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Targeting Process Improvements
Activity Based Costing + Activity Based Management

Activity based costing can be used to identify areas that would benefit from process improvements. Indeed, managers often cite this as the major benefit of activity based costing.

Activity based management (ABM) is used in conjunction with the activity based costing to improve processes and reduce costs. Activity based management (ABM) is used in organizations as diverse as manufacturing companies, hospitals, and the US marine Corp.

The first step in any improvement program is to decide what to improve. The theory of constraints approach discussed in the business improvement programs chapter is a powerful tool for targeting the area in an organization whose improvement will yield the greatest benefit. Activity based management (ABM) provides another approach. The activity rates computed in activity based costing can provide valuable clues concerning where there is waste and scope for improvement in an organization.

Benchmarking provides a systematic approach to identify the activities with the greatest room for improvement. For example, the marketing resource group of US West, the telephone company performed an ABC analysis of the activities carried out in the accounting department. Managers computed the activity rates for the activities of the accounting department and then compared these rates to the costs of carrying out the same activities in other companies. Two benchmarks were used:

  1. A sample of fortune 100 companies, which are the largest 100 companies in the united states.
  2. A sample of world class companies that had been identified by a consultant as having the best accounting practices in the world. These comparisons are as as follows:
Activity Activity Measure US WEST Cost Fortune 100 Benchmark World-Class Benchmark
Processing accounts receivables Number of invoices process $3.80 per invoice $15.00 per invoice $4.60 per invoice
Processing accounts payables Number of invoices processed $8.90 per invoice $7.00 per invoice $1.80 per invoice
Processing payroll checks Number of checks processed $7.30 per check $5.00 per check $1.72 per check
Managing customer credits Number of customer accounts $12.00 per account $16 per account $5.60 per account

It is clear from this analysis that US WEST does a good job of processing accounts receivable. Its average cost per invoice is $3.80, where the cost in other companies that are considered world class is even higher - $4.60 per invoice. On the other hand, the cost of processing payroll checks is significantly higher at US WEST that at benchmark companies. The cost per payroll check at US WEST is $7.30 versus $5.00 at Fortune 100 companies and $1.72 at world class companies. This suggests that it may be possible to wring some waste out of this activity using total quality management, process reengineering, or some other method.


Real Business Example:
Disciplining the Software Development Process

Tata Consultancy Services (TCS) of India is the largest consulting organization in India, serving both Indian and international clients. The company used activity based management to identify problem areas in its software development business. An early finding was that "quality assurance, testing and error correction activities made up a significant chunk of the overall effort required to build a system, and this cost had to be kept under control to improve productivity and profitability." The company already had in place a quality management system that helped identify the types of errors that were occurring and the corrective action that would be required, but no costs were attached these errors and actions. The activity based management system provided this cost information system, which allowed managers to set better priorities and to monitor the costs of error-correction activities.

As another example of the usefulness of the system, 54 person-days in one software development project at TCS were charged to the activity "waiting for client feedback" - a non-value-added activity. Investigation revealed that the client was taking a long time to review the graphical user interface (GUI) designed by TCS. The client was showing the GUI to various end users - often resulting in contradictory suggestions The solution was to draw up guideline for the GUI with client, which were enforced. "As a result of this corrective action, subsequent client feedback was well within the time schedule. Most of our screens were accepted because they conformed to standards . . . . ."

Source: Maha S. Mahalingam, Bala V. Balachandran, and Farooq C. Kohli, "Activity based management for systems consulting industry," Journal of cost management, May/June 1999, pp. 4 - 15.

Relevant Articles:

Definition and Explanation of Activity Based Costing
Treatment of Costs Under Activity Based Costing (ABC) System
Activity Based Costing and Top Management
Activity Based Costing, GAAP and External Reports
Designing and Implementing Activity Based Costing System
Targeting Process Improvements
Advantages, Disadvantages and Limitations of Activity Based Costing
Activity Based Costing Example




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