ABC model require a permanent IT system?

Answer:
The answer is no. ABC sits outside the IT system. It is connected to the IT system, possibly via a data warehouse created specifically for this purpose. Data can be ported to ABC using automated links, and activity rates can be transmitted to the IT system for reporting and analysis purposes. ABC is not a system; rather it is an analytic tool.

Question:
Do we start by defining the main processes or should we start with activities?

Answer:
You start with the activities, and then determine which process each one belongs to.

Question:
If I want to apply StorySolve® as a technique to improve my ABC system, do I need training? Is there any book or training session where I can get more details about it?

Answer:
StorySolve® is a proprietary storyboarding method developed over many years by Cost Technology, Inc. The method is available for license, and can include technology transfer if you wish (i.e., training, guided facilitation, etc.). The license comes with a full complement of tools and documentation.

Question:
Can we implement ABC as a system of cost accounting rather than a model of cost reduction?

Answer:
Yes, you can use ABC for cost accounting purposes. Cost accounting—the method of determining the cost of sales and inventory cost in a manufacturing company—does not require accurate product cost. It can therefore be handled quite simply. If you have an ABC system in place, then it is totally appropriate to use it for costing purposes.

Question:
If you were to implement ABC in a manufacturing environment and you were asked why it’s important, how would you summarize the reasons? Also, what are the risks involved in the implementation?

Answer:
There are many reasons why you would implement ABC in a manufacturing environment. There must be a strategic or operational issue that needs accurate, understandable, process-oriented cost information to make the proper decision. In addition, this issue must have significant consequences in terms of problems (if not resolved) or benefits (if ABC is used). The risks involved in implementation are those of failure relating primarily to organizational issues (e.g., lack of leadership), all of which are controllable.

Question:
Some decisions need to be made based on forecast development. Do you have experiences with a forward looking approach to ABC? Is it manageable to build such a model?

Answer:
A forward looking model can be built using time-driven or resource planning techniques, and it can also be done using analytics. It can be done cost-effectively, but should be done in response to a specific business need.

Question:
Our organization is very resistant to change; it is very difficult to change from a traditional governmental accounting mindset to an ABC view of the organization and its processes. How can we get people “shifted” to the ABC mindset, especially those in senior leadership, who are often the most resistant to change?

Answer:
I have encountered the resistance to change you describe in government organizations. I recommend you combine the principles of change management with a proof of value to deliver immediate results. There is nothing like results to convert the non-believers! We have followed this approach in both government and private sector organizations.

Question:
How can we use operational ABC in power distribution companies that don’t have computerized accounting systems?

Answer:
You can do a process-by-process analysis using storyboarding. Storyboarding relies on cards, dots and other non-computerized media. You can load the data from the storyboards into Excel or other tools to allow further analysis.

Question:
I’m from Peru and due to the management culture and the fact that generally owners are managers, it’s very difficult to generate change and to develop Strategic ABC because they feel challenged. What would your advice be in this case?

Answer:
You need to find out what will cause them pain if they don’t implement ABC, and what will give them success if they do implement ABC, and create a plan to resolve their problems and give them success. Then you need to treat ABC as a change management initiative, and conduct the implementation in a way that will create high levels of buy-in (ideal is to give them results).

Question:
We have established ABC measures within our organization. In looking at their P&Ls, managers seem to be managing their expenses well; however, their cost per unit is not very good, so now they are losing interest in the ABC Costs. How do we keep the buy-in of the Operations Managers?

Answer:
I am not sure I fully understand your question. It appears that you are using ABC information for responsibility budgeting. This is a great use of ABC, but there can be many reasons why it is failing. One may be that managers are responsible for budgeted expenses—but not for activity costs—and are therefore paying attention to expenses and not activities. Another may be that the ABC numbers in the budget may be poorly formulated for budgeting purposes. ABC is a good analytical tool, but looking forward you need a different type of ABC model—one that utilizes the resource planning and capacity management information. Finally, it may be a simple training issue. If this does not answer your question, please contact me and I can schedule a quick discussion.

Question:
Is it possible that the process oriented cost reduction results in a cost transfer between functions instead of a real reduction?

Answer:
Yes, it is possible, and unfortunately it does happen. The key is to make sure that resources that are released by the process improvement are redeployed to productive work, or taken out of the organization. One of the reasons it happens is the absence of management attention to the resource issue. If the resources are not deliberately redeployed, they will quickly find other (not necessarily value-added) work to do. Another reason is that many ABC models lack the ability to separate unused resources into an excess capacity category. There are some simple fixes to this omission, but the ultimate solution is to upgrade the ABC model to a Resource Planning model.

About Cost Technology
Cost Technology designs and implements solutions to support fact-based decision making.  These solutions transform existing data into strategically meaningful and actionable insights in areas such as cost and profit management, financial forecasting, analytics, and performance management.  Since 1991, the firm has helped public and private sector organizations across the world improve performance by creating the knowledge needed to make every decision count.

“Linking ABC to the scorecard helps keep the spotlight on results. If people are responsible for performance measures of cost and profitability, they will pay very close attention to cost and profitability.”
Peter B.B. Turney, PhD, Common Cents (Second Edition)

Activity-based costing (ABC), activity-based management (ABM) and the balanced scorecard (BSC) are established management methods. They are building blocks of performance management systems.

ABC and ABM provide cost and other business intelligence about key business elements including resources, activities, products, services and customers. They enable managers to make decisions that improve cost and profit performance. The BSC translates strategic goals into a set of performance measures balanced according to the important dimensions of performance. It helps communicate and execute the strategic plan by defining success in quantitative terms at each level of the organization.

