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Activity Based Management - Dispelling the myths - Part I

This is a Guest Post by Rajendra Patil from India

Profile: View Rajendra Patil's profile on LinkedIn A technocrat with 17 years of proven success in ERP Implementation, Business Analysis, Consultancy Assignments in Strategic Cost Management, Profitability Analytics, Performance Management and Business Process Management in conjunction with the enterprise wide BI solutions. Currently working as an independent consultant in the area of Performance Management and Profitability.

The list of myths on Activity Based Costing for discussion was posted by CMA.Siva Rama Krishna Srirangam. Rajendra Patil of AppsConsulting dispels the myths in two part series on the Management Accountant Blog and companies in India that have implemented ABM.

We have to understand the characteristics of the customers in each quadrant. We have to try to bring them in the ‘Top-Right’ quadrant.

Myth : All that we need are more cost centers;

Fact :

  • More cost centers would help you to get more accurate ‘Cost center accounting’. ABC is based on the ‘Cause-and-effect’ relationship. This causal relationship is lost when we try to relate the costs at various cost centers directly to the products.
  • When we use the ‘Cause-and-effect’ relationship, we understand that, the products are not the only entities that are causing the costs. With this reasoning we can segregate the costs as Product Costs, Customer Costs, Business sustaining Costs and Available to use Costs. Use this information to improve the performance of the organization.

Myth: Machine-hour systems save the time; and

Fact:

  • Machine hour system is related to the calculation of cost of production only. The experience has shown that we can take the cost of production from the conventional costing system. The accuracy is enough for the ABC models used for strategic decisions purpose. The accuracy of the production cost can also be improved, if needed using ABC. ABC is actually for assigning the ‘overheads’ with a causal relationship.

Myth: A cost system should be kept simple.

Fact:

  • This is true. It is actually true for any system. As it has been earlier explained, it is the skill of the implementation team to keep the model simple. At the same time is has to be seen that the results expected are not be compromised.
  • Alternatively, the complexity of the model in the conventional terms can be kept with the analysts and the business users are not exposed to it. The business users can use the various reports in different formats.

Myth: We do not need more accurate product costs:

Fact:

  • Yes, this true in case if the complexity of design to delivery of the products does not vary largely. If it is not so, then the typical revelation is that the products with higher volume get higher costs and those with lower volume (may be with higher complexity) get lower costs.

Myth: We know what our products cost; and

Fact:

  • It is not only the products that cause overheads. The complexity of the business causes overheads in the organization. This complexity is brought by the multiple products, customers, channels, regions etc. We should be able to segregate the costs that caused by the reasons other than the products only. Once we are able to do that, then we can understand the reasons for the same and business decisions can be taken. There is more to understand than only the product costs in ABM.

Myth: The market sets prices, so we do not need product costs.

Fact:

  • Let me take this statement as understanding or managing profitability of the organization. Firstly to understand the profit, one has to understand the proper costs. ABC helps to calculate cost more accurately. We have to also understand that the product profitability is different from customer profitability. The same product sold to different customers can bring different level of profit.
  • All customers are not equal. Generally the customers that bring more revenue are taken as most profitable customers. This may not be true, as various customers ask different prices, discounts, make changes in the schedule, ask non-standard products, order small quantities large number of times etc. This changes the profitability of the customers.

  • It has been observed typically that the top 15 percent of the customers bring the current level of profit. Top 45 percent of the customers bring 450 percent of the profit and last 20 percent of the customers take away the 350 percent of the profit away from the organization.

  • The best information for an organization is to understand whether their best customers are buying their best products.

If you have any questions on Activity Based Management and its implementation, you may post your comments on this blog post or write to Rajendra Patil on rajendra@appsconsulting.in on specific issues or concerns.

Continued... in Part II


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  1. Activity Based Management - How to collect info 10-June-08
  2. 10 myths about ABC by SSRK 26-Nov-06
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