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Tag Archive | activity-based costing

Does my milkman use Activity-Based Management ideas?

Not my milkman…

Ok, the title of this post is not really correct. It should be more like “does my milkman and his supplying dairy use activity-based management principles”? First, let me explain that where I live we still have milk delivered to our door twice per week.  This is quite common in Ireland and has been happened for as long as I can remember. The only difference nowadays is that deliveries are no longer daily due to refrigeration technology improvements. Second, what is Activity-based Management (ABM)? In a co-authored text book (see burnsetal.com), ABM is defined as “The
use of ABC information to identify operational and strategic improvement possibilities”. We could extend this to say that ABM assumes a business manages itself based on activities (as in Activity-based Costing) rather than functions.

So what has this to do with my milkman?  Well, despite its very traditional nature, technology has made its way into milk delivery. A new website (mymilkman.ie) has been set up by several dairies in Ireland to streamline milk delivery. Through the website, I can pay for my milk, change my order, pause my order if I go on holidays and so on. And when I signed up, I got €10 credit on my account.

I asked my milkman what he thought about the site. He told me that even if he gets only 50% of customers to sign-up, he will save 8 hours work per week. Why? Well he does not have to call to the door to collect money for one thing.

So what has this to do with ABM? Well the €10 credit on my account makes me think that someone is thinking that it costs less to manage a customer if online – and I would suggest this is a customer service activity. And if we think about it, how many businesses charge us more if we do things through call centres versus online for example. So there may be many businesses out there using the ideas of ABM – managing activities. But would they all use ABC? I doubt it. For example, the dairy industry probably used some form of process costing. Nevertheless, I think many businesses may use the basic idea of managing activities they perceive as costing more/less in different ways.

 

 

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What is activity-based costing?

Customer services

 

You may have heard of activity-based costing (or ABC), and here I will try to explain the basics of ABC. First, just a short reminder of the types of cost an organisation may have.

 

Costs are often classified as fixed or variable. Variable costs change in line with volume/output, and are often called direct costs as they can be attributed easily to a product or service. Fixed costs, often called indirect costs, do not change when business output changes. For example, a fixed cost might be rent of a premises or the salary of a general manager. Such costs cannot be easily traced to a product or service. However, if no effort is made to trace fixed costs to products or services, then the business does not know the full cost. This makes decision-making more difficult.

 

Traditionally fixed production costs are absorbed into a product by means of a rate per labour hour. For example if overhead was planned at €1 million for a year and 100,000 labour hours were to be worked, then each labour hour would mean a €10 overhead cost. So a product taking two labour hours to make would be charged €20 overhead.

 

The traditional method can be criticised as over the years more and more overhead has been non-production type overhead and not related to the number of labour hours spent making a product – indeed automation of production in many industries has seen labour being of decreasing importance.

 

Another more modern way to allocate overhead to products is using ABC. The key in ABC is the word “activity”. In ABC, we can think of an activity as a collection of tasks which are linked in terms of being an overhead cost. For example, customer service, facilities management, quality control and machine setup are all examples of activities. The resources of the activity are determined, which are used to determine the cost of the activity – typically for a year. Then, what causes these resources to increase or decrease is determined. This is called a cost driver. For example, more complaints from customers will increase the resources needed by a customer service department. Using the cost driver, the overhead cost driver rate can be determined. Here’s a brief example:

 

A design department costs €100,ooo per annum – costs such as salaries, design materials, computer running costs etc. The more designs for new products the greater the cost, this designs are the cost driver.  Lets assume there are 5,00o designs per annum, thus the cost driver rate is €20 per design. A product which needs say three designs will thus incur a €60 overhead costs for designs using ABC. If a product has nor designs, then zero overhead is incurred.

 

In a business, design (as per the above example) may just be one cost driver. Thus, the more resources (activities) consumer by a product the higher the overhead cost. This seems to make a lot of sense, and thus ABC is often used where overhead costs are not easily traced using direct labour hours (or similar) as a means to allocate overhead cost.

 

With ABC, all direct costs are assigned to the product/service in the same way as traditional costing methods. It is just the allocation of overheads that differs.  Typically, ABC considers not only production overhead costs, but many other overhead costs which can be defined within activities.

 

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