ABC and the BSC are often viewed as independent methods each with its own purpose. However, they are complementary and offer greater value when linked together. The benefits of linkage include additional performance measures—measures for which ABC is the only reliable source—and more comprehensive decision support.

The BSC benefits from the inclusion of ABC performance measures. These include the cost of activities and activity outputs which are used in the internal business process dimension of the BSC of public and private organizations. This activity information covers support services as well as primary business processes. For private organizations, ABC profit measures by customer, market segment, market area and distribution channel are used in the customer dimension of the BSC.

ABC can provide as much as 20-30% of the performance measures in the BSC. For example, the South Dakota Department of Transportation’s activity-based costing model provided 22% of the measures in the BSC.

The users of the BSC benefit from the analytic capabilities available in ABC. For example, a manager of a transportation department may find that the actual cost of maintaining a mile of highway exceeds the target in the scorecard. ABC allows the manager to access detailed information about the activities and resources associated with maintaining highways. A detailed “drill down” and analysis of this information in ABC may reveal the root cause of the problem and allow corrective action to be taken. Decision support is particularly effective if ABC data can be accessed from within the BSC.

Successfully linking ABC and the BSC requires a different type of ABC model. The BSC relies on up-to-date ABC data on a monthly or quarterly basis, so the ABC model must be up-dated monthly or quarterly and data fed to the scorecards in the BSC.

This ABC enterprise reporting system is quite different from the one-off desk-top models typical of early applications. Data sources unique to ABC—such as employee time reporting–are automated to reduce the cost and enhance the timeliness of data capture. Data feeds from legacy systems or enterprise resource planning systems are automated using extract, transform and load (ETL) tools.

ABC’s role as an analytic decision support tool changes the design of the ABC model and reporting system. The ABC model must be forward-looking to support planning efforts as well as a source of accurate historical performance data. A good reporting system—such as a modern web-based tool—allows managers to access, analyze and display ABC information on their desktop. This reporting capability should allow a manager to follow the trail of investigation from the targeted performance measure in the scorecard to the underlying details in the ABC model.

In summary, linking ABC and the BSC enhances the value of two proven management methods. The BSC scorecard benefits from access to performance measures for the business process and customer dimensions. The BSC also benefits from the analytic capability of ABC to support performance analyses. ABC transitions from costing tool to analytic method supplying up-to-date business intelligence to support performance improvement initiatives.

Why link ABC and the balanced scorecard?
ABC and the BSC are proven management methods. They work well on their own, but they work better together. This is why:

• The balanced scorecard benefits from ABC performance measures for the business process and customer dimensions
• Managers use ABC as a diagnostic tool to uncover the root causes of scorecard performance problems
• ABC becomes an enterprise analytic system for performance management

About Cost Technology
Cost Technology designs and implements solutions to support fact-based decision making.  These solutions transform existing data into strategically meaningful and actionable insights in areas such as cost and profit management, financial forecasting, analytics, and performance management.  Since 1991, the firm has helped public and private sector organizations across the world improve performance by creating the knowledge needed to make every decision count.

The scorecard is designed to correct this problem. By deriving goals and measures from the strategic plan, and rolling these down to each part of the organization, the scorecard is the focal point from which each part of the organization and each person know their responsibilities to execute the strategy.

In addition to providing focus, scorecards highlight important variances in performance. These variances trigger investigation of problem areas, and may lead to diagnosis and corrective action.

The ability of scorecards to trigger corrective action and positively impact performance can be dramatically increased through the use of business analytics. Analytics is the extensive use of models and algorithms to analyze data from various sources. It produces knowledge that decision makers can use to improve business performance.

This article describes how organizations benefit from integrating scorecards with business analytics. It shows how analytics identifies performance gaps, analyzes problems, and helps select the decisions that lead to the best results. It describes five analytic tools—strategy maps, activity-based costing, activity-based budgeting, process analytics, and forecasting—that help users of scorecards understand and act upon the performance signals in their scorecards.

Scorecards and Business Analytics

An organization with a scorecard system has a different scorecard for each level and responsibility. For example, a manufacturing company has a company-wide scorecard, one for each functional area such as production, procurement, and distribution, and one for each responsible manager within each functional area. There may also be scorecards for initiatives such as six sigma. Each scorecard is linked both to strategy and to the scorecards above and below them in the organization.

The value of the scorecard system is determined by four factors:

• The measures in the scorecard must be relevant to strategy. Measures that aren’t tied or represented in the strategy could misdirect employee behaviors and actions, ultimately preventing a company from achieving its strategy.
• The data needed to calculate a score must exist; otherwise it will not be possible to measure progress towards a goal. For example, if customer satisfaction cannot be measured, it will be difficult to execute a goal to improve customer satisfaction.
• It should be possible to forecast the future value of a measure in a reasonably objective manner otherwise the target will not be relevant. Basing a measure solely on assumptions can produce measures which mislead decision makers.
• The users of scorecards must be able to understand and act upon the performance signals inherent in the scorecard measurements. For example, when the target and actual performance of a measure diverge, is this divergence significant? Does it call for investigation and possible corrective action? Does the manager responsible for the value of a measure have the authority to change the resources being used to accomplish the tasks the measure is based on?

