11 Apr 2007  Research & Ideas

Adding Time to Activity-Based Costing

Determining a company's true costs and profitability has always been difficult, although advancements such as activity-based costing (ABC) have helped. In a new book, Professor Robert Kaplan and Acorn Systems' Steven Anderson offer a simplified system based on time-driven ABC that leverages existing enterprise resource planning systems. Key concepts include:

  • The activity-based costing system developed in the 1980s fell out of favor for a number of reasons, including the need for lengthy employee interviews and surveys to collect data.
  • The arrival of enterprise resource planning systems allows crucial data to be pumped automatically into a TDABC system.
  • Managers must answer two questions to build an effective TDABC system: How much does it cost to supply resource capacity for each business process in our organization? How much resource capacity (time) is required to perform work for each of our company's transactions, products, and customers?
  • Profit improvements of up to 2 percent of sales generally come in less than a year.

 

To improve any business, managers need to understand how much it costs to produce a profitable product. It seems a simple task, but the process of securing and analyzing the data can be incredibly complex and organizationally taxing.

In Time-Driven Activity-Based Costing, Harvard Business School professor Robert S. Kaplan and Acorn Systems founder and chairman Steven R. Anderson (HBS MBA '95) introduce a system that calculates product, customer, and regional or branch P&Ls quickly and inexpensively. The work marries the Activity-Based Costing system developed by Kaplan and Robin Cooper in the 1980s, with time dimension modifications introduced by Anderson for clients of Acorn Systems.

We asked Kaplan to describe the problems with traditional costing approaches, the improvements made by TDABC, and how it works with the Balanced Scorecard developed by Kaplan and David Norton.

Sarah Jane Gilbert: What inspired you to develop the concept of time-driven activity-based costing?

Robert Kaplan: When Robin Cooper and I introduced ABC in the mid-1980s, we were strongly influenced by the approach taken by strategy consultants, who used interviews and surveys to assign the cost of employees to activities. We also wrote several cases where other companies, independently, relied on this interviewing approach.

These time surveys turned out to be the Achilles heel of ABC. They were time-consuming and expensive to perform, irritating to the employees who had to fill out the forms, and error-prone by using employees' subjective time estimates. Also, in the mid-1980s, we failed to fully understand the critical role played by capacity when estimating cost driver rates. The insight about the central role for capacity did not occur until about 1990.

Thus, while ABC still represented a definite advance over the arbitrary overhead allocations done by traditional standard cost systems, many companies abandoned ABC or updated their model only infrequently, because of the high time and cost associated with re-estimating the model, and its subjectivity and latent inaccuracies.

In the 1990s, many companies introduced ERP systems that captured data at the transaction level. It was natural to think how we could modify ABC systems to benefit from the ready availability of transactional data about orders, products, and customers. The stage was set for a major advance in the conceptual foundations of strategic costing systems.

The breakthrough came by combining an idea I had while writing Cost & Effect with an innovation developed by Steve Anderson, an HBS MBA, who was a student in my second-year elective, Cost Measurement and Management. My insight was that you could build cost systems with only two parameters. One is the cost rate of supplying resource capacity (such as cost per minute for people and machine-driven processes, or cost per cubic meter per day in a warehouse). The second is an estimate of the demand made on resource capacity (typically time) by transactions, products, and customers.

Anderson, after graduation in 1995, worked at McKinsey where he got the idea for using time equations to estimate how the capacity demands by a transaction vary based on all the contingencies that introduce diversity into transaction time processing. Anderson left McKinsey to found Acorn Systems where he developed software to incorporate time equations into ABC. The software modeled how, for example, the time to process a customer order would vary depending on whether it was a standard or a custom order, a rush order or standard delivery, a domestic or an international order, and so on. Time equations handle complexity by simply adding terms with Boolean logic that test for the presence of a particular feature that adds or subtracts time to overall processing time, a simple and elegant technique. In one of the cases described in our book, a company used quite complex and multiple contingencies to reflect the factors that caused a particular transaction to be either fast or time-consuming to process.

Q: What is the relationship between TDABC and enterprise resource planning?

A: We probably could not have implemented time-driven ABC in the 1980s even if we had devised this approach then. The legacy information systems at the time could not supply the TDABC model with the detailed information on individual transactional and their special characteristics.

Now, with most companies having some form of ERP systems, the time-driven ABC software easily imports from ERP systems the extensive data on all transactions, which includes the special features of transactions that we can exploit in time equations. With this data feed, the software calculates the product, customer, and regional or branch P&Ls quickly and inexpensively.

Typically, time-driven ABC projects pay back in less than a year.

