Activity-Based Costing (ABC) and Business Process Reengineering (BPR) form a strategic management tool that assesses the alignment of business processes with corporate vision and measurable manageable change. Combined, they serve as a lens that clarifies and eliminates operation and cost distortions. They provide a clear picture of the business' future (the vision), the paths and alternatives available (the mission and the how-to), and the impact and implications of critical business issues and decisions (the business, work flow and management processes).
Business Process Reengineering is a powerful methodology for obtaining in-depth understanding of current business processes, for determining and measuring key process criteria, and for identifying areas of change to meet and exceed market competition. BPR provides a resourceful modeling, simulating, predicting, and measuring tool. BPR is a success tool that helps businesses focus on vision alignment and achieve goals.
Activity-Based Costing identifies, assigns costs and overhead to activities rather than to products or services. ABC is applicable to any process and integrates seamlessly into the systems engineering life cycle. The results of ABC are direct: flexibility, distinct financial information, a business model, decisive operations information, process and product performance metrics, and associated costs.
Does this mean everyone should undertake a consolidated ABC and BPR assessment? The answer is both yes, and no. It depends on the business focus, what the operations look like and the client base. In this White Paper, we examine selected cross-sector application examples and derive the benefits and cautions of BPR in the health care industry, ABC for manufacturing, ABC for government contracting, and the value-added benefits of ABC integration with Information System technology.
Improving business processes is critical for business survival and growth in today's highly competitive marketplace. This paper illustrates key points in the evolution of the industrial competitive marketplace and identifies a key set of methodologies. Implementing BPR and ABC concurrently renders a strategic management and modeling tool. This tool creates opportunities and offers insights otherwise difficult to obtain using each methodology independently.
Integrating ABC into the systems engineering life-cycle as a component of BPR practices offers a powerful mechanism for obtaining in-depth understanding of existing processes, measures key factors detailing these processes, and identifies areas of change to meet and exceed market competition. Together they provide a resourceful tool for modeling, simulating, predicting, and measuring the overall system and interrelated components for achieving corporate goals. In fact, the combination of BPR and ABC strengthen and add value to strategic management. The combination secures and aligns business process changes and growth with corporate vision and values while offering bottom-line business measures of success; i.e., specific cost breakdown, process optimization costs, and cost differential between change alternatives.
Historically, factories of the industrial revolution have employed large amounts of labor; all business processes and associated costs have been tracked to either direct labor costs (DLC) or direct labor hours (DLH). In comparing the direct labor costs to the direct expenses, overhead costs have been minimal. The cost structure promotes tracking overhead costs in a single pool.
As automation began replacing direct labor, overhead costs became more significant, and the business processes began to transform. This transformation strongly affected process, management, traditional costing schemes and traditional overhead structures. In the course of business evolution, the traditional ways of measuring costs remained in place, while the businesses and the marketplace in which they operated became increasingly more sophisticated. The traditional methods of cost and process analyses become less relevant. However, many businesses today rely on these basic analytical methods to assess the nature and costs of their ever-increasingly-sophisticated businesses. ABC and BPR combined are capable tools that can assist businesses in providing an explicit picture of costs and processes.
Modern businesses still practice relic procedures for integrating existing business processes with cost structures. In a rapidly growing and changing business environment fueled by technological innovations and world trade cohesion, maintaining process infrastructures and their support and tracking systems obstructs efficiency and conceals critical information necessary for decision makers. Overhead cost allocations to a product and customer or services are subject to misleading financial modeling and data representations. Business models inefficiently depict work processes concealing workflow and informational bottlenecks.
Strategic thinking is frequently confused with strategic planning, and the change process is not managed to reflect an integrated and focused effort. Information systems, including financial systems, are built for the purpose of deploying technology and do not meet and reflect the evolving operational needs.
Business Process Reengineering is the methodology used to focus and direct an organization. BPR helps the business unit(s) meet corporate vision, implement and manage change, and measure subsequent performance impacts. Although continuous improvement strategies are effective in obtaining gradual, incremental changes, BPR brings substantial changes, business process improvements, measurable breakthrough performance and immediate, significant, impact. In a world of interlocking markets, rapidly evolving technology, change requirement is not only desirable, but also critical to a business' survival.