What is the experience of organizations in deriving value from scorecards? While the score varies from organization to organization, the most common barriers to realizing value include:

• The performance measures in the scorecard are not derived from the strategic plan. They may be regarded as key performance indicators, but are missing the systematic link to corporate goals and objectives. Success on these measures cannot, therefore, be a guarantee of strategic success.
• Important performance measures related to strategic goals are missing from the scorecard. For example, a manufacturing company set goals to improve customer profitability. However, the company did not measure customer profitability, and was unable to provide scorecard measures for these goals. In the absence of measures, it was difficult to set and achieve targets to improve customer profitability.
• Measures relating to strategic projects and initiatives are often absent from scorecards. Many organizations do not measure—or are unable to measure—initiatives such as those designed to improve the performance of processes. In the absence of these measures, initiatives are often chosen without regard to their impact on performance, and are not managed for results.
• Predictions of future scores for key measures are not used to provide early warning of impending problems. If the scorecard owner is first aware of a problem when a measure flashes “red”, it may be too late for timely preventive or corrective action. A graph showing a trend of deteriorating performance can be helpful, but its significance may not be clear unless there is a forecast of the future score.

What analytic tools are available to correct these common limitations and enhance the value of the scorecard?  Below are five examples that have proven value.

Strategy maps. The relevance of scorecards to strategy is best achieved using a strategy map. A strategy map is a cause-and-effect diagram that organizes goals and objectives into four perspectives; financial, customer, internal process, and learning and growth. These perspectives are based on the idea that in order to succeed, an organization must balance short-term financial success with other factors, such as developing world-class processes, which ensure long-term success.

Figure 1: Example of a strategy map for a manufacturing company.

The value of the strategy map is its ability to link the strategic plan to the scorecards that cascade down the organization. The goals, objectives and measures of each scorecard are derived from the objectives of the scorecard directly above it. That scorecard, in turn, is derived from the one above it, and so on until you reach the strategy map. If this is done, there is a powerful logic between achieving targets in each scorecard and the successful execution of the strategic plan. The person responsible for the scorecard at the lowest level has a direct line of sight to the strategic plan.

Activity-Based Costing. ABC is a financial modeling and reporting tool. It provides accurate cost information about an organization’s resources, activities, products, services and customers. Originally developed as an improved cost accounting method, it today provides accurate cost and profit information for a variety of decision making, planning and performance measurement purposes.

ABC adds greater accuracy, relevance and understanding than traditional accounting information. ABC reports the cost of each activity in a process, as well as the cost of resources that contribute to the activity’s cost. In contrast, accounting systems typically report only the cost of depreciation, salaries, supplies and other line items that are only indirectly relevant to scorecard objectives.

ABC also reports cost and profit information about products, services and customers that is typically not available in accounting systems. For example, cost-to-serve activities such as order entry and sales are treated as period costs in accounting systems and not traced to the customers that benefit from the activities. Manufacturing companies may have a cost accounting system for reporting product cost, but these costs may not be complete or accurate. Many service organizations don’t have a cost accounting system at all.

Figure 2: This figure shows the profit per order for a company selling into seven segments in the financial services industry. Prior to an ABC study, the company was unaware of large variations in profits between segments. Armed with this information, the company implemented action plans to restore profitability in poor performing segments.

Activity-Based Budgeting. ABB is an ABC model running in reverse. ABC reports historical costs and profits, whereas ABB predicts costs and profits in a future period. An ABB model is an excellent source of targets for the scorecard.

ABB is a predictive model that derives the cost of resources needed to meet the plan. For example, the sales plan lays out the expected volume of sales of each type of product and services. This sales plan is converted by the ABB model into the demand for work for each activity (such as the number of shipments by the warehouse). Once the demand for each activity is understood, the model computes the resources required by each activity at the level of work required (such as the number of minutes of work in the warehouse). Finally, the price of each resource (cost per minute for people’s time) is applied to the quantity required to compute the budgeted cost.

Because the ABB model is based on the relationship between sales, activities and resources, it is possible to reflect changes in process performance. For example, an increase in productivity derived from an improvement initiative can be factored into the algorithms in the ABB model. As a result, the targeted cost for this process will be lower for a given set of outputs.

These computed targets are quite different from those derived from traditional budgeting exercises. ABB targets are accurate forecasts based on a predictive model that estimates the work needed to meet the plan. In contrast, traditional budgetary targets are derived from the accounting system and not susceptible to modeling the impact of demand and process changes on cost.

Process analytics. The use of process analytics in connection with operational improvement initiatives is another excellent source of objectives and measures for the scorecard. Process analytics provide measurements to guide the selection, planning and execution of change initiatives.

Process analytics convert improvement initiatives into scorecard objectives and target measures for cost savings and other performance improvements. These measures are tracked over time and surfaced in the scorecard.

For example, a government agency used an analytic method called Storysolve^® to derive objectives and targets relating to process improvement initiative. Managers could track progress on these measures and the overall success of the initiative on a monthly basis. Impressively, the agency averaged between 10 and 30% savings on analyzed cost using this method.

Figure 3: Example of process analytics. Scorecard shows analytics for an initiative to improve a machine patching process. Analytics enables measurement of cost reduction targets and tracking of outcomes via the scorecard.

Forecasting. Scorecards report actual performance on a periodic basis. These measurements are reported against targets to allow managers to separate success from failure. Forecasting using statistical methods can be used to set more accurate targets as well as to provide early warning of impending performance issues.

Reporting actual performance against target is important in a scorecard system. It provides an accounting of each manager’s responsibility for performance. It can be the basis for periodic performance reviews and corrective action.

Scorecard comparison of actual versus target performance is strong on accountability but weak on early warning of problems. For example, a measure may be trending down, but is not yet flashing yellow or red. The responsible or reviewing manager might miss the opportunity to correct a problem before it becomes too serious.