It's quite impressive to take companies with millions of transactions and customers, and be able to prepare detailed and accurate profit and loss statements, at various levels of aggregation, within days after the end of the monthly close. This would not be possible without the power of ERP systems. Many companies invested tens or hundreds of millions in their ERP systems but found it difficult to identify a return on investment from their spending. Installing analytic software, such as to implement time-driven ABC or the Balanced Scorecard, gives managers substantial benefits that would be difficult to realize without the ERP IT infrastructure.

Q: Must a company have an ERP system in place to use time-driven activity-based costing?

A: Clearly, having an automated data feed facilitates the calculation of product and customer P&Ls. But companies do not need a full-fledged ERP system to get most of the benefits. The TDABC system can import data from separate systems, such as the monthly general ledger, a production scheduling system, and a customer order file, and still do the cost and profit calculations. But having to integrate the data from these diverse systems makes the initial install somewhat more time-consuming, and the monthly and quarterly runs less automated.

Q: Does company size matter?

A: Size is not the critical parameter for the benefits a company gets from installing and acting upon a TDABC model. We have seen companies with less than $10 million in annual sales get enormous insights about products and customers that were losing money and that could be quickly transformed into profitability once the executives saw what was driving the losses.

Companies whose Balanced Score Card describes a low total cost strategy need ABC for accurately measuring the costs of critical processes.

I feel the critical parameter is diversity of products and customers. If you have only product and sell to only one or two large customers, you don't need much of a cost system to learn where you are making and losing money. But companies typically have hundreds of different products or product variations and hundreds or thousands of customers. In this situation, traditional cost systems will not accurately trace a company's expense base to each product and customer, leading to a highly distorted view of the company's economic model. Even a simple time-driven ABC model will fundamentally change the way the company manages its process improvements, its product variety, and its individual customer relationships.

Typically, time-driven ABC projects pay back in less than a year as companies increase their net profit margin by 1 to 2 percent of sales within months. These improvements are significant for both small and large companies.

Q: What are the key benefits to an organization for implementing this model? Can it be benchmarked and evaluated?

A: The benefits come from having detailed and accurate understanding of the company's actual economics. Once managers see what causes them to make or lose money, they easily identify multiple actions that transform loss or break-even operations into profitable ones.

The actions include improving internal processes and eliminating waste, partnering better with suppliers and customers to reduce demands on capacity throughout the supply chain, introducing menu-based pricing in which customers pay for the features and services they use, while other customers receive discounts because they have large order volumes and do not require special features, and, finally, redefining customer relationships that create financial benefits to both parties.

As I noted earlier, profit improvements of up to 2 percent of sales generally come in less than a year. Some companies have realized hundreds of millions of dollars in benefits from reducing capacity they saw was not needed, or that customers were unwilling to pay for, and by focusing on their most profitable products and customer segments.

Q: How does this relate to your work on the Balanced Scorecard?

A: The two work streams are different, but complementary.

They are distinct since TDABC provides enterprises with an accurate model of the cost and profitability of producing and delivering their products and services, and managing their customer relationships. TDABC provides companies with vital cost information but says little about what customers value.

The Balanced Scorecard fills this void by describing how companies create value for customers and shareholders. The BSC measures the customer value proposition, and links critical processes and intangible assets to customer and shareholder value creation. Thus, ABC provides a model of cost while BSC describes a model of value creation. They provide different levers for measuring and implementing a company's strategy.

Companies whose BSC describes a low total cost strategy need ABC for accurately measuring the costs of critical processes. Otherwise they run the considerable risk of implementing a low-cost strategy with faulty information about their fundamental cost drivers. Companies that use a BSC to describe and execute a differentiation strategy need ABC to measure whether the value they create from their differentiation for customers exceeds the cost of achieving this differentiation.

The complementary nature of the two approaches becomes even more tangible when companies contemplate adding customer profitability information to their BSC customer perspective. The ability of TDABC to measure, simply and accurately, profitability at the individual customer level allows companies to consider new customer metrics such as percentage of unprofitable customers, and dollars lost in unprofitable customer relationships. Such customer profitability metrics complement conventional customer success metrics, such as satisfaction, retention, and growth, to signal that customer relationships are desirable only if these relationships generate increased profits. They provide the link between customer satisfaction and improved financial performance. Scorecard measures of the incidence of unprofitable customers and the magnitude of losses from unprofitable relationships focus the organization on managing customers for profits, not just for sales.

