To adequately trace costs using the ABC/M) method requires more stages than the two-stage assignments displayed in Figure 2 from my earlier article. Rather than simply tracing the cost of resources to activities and then to cost objects, the multiple-stage approach models cost flows in a manner that more closely reflects the actual flow of costs through an organization. Often there are support people who support other support people who ultimately support the primary workers who make products for or deliver services to external parties, such as citizens or other agencies.
These cascading stages of indirect and shared costs should not use arbitrary broadly averaged cost allocations, but should comply with costing’s causality principle as ABC/M does. Therefore, the multi-stage cost assignment approach includes an understanding of the relationships between indirect work activities and other activities, as well as between those activities and cost objects. Costs are traced from activity to activity in a series of stages, all based on cause-and-effect relationships.
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Figure 3 – The expanded ABC/M cost assignment network
Figure 3 breaks up and expands figures 2’s two-stage view, but rotates it 90 degrees to a vertical view to reveal a generic ABC/M structure that is a good representation of any universal costing model for any organization. To understand figure 3, imagine the cost assignment paths (the arrows) as pipes and straws where the diameter of each path reflects the amount of cost flowing. The power of an ABC/M model lies in the fact that the cost assignment paths and their destinations provide traceability to segment costs from beginning to end, from resource expenditures to each type of, or each specific, customer—which is ultimately the origin for all costs and expenses. The cost assignment network captures and reflects the diversity and variation on how cost objects uniquely consume activities, which in turn consume resources. To understand costing, it is useful to mentally reverse all the arrowheads in figure 3. This polar switch reveals that all expenses originate with a demand-pull from customers or citizens. The calculated costs simply measure the effect in the opposite direction.
The bottom portion of figure 3 reveals multiple final cost objects—supplier-related activity outputs, products/services, and citizens/customers. It displays a “nested” consumption sequence of final cost objects. A metaphor for this consumption sequence is the predator food chain where mammals eat plants and large mammals eat small mammals. The final-final cost object, which in this figure are the citizens/customers, ultimately consumes all the prior final cost object costs except for the organizational sustaining costs.
Organizational sustaining costs are activity costs that are not caused by making products or delivering services to customers or citizens. The consumption of these costs cannot be logically traced to products, standard service lines, channels, or customers (they can be arbitrarily allocated but not with a causal relationship). An example would be when the accountants close the books each month. These activity costs would be traced respectively to senior management as an example of an organizational sustaining cost object. Allocating them to products, services, or customers would be misleading because they did not cause these activities and would overstate those costs—which sends wrong signals to employees who use product cost information for decision making.
The direct costing of indirect and shared costs is no longer, as it was in the past, an insurmountable problem, given the existence of commercial ABC software products. ABC software allows intermediate direct costing to a local process, an internal customer, or a required component that is causing the demand for work. Visibility to costs is provided everywhere throughout the cost assignment network.
Operational ABC/M for productivity
Managers and employee teams are seeking more transparency and visibility of their costs. Just reliably knowing ABC/M’s per-each-unit costs of their outputs of work is useful for benchmarking to search for best practices or monitor trends to measure performance improvement. ABC/M removes the illusion that support overhead (i.e., indirect) expenses are necessary and, therefore, appear to be free—they are not free.
The costs of an output, product, or service (i.e., a final cost object) can be reduced by:
- Reducing the quantity, frequency, and/or intensity of the activity driver (e.g., fewer inspections reduces the “inspect product” activity cost);
- Lowering the activity driver cost rate from productivity improvements (e.g., shorten the time for each “inspect product” event); and
- Understanding the sources and causes of waste leading to nonvalue-adding activities to reduce or eliminate them (e.g., solve the problem that requires an inspection in the first place).
These three are examples of how ABC/M data leads to cost management for productivity improvement. The idea is to do more with less (or at least with the same). That is, produce more outputs with the same amount of resources or the same amount of outputs with fewer resources. Note how these actions support the continuous improvement principles of the Six Sigma quality and lean management initiatives that are embraced by the operations and quality communities.
ABC has a bonus (available with commercial ABC software) referred to as ABC/M “attributes.” It can report another dimension of costs—the “color of money” spent. It applies cost attributes, usually to an activity, by tagging or scoring each activity with a code. This dimension of cost does not exist in general ledger accounting systems because attributes are tagged to activities or to cost objects, not to resource expenses.
An example of a tag would be if an activity is deemed as value-adding or nonvalue-adding. Another example is the five sequential “cost of quality” (COQ) categories of work that increase in their severity: error free, prevention related, appraisal related, internal failure work, and external work. Attributes do not alter the cost of anything calculated by ABC/M. Costs remain unaffected. But attributes facilitate grouping activity costs into various categories that in turn help focus (e.g., nonvalue-added costs) and can suggest actions. This insight could never be detected using general ledger cost center reporting and or traditional broadly averaged cost allocations.
But our department does not have outputs
This is an inaccurate statement by some departments that, presumably due to the nature of their work, believe that they have no outputs. There is no dichotomy between workers who think and plan and workers who deliver services and tangible products. Managers and workers who think, plan, and give direction conclude that since their work deals with intangibles, not tangible things, then there is no definable output from their work. But outputs can be intangible. Many are. What is the output of a university education? Is it the diploma? Is it each professor’s course? Is it the learning by each student? These may all appear to be intangible. But the financial cost for each one is measurable.
Several years ago at one of the US government laboratories, where well-paid physicists wrestle with theory and advances in their field, a business-process effectiveness study was conducted. Debate surrounded how to map inputs, processes, and outputs. Some of the physicists believed their work was un-mappable. The physicists argued that one could not rigorously define the brain’s thinking process when it comes to innovation. That is not the point with ABC/M. The point was to convert salaries and supplies expenses into outputs. What was realized is that the physicists conducted different types of experiments that resulted in different types of papers. The papers became the final cost object—the output. And some papers were hundreds of thousands of dollars! In short, all work has outputs.
Seeing the true cost of outputs can produce some organizational shock. In the government laboratory they now had a significant piece of information that they did not have before—the true cost to produce reports. If for example a specific report cost $325,000 then it might stimulate some other government service provider—let’s say one that may be very strapped for budget and whose mission is feeding and caring for children in need—to really think about whether appropriations are fairly distributed. Understanding the value of the contribution of government work should be understood and compared among alternatives.
The purpose here is not to get emotional or political or to tug on heartstrings. ABC/M does not take sides. It just reports the facts. People can then debate their own positions about what is the value of it all. But ABC/M does provide the basis for determining cost/benefit tradeoffs and thus allows comparison with other services competing for tax dollars. This type of dialogue and discussion cannot easily occur when funding is simply stated in the form of salaries, supporting expense, and supplies (e.g., budgets). Dialogue is better stimulated when costs are stated in other terms, such as unit costs per each output, permitting comparisons to be made.
This is the third article (Part 3 of 4) in a four-part series based on the book, Activity-Based Cost Management in Government by Gary Cokins (Second Edition; Management Concepts, 2006, ISBN 978-1-56726-181-3).
