Activity-Based Costing An Emerging Foundation for Performance Management

Activity-Based Costing An Emerging Foundation for Performance Management Peter B.B. Turney, PhD President and Chief Executive Officer Cost Technology, Inc. Activity-based costing has been around since the mid-nineteen eighties. Given its longevity, it’s worthwhile to answer: ! How has ABC evolved over its life cycle? ! What lessons have been learned from the evolution of ABC? ! What can ABC do today that it could not do 20 years ago? This article answers these questions by examining the evolution of ABC in the context of a product life cycle. It summarizes the history of ABC according to the phases of its life cycle, highlights its expanding functionality over time, and details the lessons learned from two decades of use. It concludes with a description of the current state of ABC as a key input and value adder to performance management systems. It took just a short time for ABC to be recognized as an innovative and potentially valuable costing methodology; yet it took another 20 years to reach its full potential. ABC emerged in response to competitive pressures that exposed inaccuracies in cost accounting. Early uses helped companies view the distortions inherent in cost accounting systems leading to changes in strategy, processes, operations and improved competitive position. Buoyed by early successes, ABC emerged as a powerful profit analysis tool. These successes stemmed from ABC’s ability to reveal the hidden sources of profitability and embedded cost, and to serve as a catalyst for decisions to improve profitability. Over time ABC adapted to new areas such as cost-to-serve activities, customer profitability, channel profitability, and the use of ABC outputs to perform capacity planning and drive predictive modeling. By the late nineties ABC was used extensively in diverse industry and government sectors. Today, ABC is the emerging foundation of performance management. If you lift up the hood of a performance management system, you will find ABC powering performance measures for scorecards, providing rates for customer profitability analytics, helping devise human resource plans, modeling sustainability, and supporting budget development and planning. Like most technologies, the value of today’s ABC is the result of many years of development and learning. In assessing its value for your organization, it is important to understand how it has evolved and how this evolution has created opportunities to create value. Whether you are considering ABC for the first time, or a returning early adopter, it is time to take a fresh look. 5635 SW Hewett Blvd., Portland, Oregon 97221 -1- costinfo@costechnology.com Phone: 484-244-7016 Fax: 503-292-2382 www.costechnology.com SAS and all other SAS Institute Inc. product or service names are registered trademarks or trademarks of SAS Institute Inc. in the USA and other countries. ® indicates USA registration. Copyright © 2008, SAS Institute Inc. All rights reserved. THE ABC HYPE CYCLE The hype cycle is a graphic representation of the maturity, adoption and business application of a technology. It reflects differences in human attitudes to the technology as knowledge increases and risk decreases over its development and deployment cycle1. Early in the cycle there is little practical knowledge about the technology. Thus, an organization’s cost/benefit analysis is often dominated by unknown risk factors making an adoption decision difficult. As knowledge accumulates over the cycle risks reduction occurs facilitating more informed judgments regarding adoption. The hype cycle typically covers the period of time between market introduction and a 30 to 50% adoption by the mainstream business community. The ABC hype cycle has six phases of evolution: (1) technology trigger, (2) peak of inflated expectations, (3) trough of disillusionment, (4) slope of enlightenment, (5) the plateau of productivity, and (6) the post-plateau phase (Figure 1). The first five phases represent the history of ABC, while the sixth phase is the current state. Activity-Based Management Visibility Profit Improvement Performance Resource and Management Capacity Planning New Application Cost Allocation Technology Peak of Inflated Trough of Slope of Plateau of Post-Plateau Trigger Expectations Disillusionment Enlightenment Productivity Maturity Figure 1: The ABC hype cycle. What results from this exercise is that the evolution of ABC is not unique. In fact, it is remarkably similar to the life cycle of other technologies, including the achievement of two milestones typically reached by only mature and successful technologies. First, the performance of ABC has increased over time reflecting ongoing research and development, cumulative learning from application of the method, and enhancements in systems technology. Second, the 1 Understanding Gartner’s Hype Cycle, Strategic Analysis Report, Gartner Research, Gartner Inc., 2003. 5635 SW Hewett Blvd., Portland, Oregon 97221 -2- costinfo@costechnology.com Phone: 484-244-7016 Fax: 503-292-2382 www.costechnology.com behavioral response to ABC has progressed from user enthusiasm, through disillusionment, to eventual acceptance of the technology’s relevance to business success. Technology Trigger (1984-1987) Innovations in Cost Accounting Discontinuous innovation is generally the result of a trigger - an external impetus that stimulates innovation. The trigger for ABC was the increasing Japanese competition experienced by western companies, particularly those in the electronics and automotive verticals. Believed to be the result of low-wage labor and undervalued currencies, they were de facto innovative management practices, such as just-in-time material flow systems, continuous improvement, and statistical process control. The impact of this change on western companies was dramatic. Some retreated and complained of unfair competition, and others adopted the management practices used at leading Japanese companies such as Toyota. A few western companies developed innovative practices of their own, including innovative costing methods. New approaches to costing emerged in several manufacturing companies. These companies recognized that the cost accounting systems used at that time had unintended negative strategic and operational consequences. Tektronix, for example, allocated manufacturing overhead to products based on direct labor, which encouraged engineers to design products that required less labor to manufacture. This design directive increased the complexity of products and the number of unique parts in each product. It also increased the cost of purchasing, receiving, and stocking thousands of different parts, thereby reducing profitability and ultimately Tektronix’s competitiveness. Only when the cost of procurement was allocated to products based on the number of unique part numbers used in the product was this bias corrected and engineers encouraged to use common parts wherever possible. Tektronix’ new cost accounting method helped engineers see the impact of their decisions. While lacking the accuracy and diagnostic capability of ABC systems, the elimination of the behavioral distortion inherent in the cost accounting system helped Tektronix compete2. Tektronix’s success, along with that of others, was an important step to developing first generation ABC methods. Peak of Inflated Expectations (1987-1991) First Generation The peak of inflated expectations is a bubble of enthusiasm for a new technology. For ABC, the journey to the top of the bubble was accompanied by extensive publicity and the emergence of first generation methods and tools. Beginning in 1987, a flood of articles on ABC appeared in the Harvard Business Review, Journal of Cost Management and other publications. Invitations to attend conferences by the Institute for International Research and other organizations filled mail boxes. These publications and presentations explained how to implement ABC, what it meant, and what impact it would have on businesses that adopted it. 2 Peter B.B. Turney, Common Cents: The Activity-Based Costing and Activity-Based Management Performance Breakthrough (New York: McGraw-Hill), 2005, pp. 27-29. 5635 SW Hewett Blvd., Portland, Oregon 97221 -3- costinfo@costechnology.com Phone: 484-244-7016 Fax: 503-292-2382 www.costechnology.com As with most technologies, the combination of interest among potential users and the development of first generation methods encouraged commercial development of the ABC market.