A prominent benefit of BPR is seen in the Health Care Industry. It is sometimes argued that the health care industry is inherently inefficient due to the high cost of insurance, high administrative costs, and the low number of insured people. A unique complexity of the Health Care Industry is a cessation in communication between facilities, pressure for lower costs, and continuous quality improvement. Traditional Health Care Industry response has been to merge business units or redirect strategic thinking. The key to future industry success lies in the Health Care Industry leadership's ability to redefine its structure in terms of processes.
Health Care Industry business is a member of the fee-for-service industry, implying a functional or unit based business model. While functional models allow for substantial profit gains through specialty injection, process-oriented health care delivery systems provide a competitive and more efficient model for delivering higher customer care quality (receiving, handling records and information, centralization of customer services). These qualified organizations are better situated to meet the changing industry trends of improving customer satisfaction, quality of service, and to handling substantial growth.
How does BPR play a role in this process evolution? Process-oriented health care groups pay per capita and not per service. The process is identified as a predetermined set of activities required to take a customer through the complete cycle from reception to the completion and delivery of service.
A surgical center requires hundreds of functions in order to operate. The output of a surgical center for each patient is a surgical service. However, the patient as a consumer expects a consultation, pre-operative teams, surgical procedures and follow-up care. Each of these visits is seen by patients as a completed outcome. A surgical center going through the exercise of process definition may identify these elements as their business processes. Work and people are categorized within the processes.
The point is that processes will share activities. The clear identification, integration and optimization of the processes fulfilling business needs and customer requirements eliminates work flow redundancy, optimizes resources (physical space, person time and system usage), and renders an image of cross-functionality in between specialties; a general increase in efficiency from both the customers' and the business' perspectives.
The Health Care Industry must move from its traditional image of bureaucracy, complexity and functional boundaries, to a more flexible, customer-focused enterprise. The challenge will remain to maintain and continue to excel in the specialties of the industry that fill the ranks of the processes and to not lose sight of the mission of the Health Care Industry in lieu of competitive advantage.
As in the Health Care Industry, today more than ever, customers want and expect products, services and support with excellent quality and maximum expanded functionality. They want this at economical and competitive prices. In such a competitive environment, businesses need to not only re-evaluate and reengineer their processes, but need to track the changes, the effects, the direct relationships between their products and services, and their costs.
Traditional Volume-Based Costing (VBC) has become dangerously unreliable for companies operating with a variety of customers, products, services, and multiple lot sizes. Activity-Based Costing identifies, assigns costs and overhead to activities rather than to products or services. The impact is a direct correlation between output (the products and services) and the company business process. ABC is an integrated systemic approach mapping costs to activities, activities to functions, functions to processes, and processes to qualitative output.
The results of ABC are straightforward. They include a clear financial understanding and modeling of the business. This is made possible by improved accuracy of data, information, improved performance metrics and associated costs capturing and reporting, which results in an improved strategic management tool. This resulting improved strategic management tool means a more seamless integration of BPR practice with the ABC component. It means a more in-depth understanding of the effect that identification and analysis of the change solutions, integration implementation factors, methods and means, and measuring and modeling of existing and (potential or actual) reengineered processes.
The application of ABC is straightforward but must be tailored to the actual process. Since no two business processes are alike, caution in applying ABC must be taken. ABC is successful when senior management is committed, operational or line managers are involved, and the right ABC tools are used correctly.
The initial steps to implementing ABC are identical to BPR implementation methodologies. Prior to beginning, the project implementation team must have full commitment and support from top management and the business scope. The project should also be clearly defined, for which an agreed upon project prospectus usually suffices. A study period must follow, which must involve all stakeholders (customers, employees, managers, system users, etc.), and coexist with strategic alignment. A new business process model and vision must then be created to reflect the purpose of the prospectus and to create a compelling business case for change.
Subsequently, the enabling processes and technology must be developed, and prior to implementation, a gap analysis must be done to plan a seamless migration and system engineering level integration. The processes must be fully defined. The system design and the implementation plan should be designed to include training and operations documentation and issues. A prototype of this new model is critical. The prototype helps refine and finalize the final system plan, to manage ensuing change. The final step to implementing BPR and ABC is to initiate a continuous improvement process through feedback and continual change.