The newest and potentially most powerful linkage between the BSC and ABC is articulated in a book chapter that illustrates how a time-driven ABC model bridges the gap between the Balanced Scorecard's strategy focus and the budget, which authorizes spending for the resources required to create, produce, and deliver on the company's strategic plan. TDABC's ability to measure and manage the costs of a company's capacity resources can be tightly linked to fulfillment of the company's strategy, as articulated in the company's strategy map and Balanced Scorecard.

Q: What are you working on now?

A: I hope to work with companies to learn more about how to use the TDABC model to link strategic planning and operational budgeting. This work is central to the next book, which Dave Norton and I are currently writing, on using the Balanced Scorecard to link strategy and operations. Our four previous Balanced Scorecard books focused almost exclusively on strategy and its implementation. Now we are identifying the important linkages between strategy and operations that will give companies a comprehensive, integrated system to manage both for short-term results and long-term value creation. Norton and I are quite excited about how all this is coming together.

Book Excerpt: "Time Equations"

Time-Driven ABC easily incorporates variation in the time demands made by different types of transactions. It does not require the simplifying assumption, made so far, that all orders or transactions are the same and require the same amount of time to be processed. We can allow the unit time estimates in a TDABC model to vary on the basis of order and activity characteristics.

Companies can usually predict the drivers that cause individual transactions to be simpler or more complex to process. For example, consider the department of a chemicals distribution company that packages customer orders for shipment. A standard item in a compliant package may require only 0.5 minutes. If the item requires a special package, then an additional 6.5 minutes is required. And if the item is to be shipped by air, than define a separate activity for every possible combination of shipping characteristics, or estimate transaction times for every possible shipping combination, the time-driven approach estimates the department's resource demand by a simple equation:

Packaging time - 0.5 +6.5 {if special handling required}
      + 0.2 {if shipping by air}

While seemingly complicated and demanding of data, in fact time equations are generally quite simple to implement since many companies' ERP systems already store data on order, packaging, distribution, and other characteristics. These order- and transaction-specific data enable the particular time demands for any given order to be quickly calculated with a simple algorithm that tests for the existence of each characteristic affecting resource consumption. TDABC models expand linearly with variation by adding terms in a time equation.

The accuracy of a TDABC model arises from its ability to capture the resource demands from diverse operations by simply adding more terms to the departmental time equation. Returning to the packaging department, let's say that the chemicals company wants to offer a new differentiating feature by giving its customers access to hazardous materials. To capture the cost of this feature, packaging personnel do not need to be reinterviewed to learn what percentage of their time will be required for packaging orders for hazardous chemicals. The TDABC model manager simply adds one more term for this possible variation in the packaging activity. The new equation becomes

Packaging time = 0.5 + 6.5 {if special handling required}
       + 0.2 {if shipping by air}
      + 30 minutes {if hazardous material}

In contrast, conventional ABC requires geometric expansion to capture the increase in complexity. The packaging department's work would be decomposed into four distinct activities:

  • Packaging standard product
  • Packaging product with special handling requirements
  • Packaging product for air shipment
  • Packaging hazardous material

Each period (e.g., month), personnel in the packaging department would be surveyed for estimates of what percentage of their time is spent with each activity. This survey is time-consuming and subjective. The TDABC model allows all these activities to be combined into one process, with one equation. A typical TDABC model requires fewer equations than the number of activities used in a conventional ABC system, while permitting much more variety and complexity in orders, products, and customers. Complexity in the process, caused by a particular product or order, may add terms, but the department is still modeled as one process with one time equation. This feature adds accuracy to the model at little additional cost and effort. And once a time equation is built for each process, through interviews and time studies…the model dynamically reflects the actual activity in each period.

The time equations in a TDABC model also provide managers with a capability for stimulating the future. The equations capture the principle factors that create demands for process capacity, including changes in process efficiencies, product volume and mix, customer order patterns, and channel mix. Managers can use their TDABC model to perform dynamic what-if analysis of various scenarios. The model can easily be incorporated into a new budgeting process that analytically calculates the required supply and spending on resource capacity that is needed to deliver future periods' sales and production plans. For example, at Citigroup, managers use the TDABC model for business planning, determining the level of staffing necessary to deliver anticipated customer service demands.5

Excerpted with permission from Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits, by Robert S. Kaplan and Steven R. Anderson. Copyright 2007 Harvard Business School Publishing Corporation. All rights reserved.

Footnotes:

5. S. Anderson and L. Maisel, "Putting It All Together at Citigroup: How IT Value Management Is Leading CTI into the Next Millennium," Acorn Systems white paper (Houston: Acorn Systems, April 2006).

About the author

Sarah Jane Gilbert is a product manager at Harvard Business School's Baker Library.