Statistical forecasts look forward and predict which problems are likely to become serious in the future. When automated, forecasts can provide a running prediction of what will happen in the next week, two weeks, month, quarter or six months. Managers can then take corrective action long before the measures flash red on the scorecard.

There are many different types of measures—and potential problems—that can be forecast. For example, percent utilization of an IT application can be forecast relative to trends in demand and anticipated changes in usage. Another example is forecasting the load on a critical process step to determine how much capacity is available under expected operating conditions. This could avoid situations where the resource becomes a constraint causing disruption to production and revenue losses.

Summary

Scorecards are powerful performance management tools. Their ability to execute strategy and drive successful performance is enhanced by the use of analytic tools. Analytic tools increase the strategic relevance of the scorecards, provide accurate measurements, and enhance the manager’s understanding of performance patterns.

The strategy map is a cause-and-effect diagram of strategy. It links strategy and the scorecards. When scorecards are tied to a strategy map, they are relevant to the success of the organization as a whole. Focusing on measures that are linked to strategy leads directly to strategic results.

Activity-based costing is a financial and organizational measurement and modeling tool. It feeds cost measures to the process perspective, and profit measures to the customer perspective of the scorecard. ABC is the single most important tool for resolving missing measures. Organizations with ABC systems derive as many as 25% of their measures from ABC. These measures include the cost of activities in the process perspective of the scorecard, and the profitability of products, services and customers in the customer perspective of the scorecard.

Activity-based budgeting is a forward looking version of ABC. ABB models the relationship between the plan, the demand for work, and the need for resources to complete the needed work. It provides accurate forecasts of costs that can be used as targets in the scorecards.

Process analytics provide measurements for change associated with operational improvement programs. Action plans can be loaded into scorecards along with their estimated impact on future performance. Process analytics also track—and report—changes in performance that occur when action plans are implemented.

Forecasting the value of future scores increases the accuracy of targeted scores, and also the diagnostic and early warning power of scorecards. Forecasts include trending of historical performance data as well as predictions based on multiple external and internal variables. These allow corrective action to be taken before scorecard measures flash warning signs.

Taken together, these tools increase the value of scorecard systems. They become more relevant, include more accurate measures, and are easier to understand and use. They support early warning and intervention, and lead to better decisions and improved results.

About Cost Technology

Cost Technology designs and implements solutions to support fact-based decision making.  These solutions transform existing data into strategically meaningful and actionable insights in areas such as cost and profit management, financial forecasting, analytics, and performance management.  Since 1991, the firm has helped public and private sector organizations across the world improve performance by creating the knowledge needed to make every decision count.

By Dr. Peter Turney
CEO, Cost Technology

Executive summary

The tremendous value that manufacturing companies realized in early applications of activity-based costing (ABC) sparked efforts to develop its power and extend its functionality to new areas. Today, ABC is a management practice found in diverse organizations, including government. The multitude of functions provided by state and local organizations, including transit and health services, makes them just as complex and diverse as manufacturing companies and, therefore, enables them to truly benefit from a technique that reveals the sources of cost and profitability, non-financial performance.

Applying lessons learned from ABC, government agencies have a clear understanding of where to transform operations to deliver services in a more cost-effective manner, benefiting both clients and taxpayers. Many government organizations cited in this paper have identified substantial cost savings through cost modeling and have realized both tangible and intangible benefits from capturing that value.

Activity-based costing models can be deployed to predict the impact of future activities and can be a central component of many performance management systems. Through the integration of ABC into performance management initiatives, an organization can communicate financial and non-financial strategies to everyone in the organization, measuring performance, developing financial and resource plans, analyzing performance, and creating value. A “collaborative performance management” initiative indicates the inclusion of costing models in determining corporate strategy.

Activity-based costing and collaborative performance management are long-term strategic endeavors. Neither should be approached as a project that will be completed and marked off the “to do” list because it really has no “end.” Rather, it is a journey wherein there will always be room to improve effectiveness and efficiency within any organization. Its unending nature is largely due to the environmental factors that constantly change, bringing new challenges and opportunities.

The transformation of activity-based costing

Activity-based costing (ABC) was first used in manufacturing companies in the mid-1980s as a methodology to accurately compute the cost and profitability of products. Its emergence coincided with global competition in automobiles, electronics and other manufactured goods that increased cost and profit pressures for domestic manufacturers.

ABC revealed significant methodological and computational errors in traditional cost accounting systems. Costs reported by these traditional systems often erred by hundreds, and in some cases, thousands of percent when compared with accurate ABC costs. When these errors were corrected using ABC, it was common to find as many as 80 percent of a company’s products unprofitable. In contrast, traditional cost systems incorrectly reported most products as profitable, failed to communicate opportunities to improve profitability and lulled companies into complacency.

Accurate ABC costs were accompanied by new insights into the drivers of profitability. ABC cost information spurred changes in price, product design, cost reduction, and other strategic and operational changes that led to profit improvement.

Given ABC’s early success in reporting accurate cost information, it is common to confuse ABC with cost accounting systems. Cost accounting originated in the 1920-1930s to enable manufacturing companies to value inventory for financial statement purposes. Only later were these costs used for management decision-making purposes, a function for which they had not been designed. In contrast, ABC sprang from the need to understand the sources of cost, profitability and non-financial performance in complex and diverse modern organizations. The early success of ABC led to significant efforts to develop its power, extend its functionality to new areas and harness new technology. Today, ABC is an analytic tool found in service and government organizations, as well as in manufacturing companies. Service organizations are often just as complex and diverse as manufacturing companies and benefit from a tool that reveals the sources of cost and profitability. ABC helps government agencies deliver services in a more cost-effective manner benefiting both clients and taxpayers.