The key differences between implementing BPR and ABC is that ABC does not usually require the extensive and exhaustive work that is inherent in BPR. Understanding the existing or future needs and processes, depicting potential benefits of applying the methodology, prototyping integrated tools and analyzing their impacts are sample components that should be included as part of a bare-bones ABC. When properly performed, that plan that can be successfully completed within just a few months (clearly, time expended varies by the size and complexity of the business).
ABC can be initiated or incorporated at numerous stages of the BPR cycle. ABC provides the BPR team flexibility in integration and implementation. Like BPR, the details of implementing ABC are therefore straightforward. In fact, they can be viewed as a subset of the major BPR steps: as ABC is a component of BPR, the ABC steps are components of the BPR steps. The benefit of ABC is its component aspect; it does not require nor depend on the full blown out changes brought on by BPR.
The initial step to successful implementation of ABC is to formulate and define the major business processes (taken from or supporting BPR) and to derive the key activities of the organization. Next, the operating costs, capital charges and financial flux are traced to these key activities: sample reports suitable for analysis, the budget, general ledger and supplier invoices. The activities are then linked to the functions of the processes and cost drivers are determined. Cost drivers are the factors or triggers that affect the cost of an activity; e.g. poor quality. Subsequently, activity costs are then summarized, categorized and totaled on a per process basis. These procedures apply to existing business processes as well as modeled future implementation designs and alternatives.
Comparisons and simulations (projections) can be easily determined. Therefore decision-makers are supplied with factual and precise information about what changes can be made, how to implement them, and how to manage them. Every step defined in BPR or ABC reflects a common agenda - the Systems Engineering Process. Whether it's reengineering just a component or the whole element, adding a tool (ABC), measuring change, or implementing a new idea, every activity is tied to the overall vision and maps into the steps of the engineering process cycle. BPR and ABC steps then become integral elements of the life cycle. The identification, definition, analysis, prototype, implementation, and management steps are interdependent and inter-related to the life-cycle steps. The cycle is closed when at the end of implementation a feedback and improvement mechanism is instilled (i.e. continuous improvement). Applying ABC requires the systems approach and process knowledge and therefore can be applied to any business practice. The key is the efficient and complete application of the systems approach.
Activity Based Costing can be applied to any business process. Companies who serve several customers with a variety of products have identified critical misconceptions in their costing process relationships. Discovering dramatic insights is a by-product of applying the ABC methodology. The following sections illustrate the beneficial role that ABC has played for the manufacturing industry, the benefits of integration with the service and information technology industry, and the government contracting industry.
Switching from VBC to ABC is not always a clear-cut solution to eliminating VBC created distortions. Management and management accountants should recognize that when companies utilize multiple lot sizes, the per-unit costs measured under ABC methodologies can still vary. Specifically, the size of production batches affects bottom line costs and the associated process activity costs.
Applying successful ABC implementation entails identifying all applicable business processes and the activities comprising them. Each activity is then associated to resources used to perform the activity. The cost of the resources is then assigned to a specific cost pool. A cost base, e.g. processing a purchase order, is identified and the activity level of the allocation cost base divides the expected cost of the activity. What this means is that there should be, when possible, a strong causal relationship between the identified and selected cost drivers and their associated activity pools.
The per-unit cost of a product measured by ABC may therefore vary significantly depending on lot size and production demands. The competitive advantage gained by implementing ABC, is accuracy and precision in proposal pricing, profit strategy, and business knowledge. The business decision-makers have an accurate picture of what their business is doing and they have the opportunity to inject critical decisions. The insight is a tool for managing strategic objectives.
The information engineering business is a highly competitive and evolving industry. The benefits and hazards of dealing with this industry are evident from the beginning of technology inception. It is clear that systems must meet operational needs and they must be technically competitive. Production of software and hardware involves the inclusion of many General and Administrative (G&A) costs associated with development, production, and strategic market analysis and penetration. An Information System (IS) is therefore only value-added when it improves business process efficiency and optimizes cost-effectiveness. Some IS tools that are developed and deployed offer technology without clear and qualitative integration with user needs, requirements and process stipulations.
