In a three part mini-series, we’re going to look at activity based costing – how it works, what the advantages are, and it delivering insight in practice. It’s not a new concept, but it’s still not something that every business makes use of in their accounting.

What is it?
ABC assigns costs to products or services based on the resources they consume through operational activities. It’s an alternative to traditional accounting where overheads (indirect costs such as lighting, heating and marketing) are allocated in proportion to activities’ direct costs.

How does it work?
Time-driven activity-based costing zooms in on the link between cost measurement and time. By making time the common denominator of every cost generating activity, any business cost can be calculated via two specific questions:

What does one time unit of a (business process) resource cost?
(E.g. 1 minute of an administrative worker dealing with customers on the phone)

How many units of time are required to complete each business process?
(E.g. How many minutes does it take for the phone worker to fill in an order, process it in the system, update the database etc. etc.)

What does it look like in practice?
Let’s look at a corporate customer service department. In Q1, they completed the following:

• Processing customer orders from the website (30,000)
• Inputting customer orders via the phone (10,000)
• Updating the database with new customer details (1,000)

The total overhead costs for the quarter are €600,000.

Traditional accounting merely spreads the overhead across the tasks according to volume and 100% worker efficiency. This tells us little more than the fact that handling these activities cost €600,000. We don’t know which activity relatively uses the most overhead, or how well matched our capacity is to the workload.

TDABC goes further, bringing the time taken to complete tasks into the equation to create insight into capacity utilization. Let’s look at the two important questions in turn:

1. What does one time unit of a (business process) resource cost?
The department has 30 staff, all working 40 hours a week. This is 1200 total hours, or 72,000 minutes capacity per week. Over the 12 weeks of the quarter we have capacity of 864,000 minutes if they are all 100% efficient.

However, when we assume 80% productivity (to allow for all the non-core tasks that take place during the work day), we correct to 691,200 minutes/quarter. We know the costs to be €600,000 for the quarter, so that works out at €0.87/minute.

2. How many units of time are required to complete each business process?
Direct observation by managers reveals that on average, web orders take 10 minutes to complete, phone orders 20 minutes to complete, and setting up a new customer 1 hour.

This produces cost drivers as follows:
Web = 10*0.87 = €8.70/task
Phone = 20*0.87 = €17.40/task
Database = 60*0.87 = €52.20/task

We can now work out the following total costs per process for the quarter:

Web: 30,000*(10*0.87) = €261,000
Phone: 10,000*(20*0.87) = €174,000
Database: 1,000*(60*0.87) = € 52,200

Total: €487,200

This in turn can be used to highlight an unused capacity within the department worth nearly €115,000:

691,200 – [(30,000*10) + (10,000*20) + (1,000*60)] = 131,200 minutes

In addition to having a much more accurate idea of what each activity actually costs us, the time driven analysis gives us completely new insight into capacity available for new work or reallocation.

Next time…
In part two, we’ll look at the impact gaining this cost insight can have at the operational level – both in terms of correctly allocating resources, and in reviewing the profitability of certain processes and customer relationships.