ABC supplies business intelligence about processes, customers, equipment, and human resources, in addition to products and services. Areas of application include cost-to-serve activities, distribution and logistics, and support services. Activity-based costing models can be deployed with predictive capabilities, and they are the central component of many performance management systems.

Addressing performance management has been a battle cry for government agencies throughout the last decade. From elder care to transportation projects, activity-based costing plays a vital role in measuring the impact of service components on quality delivery. The next section will discuss this intersection of cost and performance.

Bridging cost and performance

Collaborative performance management (CPM) is an approach to measuring, analyzing, reporting and improving performance. It transforms analytic tools from “number crunchers” to interactive multivariate models that are accessed in a collaborative environment throughout the enterprise. People involvement, decision analysis, change management and value creation are the cornerstones of this method. CPM plays an important role in communicating and executing strategy. Government organizations receive new mandates and requirements for service delivery on an ongoing basis from federal agencies and state legislation. What is often missing in the directive is the detail of how to modify the internal processes to satisfy the requirements. Responding to the ever-changing environment, while continuing to meet constituent needs, requires highly energetic and capable management. Experience confirms that most business failure is attributable to faulty execution of plans rather than lack of vision. CPM helps correct this problem by communicating the strategic plan to everyone in the organization, measuring performance, developing financial and resource plans, analyzing performance, and creating value.

The CPM system includes five management methods: strategy map, balanced scorecard, activity-based costing, resource planning and value creation (Figure 1). Figure 1 – Value Creation Diagram These are described as follows:

Strategy map. A strategy map is a way of communicating strategy in a single page that everyone can understand. It is typically broken into four perspectives: customer, internal process, organization health and learning, and financial. The strategy map includes high-level objectives for each of these perspectives in a cause-and-effect framework.

• The balanced scorecard. The balanced scorecard is a set of goals and performance measures derived from the strategy map (and, therefore, linked directly to the organization’s strategic plan). It includes goals and measures in each of the four perspectives to provide balance across all important dimensions of performance. Each organization has a set of scorecards – one for each part of the business and the manager responsible – that are linked to each other and the strategy map. Hierarchically, goals are linked to objectives, which are linked to measures in a weighted cause-andeffect relationship. A balanced scorecard can be descriptive as well as predictive of organizational performance.
• Activity-based costing. As described previously, ABC is an analytic tool providing business intelligence about resources, processes, products and services, customers, and other business elements. It is used to optimize business decisions in terms of cost and profit impact and to provide performance measures for the balanced scorecard.
• Resource planning. Resource planning is a predictive version of activity-based costing. It simulates process capacity and resource requirements based on planned quantities and types of output. It helps answer “what if” questions about the impact of business changes on financial performance.
• Value creation. Value creation is a process to convert analysis into action and action into results. It includes a change management program (leadership, communications, defined roles and responsibilities, training) to enhance buy-in and learning. It also includes a process for executing action plans, analytics to support action plan decisions, tracking of results and communication of success.

Lessons learned: A government perspective

Among government and private industry organizations that implement performance management, achieving a balance between effectiveness and efficiency is a common success factor. Organizations that focus more on one and less the other do not reach the full potential of performance management. An organization can be very effective, but also be wasteful with resources. In contrast, an organization can be so cost-focused that service levels or product quality do not meet constituent expectations and needs. The most successful organizations balance the scales between effectiveness and efficiency – and the use of performance and cost information (including performance indicators) is paramount to this success. Effectiveness and efficiency can be optimized by connecting strategic performance and operational performance. The top of the organization is connected to and aligned with the front-line where operations are run. If everyone from top to bottom agrees and accepts the strategy and how it should be implemented, then the organization can move in a unified fashion to improve overall performance. ABC has proven to be a very descriptive connection between strategic performance and operational performance.

Even with the strategy and measures in place, many government organizations struggle to achieve the requisite cultural transformation. Organizations as a whole must learn to accept and adopt performance management as a discipline. This culture change involves denouncing fears that performance and cost information will be used as a disciplinary tactic; it should not be the reason or motivation for implementing performance management. Rather, the intent should be to give employees the intelligence they need to do their jobs better and make better decisions.

Cultural transformation can be spurred on through great leadership. Some of the most successful implementations of ABC and CPM are in organizations with top leadership spearheading this initiative. They sponsor it and believe in it. Once employees understand this, they are inspired to believe in it themselves – and adopt it. But the top-down push should be met with bottom-up involvement in building a performance management system. It is a collaborative effort. Finally, ABC and CPM are long-term strategic endeavors. Neither should be approached as a project that will be completed and marked off the “to do” list because it really has no end. Rather, it is a journey wherein there will always be room to improve effectiveness and efficiency within any organization. Its unending nature is largely due to the environmental factors that constantly change, bringing new challenges and opportunities.

The impact of CPM: Real-world case studies

The impetus for collaborative performance management is the drive to do more with less that is affecting the public sector in all areas of government. CPM works by helping communicate and execute strategy, as well as by transforming operating performance.

