The Importance of Activity-Based Costing/Management to the Balanced Scorecard

Andrew Lim, director, Balanced Scorecard Solutions Pte Ltd. Summary This article considers how Activity Based Costing and Management (ABC/M) approaches may complement a balanced scorecard effort. Attention is paid to the critical success factors in ensuring that ABC/M adds value to the balanced scorecard initiative. Introduction Throughout the world we have seen scorecard adopters rush to define key performance indicators (KPIs) for their balanced scorecards, and with equal alacrity determine the data that supports these KPIs. However, a question that quickly emerges is whether the data is good enough, and accurate enough, for the management team to make important strategic and operational decisions. Some experts have called a hastily assembled balanced scorecard a shortcut to disaster. Quite simply, the argument goes, if you have erroneous data going into your scorecard, and you make a big decision based on this information then cataclysmic failure is a likely outcome. "Some experts have called a hastily assembled balanced scorecard a shortcut to disaster. Quite simply... if you have erroneous data going into your scorecard, and you make a big decision based on this information then cataclysmic failure is a likely outcome." In this article, I will discuss how activity-based costing / management (ABC/M) contributes to the reliability and the quality of the metrics that populate the balanced scorecard. I have been involved in over 30 A BC/M implementations and more than 10 balanced scorecard implementations in Asia over the last five years. Most of what you read here is based on the learning that I have gleaned from these implementations. Firstly, I will outline briefly the concept of ABC/M and it's implementation. I will then discuss the various outputs from ABC/M and how they can enhance the balanced scorecard. However the entire subject of ABC/M cannot be sufficiently covered by a short article like this, and there are indeed many books covering the subject in detail. Some recommended readings are listed at the end of the article. ABC/M and Robert Kaplan Through the popularity of the balanced scorecard, more and more people recognise the name of Professor Robert Kaplan, who cocreated the concept with Dr David Norton. What is much less widely known is that Professor Kaplan was also, along with Dr Robin Cooper, the creator of the ABC/M approach. Both ABC/M and the balanced scorecard are in essence management accounting (reporting) concepts. With ABC/M becoming popular in the 1980s, it therefore precedes the 1990s-launched balanced scorecard. However, with both approaches co-authored by Professor Kaplan there was always going to be areas that mutually reinforce. Activity -Based Costing / Management Described Simply put, the concept of ABC/M looks at how resource costs like salaries, utilities and rental, are consumed by work activities, which are components of various processes in an organisation. The activities and processes are in turn consumed by the output of the organisation. The output includes products and services provided to the customers. This consumption flow is best described by the CAM-I (Consortium of Advanced Manufacturing-International) Cross, shown in figure 1.

Figure 1: The CAM-I cross Because of the way it looks at how products and services consume resources via activities performed, ABC/M is a particularly accurate way of computing product and services costs. It is indeed a very useful way to assign overheads to the product / services, as depicted by the vertical view of the CAM-I Cross. A major benefit of ABC/M is thus higher accuracy in products and services costing, and hence in profitability computations. Bear in mind that in today's competitive environment, profitability analysis is not just about looking at the last figure in the Profit & Loss statement. It is more about knowing which are your profitable p roducts and which are the unprofitable ones. It is about knowing which of your customers are making you money and which are losing you money. Above all, the ABC/M methodology provides critical information for the effective management of the activities and processes of the organisation. What is the cost of a machine set-up? What is the cost of processing a sales order? What is the cost of re-work? What is the cost of a customer service call? What are the cycle times of these activities? Answers to these questions are found in the analysis of activities in an ABC/M model (the horizontal or process view of the CAM-I Cross).