The United States and Canadian federal governments, in their respective economies, are some of the largest purchasers of goods and services. A significant portion of all purchases and expenditures by government are based on cost and profit margin. Costs are established by free market trading where pricing is public knowledge, and are regulated by commercial trading. Pricing stems from a financial infrastructure that incorporates basic costs and allowable margins of profit. Government purchases are usually made in the form of direct or competitive contracts. In both cases, a set of rules and regulations guides what costs may be included in the balance sheets and what profits may be drawn for completion of contractual obligations; the underlying assumption is that costs are reasonable and proper.
Significant portions of the overhead incurred by businesses include indirect costs. Examples are costs of selling, general and administrative (G&A), and bid and proposal (B&P) expenses. Traditionally, overhead funds are directed to cumulative pools that are then allocated to contracts on a basis of volume-variable output measures. Although some costs such as advertising and interest are non-applicable costs, there are methods of diverting portions of allocated funds as "take-outs", funds that will be used for other purposes than stipulated by their basis for being overhead expenditures.
The basis for take-outs is normally arbitrary. It reflects and uses the fact that overhead is usually an estimated value for the upcoming year. The purpose for take-outs is straightforward. It lowers or raises the G&A to become more competitive on a given contract and attempts to improve cost allocation. Profit is then based on a percentage of the total cost of the project. Adjustments can be made for contractor investments in capital, risk factors, and other issues. In essence, the approach to government contracting cost processes is that of VBC. The distortion of cost assignments stems from the imprecision of fund tracking and cost to performance value of indirect overhead expenditures.
Applying ABC to government contracting offers the potential of disclosing a significant lesson that others have learned the hard way: average rates can lead to significant distortions in cost for specific items and needs, for varied production lot sizes, and for services. Individual business units, groups and project teams consume indirect resources differently. Is this a problem? Not likely if the contractor has one project with one government customer or several projects with the same customer because although their could be significant distortions, the total would be correct. In a multi-project or multi-customer contracting environment, indirect overhead reflects value of resources, resources consumed by activities and the consumption of indirect resources. These can matter significantly and distort the true image of operational costs.
ABC is a methodology and tool that assists in identifying business and project critical activities that can consume business valued resources. Activity information can be used for assessments to identify opportunities for improving processes, reducing cost thus optimizing cost-effectiveness, and measuring performance and process outcome. Trade-off and alternative solution analyses that provide insights into the costs of support work can be performed. It also enables the establishment of performance measurement targets for activities, functions and processes.
The first steps are to define cost categories, identify processes with their associated functions and activities, determine activity costs, and assign costs to categories. The immediate benefits are the instantaneous characterization of the business cost infrastructure, the identification of profitable and non-profitable products and services, and the identification of a business' best customers. Other direct benefits include demonstrable control of margins for competitive orders, educated customers who can see the implications of change in design or quantity, and quality controls. The results are savings and accurate costing for all participants.
The lessons drawn from the various industry application of ABC draw attention to the many successful uses, implications and implementations of ABC as both a tool and a methodology. In most operational business situations, the objective standard is the optimization of the process or system's cost-effectiveness. ABC focuses on cost-effectiveness factors and provides a means of indirect experimentation to explore existing system to costing relationships and alternative effects of system characteristics and system performance.
ABC is a methodology and a tool that helps identify business and project critical activities that consume business valued resources. Activity information can be used for assessments, cost-effectiveness optimization, process improvement, performance evaluation and metric definition, and trade-off analysis.
A key factor in successful implementation is the accurate selection of cost pools in which all of the overhead resources in the cost pool are consumed by the products using that cost pool in a similar manner. There should be strong causal relationships between identified and selected cost drivers and their associated activity pools. When administrative activities are correlated with specific products and customers, information on which to base pricing and other decisions are reliable.
In conclusion, Volume-Based Costing can and should only be applied on a per like-project basis. In dealing with multiple projects, ABC should be applied to the cost infrastructure of the business entity selling products and services so that the overall cost structure is optimized and the individual components or projects are completely and accurately depicted, measured and improved.
Business processes, like system design evaluations, should be pursued continuously in terms of life-cycle cost and system effectiveness. ABC as a methodology and practice within the scope of BPR creates a strategic tool that exacts the business cost flux and tracks with an unprecedented precision the cash flow. When integrated with the operational requirements and business vision, ABC results offer decision-makers clear alternatives and solutions, highlighting the key factors that differentiate alternatives. ABC not only offers solutions but postulates on the likely outcome of the decisions.