South Dakota Department of Transportation

The South Dakota Department of Transportation (SDDOT) implemented a comprehensive CPM system to help the department achieve its vision of providing cost-effective transportation. CPM helps the department run its operations “like a business.” It is credited with significant improvements in performance including millions of dollars of savings annually. Roxanne Rice, Fiscal and Public Assistance Director of SDDOT, commented on the success of CPM: “Through CPM, employees know how their activities contribute to the mission, vision and SDDOT strategic plan. They are responsible for strategic performance measures and are motivated to contribute to their success. CPM encourages employees to tell us what should be expected with regard to their activities. It gives them the opportunity to make changes to their work that increase efficiency and help them contribute to the goals of the department. Everyone participates in running the department like a business. All of us are knowledgeable about the department and its mission. We have buy-in regarding changes in the way we operate because these changes come from the employees and are based on analysis of their impact on performance. We are able to show our stakeholders how we are doing, what we are doing, why we are doing it and what it costs the taxpayer.” An impetus to implementing CPM at SDDOT was the difficulty managers had in making a decision about the manufacturing of road signs. A vendor offered to make all of the department’s road signs. These signs were currently made in-house, but the option of outsourcing was attractive if the cost were less. Unfortunately, in the absence of an ABC system, the department did not know what it currently cost to make road signs in-house and was, therefore, unable to determine if outsourcing would reduce the cost. Today, thanks to CPM, SDDOT managers have cost and other performance information at their fingertips. They use this business intelligence to reduce the cost of processes, lower the lifetime cost of ownership and operation of specific assets, monitor the effectiveness of the department’s transportation services, maintain the knowledge base even as pertinent staff retire, and prepare performance-based business plans and budgets.

Multnomah County Sheriff’s Department

Through activity-based management, the Multnomah County Sheriff’s Department in Oregon has shifted its standard cost-per-bed formula at its jails to more accurately forecast budget needs and the impact of projected shortfalls. Corrections officials can now identify and understand incarceration costs more accurately than ever before, and administrators can effectively convey the complexity of those costs to county and public stakeholders.

In addition to evaluating activity costs for each type of inmate, officials are also looking at the expenses associated with every step in the county’s booking system. Their analysis will show decision makers how costs escalate as prisoners move through the system, revealing steps in the booking process that might be combined or changed to save money. Shifting the medical evaluation to a point later in the process, for example, could decrease the number of prisoners evaluated and save the county thousands of dollars, since many inmates are released or transferred before ever being assigned housing in the jails. Finally, activity-based management supports what-if analyses, allowing decision makers to simulate real-life scenarios and understand the long-term impact of any potential change. This feature, for example, could predict the budgetary impacts that would result from increasing or decreasing the number of state prisoners in the county’s new jail.

Producing results in a government culture

As discussed above, activity-based costing and collaborative performance management are both strategic indicators for measuring results achieved in government programs and services. The results are most likely to have an impact when the performance management system is designed with results in mind to meet the specific business requirements of each agency. A performance management system with a high propensity for producing results has the following characteristics:

• The system is designed based on a thorough assessment of business needs. This ensures that the analytic components of the system can be used to resolve the agencies specific problems and decision requirements.
• The system is implemented using collaborative techniques wherever appropriate. Collaborative techniques—including worker participation in improving efficiency— enhance buy-in and create enthusiasm for performance management.
• The system is built around integrated technology solutions that make it easy for management to access, report, comprehend, analyze, optimize and track performance information on an ongoing basis.
• The system emphasizes learning to enhance each employee’s knowledge and ability to optimize performance.

‘Government as usual’ redefined

Activity-based costing models and performance measures are excellent sources of information for business intelligence (BI) and advanced data analysis. Governments use business intelligence to assess and report on current performance, trends and areas needing attention across the enterprise. Further use of analytic capabilities with business intelligence can forecast requirements and make decisions to optimize future performance. The application of business intelligence and analytics often results in decision makers spending less time looking for answers and more time determining the right solution.

Government has used business intelligence and analytic methods to:

• Analyze the cost of decision alternatives.
• Prepare outcome-based plans and budgets.
• Measure, track, analyze and compare business practices.
• Analyze the impact of different resource replacement, deployment and maintenance decisions.

Measure, track and monitor strategic goals. According to the National Conference of State Legislators, “Traditionally, government policies and programs discourage a review of priorities, effectiveness and outcomes. This is under attack in our states as the public is challenging how state governments operate, questioning
their efficiency and effectiveness, and expressing distrust of representative government
itself.”¹ There is a growing public perception that government could do a better job of allocating resources to meet constituent needs and eliminating fraudulent payments. Citizens are demanding the same integrated services from government that they receive from the private sector. Business intelligence and analytics help state and local governments transform their operations to deliver the right services, at the right time, with the appropriate resources.

State departments of social services are an excellent example of the value that performance management delivers. Ever-increasing case loads, burgeoning enrollment in entitlement programs and other demands are straining the ability to provide quality service. In some cases, high rates of staff turnover and process inefficiencies make it more difficult to respond cost-effectively to these demands.

Performance management is the remedy for these difficulties. With it, organizations can improve process efficiency, reduce costs, manage knowledge, measure client service and quality performance, forecast the resources needed to meet increasing demands for services, among other key capabilities. It helps organizations meet ambitious service and delivery goals within strict budget constraints.