Benefits to the Balanced Scorecard In considering the benefits of ABC/M to the balanced scorecard, I will first quote Dr David Norton, p resident and co-founder of the Balanced Scorecard Collaborative: "The balanced scorecard provides a top down model of business strategy, ABC/M provides a bottom-up view of business processes. Linking the two together opens new opportunities for strategic insight and action. "As a source of strategically relevant information about customer and product profitability, ABC/M makes an invaluable contribution to enabling the balanced scorecard strategic management process." (1) Considering earlier points in this article, two benefits of ABC/M to the balanced scorecard become obvious - profitability management and process management. We will explore these benefits as we look at how ABC/M information can impact each of the conventional scorecard perspectives. ABC/M and the Scorecard Perspectives In the financial perspective of the balanced scorecard, there will typically be key performance indicators (KPIs) around profitability. ABC/M makes it possible for the organisation to know quite accurately where its profits a re coming from - from which products and which customers. The traditional Profit & Loss statement provides one big profit/loss figure, and for lack of better information, it is easy to end up assuming all products/customers are equally profitable or equally unprofitable, which is clearly untrue. The customer profitability information is also very useful for the customer perspective. It helps in identifying the most suitable customer strategy and also in the execution of the strategy. Organisations need to u nderstand what it takes to keep the customers happy and yet remain profitable. Services provided must add value to the customer whilst simultaneously being provided in a costefficient manner, so ABC/M provides the data through which to ensure that balance is reached. The Internal Process perspective of the balanced scorecard contains information of the key processes in the business. ABC/M provides process cost information, as well as process efficiency information. These are essential for business process improvement. The scorecard identifies processes that are most important to the successful execution of strategy, and ABM helps ensure that these processes are run well. It provides measures of cost, time, and quality for the key activities within these processes. In some cases, outsourcing may become a much better option, if the organisation is not able to perform the process well. The learning and growth perspective usually has the least input from the ABC/M model. It is quite often limited to the rare situations where costing measures appear in this perspective. Furthermore, in building an ABC/M model, drivers are used to 'drive' resource costs to activities, and activity costs to cost objects (products and services). These drivers are essentially 'consumption rates', which are really measures of productivity. Examples of consumption rates are: the number of full-time equivalents that is required to perform the activity called setting-up machines and the number of setting-up machine activities required to produce one million units of Integrated Circuits. The driver rates are also necessary for another big area in ABM - activity-based budgeting (ABB). ABB makes use of unit driver rates to budget resources required to meet new output levels. It also helps companies to predict financial outcomes of sudden change in business, for instance the loss of a major customer, in a timely manner. Shareholders are now demanding fast and accurate information, and driver-based budgeting is the best way for this to be accomplished.

Figure 2: Applying ABC within the balanced scorecard framework. The role of ABC/M and ABB in the scorecard process is shown in figure 2. The figure shows a typical process, beginning with the clarification of the vision and strategy. Once this is done, strategic objectives can then be set and measures linked to them. ABC/M is applied here, essentially to model the business, identify the appropriate measures, and also provide the correct figures for these measures in the scorecard in Step four. The third step is where budgeting and planning takes place. Very few organisations have implemented ABB, but if they have done ABC/M this is a natural progression. The final step is where performance management takes place. The scorecard gives feedback on how well the organisation is doing with respect to its strategy. Are changes in the strategy necessary? Do any of the processes and hence the measures need to be replaced? The entire loop is a continuous learning process and organisations go through numerous iterations, sometimes without ever arriving at the perfect permanent strategy. "Shareholders are now demanding fast and accurate information, and driver-based budgeting is the best way for this to be accomplished."

