In a three part mini-series, we’re looking at activity based costing – how it works, what the advantages are, and it delivering insight in practice. This time, the operational impact its results can have.

Using the data
We saw in Part 1 how ABC can create insight into the specific costs of the various activities carried out by a department. In comparison to one generic cost associated with traditional accounting, the information can directly affect strategic decisions on how best to run the department moving forward (new software, more attention to the website etc.). Without ABC, the management would have no idea of the varying impact the individual activities have on profitability and the margins of specific customer relationships.

Revealing what teams can actually handle
However, the really key benefit is the distinction between capacity supplied and capacity used. Calculating the time required to carry out activities and then linking it to a clear cost calculation gives managers powerful insight. Unused capacity can be structurally reviewed to facilitate appropriate FTE reallocation. It also gives a more accurate idea of what increases in workload teams can handle – preventing increased workloads automatically leading to new personnel.

The friend of complexity
Expanding the model for new activities or greater process complexity is easily done, as is recalculation of cost driver rates when resources become more expensive (salary increases or new machines). Doing this is as soon as processes are improved or reorganized creates a much more dynamic cost overview than standard quarterly or per half reviews. And when you compare this to what you’re charging customers, you can make sure your margins stay where you need them.

It’s already hiding in your ERP
Many companies already house data for each stage of any process (order, packaging, shipping method etc.). As such, creating calculations to cost multi-step processes can be easier than you might think. If the activities all fit within a flow, equations can be used to add up the time involved at each step on a case by case basis.

Let’s say that employees handling sales order complete four activities – collecting and printing information from the computer, picking the product from the warehouse, wrapping it in the appropriate packaging, and organizing the freight.

Collecting and printing the order takes 3 minutes, picking the order takes 2 minutes per item line, wrapping takes 5 minutes plus 30 seconds per item line, and booking the shipment takes 5 minutes. ABC can consider this one process, while still creating accurate costs on a per order basis:

Order dispatch time = 3 + (2 x Number lines) + 5 + (0.5 x Number lines) + 5

More insightful, more flexible and cheaper to run
With this encased in an ERP system, accurate costs can easily follow every order transaction. We see a continually accurate picture of how costs are distributed to particular customers, empowering relationship profitability analysis. Changes in work methods can be easily included by adding an extra time dimension to the equation, while the whole accounting system becomes simplified by replacing large numbers of activities with far fewer processes. And a simplified accounting model requires less resources and less time to manage and update it.

Making the right decisions
Being able to identify and report complex processes simply is also a major aid to negotiation with customers. Having an accurate idea of costs for changes to standard designs or the introduction of new processes ensures you operate at the right price point. Without knowing the real investment required to deliver a product or service, you run the risk of cutting too deep into a margin, or even completing work at a loss.

In part 3, we’ll look at ABC in action at a company, and the results this business intelligence can actually deliver in practice.