Developing a road map for success

A successful ABC and performance management initiative is one that provides a positive return on investment (ROI), as well as the intangible benefits of enhanced learning and improved communications. Experience confirms that a positive ROI is most likely to result when the agency’s staff supports the initiative, implementation adheres to a systematic process and technology is used for maximum benefit. People

Support for the performance management initiative is vital to its success. Agency staff must be involved in the implementation process, providing input into the design of the system as well as creating an opportunity to learn about performance management. Staff also needs to be active users of performance management information and tools to have a positive impact on the outcome of decisions. ¹ Fundamentals of Sound State Budgeting Practices, National Conference of State Legislatures, May 20, 2005 Achieving these positive outcomes requires cultural change, buy-in to the initiative and learning at all levels of the agency. This is accomplished via sponsorship at the highest level of the agency, a positive communications program, and assignment of roles and responsibilities for implementation and use. Collaborative implementation methods engage staff at every step along the way and create opportunities for learning. Finding creative ways to communicate the results of performance management provides positive feedback, enhances perceptions of relevance to strategic purpose and reinforces the change process.
Process
An iterative implementation process is essential to the success of any ABC and performance management initiatives. Systems development must be carefully phased, and the analytic methods must be sequenced correctly. For example, it is recommended that activity-based costing precede building balanced scorecards, since balanced scorecards are heavily dependent on ABC as a source of performance measures.
Technology
Technology enables both of these projects. To maximize the value of a performance management system, data must be available. Data can be collected if it does not already exist (e.g., Web surveys). Data is the catalyst for disseminating fact-based information to the work force. Facts are hard to argue with. The following capabilities can help organizations realize the full potential of a performance management system, as well as ensure a low total cost of ownership:

• Data integration: Provides ability to smoothly and seamlessly collect data from disparate systems across the enterprise. Features should include the ability to automate and manage these processes. Data must be first accessed and then transformed into useful information.
• Business intelligence: Allows users (both technical and non-technical) of the system to query, report and drill down into data, information and details. View summarized and detailed data to investigate and analyze performance and cost. Use data integration capabilities to automate data updates to view current and accurate information.
• Business analytics: A scorecard or dashboard is very “thin” if it only provides a status indicator for measures. Status is important to know, but when one asks the question “why,” then analytics can be used to assess the underlying causes. Analytics can be used to prove or disprove cause-and-effect linkages or to forecast future performance, a capability that is especially helpful for budgeting and planning.
• Web user interfaces: A performance management system serves as an enabler for communication and collaboration. An application that is Web-enabled and easy to use is recommended to best achieve this. Web applications serve the purpose of “reaching out to the masses.”

ABC software: Use software specifically designed for ABC modeling and reporting. Using commercially available ABC software lowers the total cost of ownership compared with building customized applications or using desktop software (which both require time and resources to build and maintain).

Summary

Activity-based costing has been transformed from a tool that simply improves the accuracy of cost computations to one that adds immeasurable value to forward-looking government organizations. Leveraging ABC information for performance management initiatives, business intelligence and advanced analytics has elevated its value. Organizations are now able to make smarter decisions about outsourcing, maintenance schedules, caseload shifts and budget requests based on the most complete and robust intelligence.

We are in a new age of opportunity in the government, when organizations truly must respond to the mantra of doing more with less. Fiscal demands for homeland security, emergency management, defense, education and social programs will continue to dominate the spending at the federal, state and local levels. Governments cannot expect to receive funding increases commensurate with the demands for services; therefore, they must shift their thinking about delivery and management if they are to optimize performance.

The mere availability of technology that enables ABC and performance measurement does not ensure that initiatives will be successful. Strong leadership, cultural support for change and reinforcement of the systems’ value through results are the cornerstones of initiatives that last more than one administration or one fleeting year. Finally, smart government leaders will always be searching for ways to improve service delivery while reducing cost. ABC and performance management are additional tools in their toolkit for achieving this goal. Government leaders are tax-paying citizens of these great cities, states and nation, so we can all work to find ways to make the tax dollar go farther and do more, thus assuring a bright future for our children and the next generation of leaders.

The SAS and Cost Technology partnership

SAS and Cost Technology deliver award-winning technology and domain expertise to the government market. Government and private companies alike focus on achieving results, successful implementations and customer satisfaction.

The SAS and Cost Technology partnership is built around:

• SAS® technology. The most complete, incomparable set of software and solutions for data warehousing, mining, cleansing, integration and analytics – including SAS Activity-Based Management and SAS Strategic Performance Management. Supporting all activity-based costing methodologies, SAS Activity-Based Management takes into account bottom-up as well as consumption-driven ABC methodologies. With SAS Strategic Performance Management, organizations can focus on performance, align resources and adapt to meet changing demands.
• Project planning, design, integration and implementation. Cost Technology offers innovative thought-leadership in business performance optimization and business analytics. With technical expertise in SAS solutions and years of experience in implementation services, Cost Technology delivers value to government customers nationwide.
• Government expertise. Created to serve the complex business issues of government customers, SAS and Cost Technology share similar roots. Our dedicated public sector staff understands the business pressures that today’s government faces.

Over the last month, many organizations have reported serious drops in profitability, with decreases ranging from 28 percent to more than 200 percent. Whether you call it a down economy, a “credit crunch” or a recession, the truth is that few industries have avoided the impact.

What if you could deliver 400% of last year’s net income without increasing revenue or laying off staff? What some might consider a pipe dream could be reality with today’s technology and experience. Here, Peter Turney, CEO of Cost Technology, explains how activity-based costing (ABC) can identify your profitable customers – helping you potentially recover your losses and survive the down economy.

Let’s get right down to it. 400 percent is impressive. How can you offer that much value?
It’s true. Potentially, 400 percent of the figures listed on your profit-and-loss statement could be recovered as profit.
The real value is exposing the hidden sources (or drivers) of cost and profit associated with the actions we perform every day. This value is visible in what we call the “profit cliff”: an enduring picture of profitability that appears in just about every ABC implementation over the past 20 years. The graph of the profit cliff consistently shows that the best 20 percent of customers contribute profits equal to 500 percent of earned income, while 60 percent break even at best; the worst 20 percent destroy 400 percent of earned income.

If you don’t know which customers are destroying profits, your earnings will be a fraction of its potential. Plus, you won’t know which decisions will capture that value.