Critical Success Factors I will conclude with five critical success factors (CSFs). As ABC/M and the balanced scorecard are usually separate initiatives, CSF 1 applies to ABC/M whilst CSF 2-5 applies equally to both. Many authors of books on Managerial and Cost Accounting, whilst expounding the virtues of ABC/M, caution that it may be too difficult to deploy. This stems from the fact that ABC/M is often perceived to be an exercise to 'split hairs'. And this signals the most important of all the following critical success factors: 1. Have the right amount of details The 80/20 rule usually works. 80% of the costs are consumed by the top three-five activities. So don't spend too much time worrying about the other 100 activities that consume the remaining 20%. Only go to greater details on a need-to basis, for instance, when attempting to improve a costly and important customer-facing process. 2. Do not measure everything Choose only the relevant measures - those that are aligned to the strategic objectives of the organisation. When you have too many measures, you are bound to have lots of irrelevant ones. More measures means bigger models and more data collection; both of which contribute to greater difficulty in deployment. And when Using ABC/M to drive performance against balanced scorecard objectives and measures then ABC/M methodology should be primarily applied to the critical few strategic measures. "When you have too many measures, you are bound to have lots of irrelevant ones. More measures means bigger models and more data collection; both of which contribute to greater difficulty in deployment." 3. Senior Management commitment Senior management buy-in and support is crucial, otherwise the project will quickly become a 'flavour of the month' exercise. Employees throughout the organisation generally become nervous when work processes are being analysed and reviewed. They think that a retrenchment exercise is in the pipeline. Top management must show commitment, and clear messages disseminated throughout so that all employees will not have the wrong perception. In this way, employees will cooperate, and roadblocks will be minimised. 4. Resource Commitment The ABC / M/balanced scorecard initiative is not without costs. Expertise is also required. Some of this will be available in house and some will come from external consultants. A budget has to be set aside to start the programme and also to maintain the programme. The initiative should not be seen as a one-of exercise. The long-term objective is to turn it into a part of the management system of the organisation. The ABM/balanced scorecard information should be used on a regular basis to help define strategies, implement strategies and manage performance. This is where technology becomes very useful. Successful organisations rely on specialised software tools to operationalise and hence sustain, their ABM and balanced scorecard initiatives, turning them into a standard part of the management system. 5. Start with a Pilot I would argue against a company-wide big bang approach. Begin with a pilot, which may take three to four months to complete. This way, you will have some quick successes that will be important for the learning it gives to the people involved. It will also give the management confidence to expand the scope of the programme. Andrew Lim is director Balanced Scorecard Solutions Pte ltd. He may be contacted via post at 271 Bukit Timah Road, 04-03 Balmoral Plaza. Singapore 259708 or via telephone on 65 6736 4285

Reference 1. Remarks made at the ABC Technologies User Conference 1998. REFERENCE BOOKS ON ACTIVITY-BASED COSTING Activity-Based Information Systems: An Executive's Guide to Implementation Mohan Nair Activity-Based Information Systems provides an in-depth knowledge of costing, along with an appreciation for capitalizing on the use of systems and software. Whether looking to improve your business's bottom line or streamlining your company's financial decisions, this book will help you examine the complex choices on the ABC/M Journey. Activity-Based Cost Management: Making It Work Gary Cokins If you're about to implement an activity -based costing programme at your firm, this book shows you how to do it. It will help you avoid pitfalls, and tells you how to sustain an activity-based costing and management system. An effective learning tool for managers and an excellent internal selling tool for ABC advocates. Activity-Based Costing: The Key to World Class Performance Peter L. Grieco, Jr. Activity-Based Costing (ABC) provides you with the information needed to run your company in the most efficient and profitable manner possible. Each chapter focuses on an important facet of ABC with step-by-step examples of how to find the true Total Cost of producing a part or providing a service. All areas and functions of the company are explored. This book gets beyond reading and thinking stage; it puts ABC into action. Activity-Based Costing and Performance Karen B. Burk and Douglas W. Webste r, PhD. Activity-Based Costing and Performance (ABC&P) combines the principles of activity -based costing with performance measurement, applying these to business process reengineering. ABC&P helps managers understand the true costs of providing products and services, and the factors that drive these costs while addressing other concerns such as customer satisfaction. This book explains the fundamentals, providing step-by-step guidance on how ABC&P is used in each phase of a reengineering project. Cost & Effect - Using Integrated Cost Systems to Drive Profitability and Performance Robert S Kaplan & Robin Cooper Kaplan & Cooper reveal that most companies do not know how to measure accurately, influence, or understand the fundamental cost drivers in their businesses. They then provide a detailed and comprehensive blueprint that will enable managers to make better decisions and to promote organisational learning and improvement.