Let’s put it another way. If market segmentation analysis relies on incorrect information about profitability, efforts to grow sales could be directed toward the 20 percent of customers that are unprofitable. In reality, these efforts will accelerate the destruction of profits.

The real value is not in the money saved, but how you use information to adapt in challenging environments such as today’s economic spiral.

It’s a similar story in the public sector. Government is under intense pressure to do more with less. Resolving this pressure requires tools that reveal the opportunities to increase efficiency and effectiveness.

For both public and private organizations, these tools tell you which activities contribute most to strategic goals and the delivery of services; where the opportunities are to reduce costs; which processes and activities should be outsourced; and does the budget accurately reflect our strategic priorities and the expected demands for our services?

The value you reference comes from using activity-based management (ABM) techniques. Can you explain to our readers how this differs from traditional financial management approaches?
Traditional financial management systems work well for their intended purposes – financial reporting, compliance, etc. However, these systems are not designed to provide managers with ready-to-use information about the myriad of internal sources of cost and profit. In a profit-seeking organization, financial systems do not delineate cost by activity or process. They do not report the profitability of services, customers, segments, channels and so on. In the case of manufacturing companies, financial reporting systems often do not accurately determine product costs. Similarly, government accounting systems do not reveal the sources or causes of overspending; don’t relate expenditures to processes in a meaningful way; and are disconnected from strategic goals, performance measures, rewards, outcomes and budgets.

ABM is not a financial system. Rather, it is an organizational cost-and-profit-analysis tool. It attributes costs to processes, and process costs to the products and services that benefit, and ultimately to the customers that receive those benefits. ABM pinpoints, in a highly understandable way, the top areas for action and the changes that will maximize profits and minimize costs.

ABM is not a one-size-fits-all methodology. It is a diverse tool kit – including time-based and consumption modeling – that allows ABC to support historical analysis, predictive modeling, scenario analysis, budgeting and capacity planning. Importantly, ABM adapts to any industry and all parts of the value chain.

Who is your typical customer and what triggers the need to look at ABM?
There is no typical organization, just a universal trigger for action. It is not uncommon to work one week with a bank that wants to understand customer profitability, and then work the following week with a government agency that wants to know the cost of outsourcing work.

The universal trigger for all organizations is the need to accurately and relevantly understand their business – and the best way to meet strategic goals and address competitive or budget pressures. This need is accelerated when there is a “burning platform,” such as reduced profits or an economic downturn that has the potential to radically change the business environment.

Given today’s credit crunch, consider how many banks are currently thinking about restructuring, downsizing or selling-off assets. That one event has an impact on virtually every organization. When the pressure is on, it’s tempting to make easy cuts (e.g., headcount). However, without a true understanding of costs and what drives value, some of those decisions may undermine future growth and stability. The irony is that most organizations can recover vast sums of money (400 percent) without letting go of a single employee.

Whether the champion is finance or IT, the information from ABM will be used to reduce process costs and improve product and customer profitability. Departments such as operations, shared services, sales and marketing, supply chain, etc. can use ABM to resolve budget pressures or pricing wars, re-engineer processes, consolidate overlapping organizations, optimize customer acquisition and retention, reduce unused capacity, and more.

Cost is just one vector for improving value. How do you see ABM integrating with performance management?
Performance management is about strategically leveraging resources, processes and technology to deliver value to customers in a profitable and sustainable manner. ABM is the cornerstone of that effort. It includes providing accurate rates for analyzing the profitability of customers, and uncovering the hidden drivers of profitability and operational efficiency. ABM is an important source of performance measures for the process and customer dimensions of scorecards. ABM supports the preparation of budgets and long-term plans that are logically derived from strategic goals, and reflects the resource requirements of business plans. ABM helps you manage resource capacity and forecast human resource needs for each skill type. In response to the increasing pressures for sustainability, ABM is used to model and report the use of carbon dioxide, and support decisions that are both sustainable and financially prudent.

What are the top three barriers to adoption, and what advice would you give our readers about learning more?
Let me start by saying what is not included in the list of barriers. It does not include technology and knowledge. Today’s SAS software provides sustainable, enterprisewide solutions. Combine this technology with the know-how from more than twenty years of experience with ABM customers, and you can build cost-effective systems.

So, what are the significant barriers to adoption? These are failure to convince management that change is needed, lack of business purpose, and failure to demonstrate the ROI from ABM. ABM is not the only management initiative that needs change management, but it is an imperative because of ABM’s ability to reveal hidden losses and challenge the ingrained perceptions of profitability. Resolution requires leadership, communication, learning and the ability to build a broad-based coalition of the willing.

A second common barrier is the failure to define a clear business purpose for ABM. Implementing ABM involves finance and IT, but it is not a finance or IT initiative. It belongs to the business users. If a value proposition is not crafted for ABM, it will likely be a case of “We will build it, but they will not come.” Define the business needs, formulate ABM to clinically meet those needs, and you will have a winner.

A third common barrier is the failure to plan for and capture a significant ROI. If the business purpose of ABM is to change decisions for the better, it should be possible to anticipate where the returns will be. And, once the system is in place, you should be able to compute the returns from the resulting decisions.

In one situation, an organization spent over a half-billion dollars on an enterprise resource planning system, yet failed to anticipate a return from ABM. The investment in ABM was trivial compared with the investment in the ERP system. From a ROI perspective, ABM was the final mile, the last 1 percent of the investment that provided 90 percent of the return.

Often, the root cause of barriers to adoption is lack of knowledge about ABM. There are plenty of materials that can help; share them with your colleagues and build a coalition of the willing in order to get ABM adopted in your organization.