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Activity-based costing Author(s): John L. Eggers and Charles E. Bangert Jr. Source: Journal (American Water Works Association), Vol. 90, No. 6, Management ABCs (JUNE

1998), pp. 63-69Published by: American Water Works AssociationStable URL: http://www.jstor.org/stable/41296289Accessed: 31-08-2015 18:48 UTC

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MANAGEMENT ABCs

AtfMytod

costing

Activity-based accounting provides a true measure of services and goods and helps target business processes that need improvement.

John L. Eggers and Charles E. Bangert Jr.

very enterprise in today's business environment public or private, faces continuing and unrelenting pressure to become "world class" or "best of breed* or some other epitome of excellence. Just as there are businesses that fail to accommodate or respond to this pressure, there are many others that will rise to the competitive challenge. It doesn't mat- ter whether an organization manufactures hard goods or provides a service; organizations must become more efficient in order to survive.

Water utility managers are likely to agree that providing the highest quality product and service at the

lowest possible price has always been important. Those same utility managers, however, may also agree that managing costs has never been more dif- ficult than it is today.

Search for efficiency leads to change

Municipal governments, like the private sector, are feeling extreme

For executive summary, see page 172 .

JUNE 1998 J.L. EGGERS ET AL 63



Model of utility resources, activities, and services

budget pressures as they provide their citizens with necessary services. Rates are rising to pay for regulatory compliance, infrastructure repair, and a host of other needs, and consumers are not happy about it. Unhappy citizens can lead to cranky mayors and city council members. Within the water supply industry, consumer concerns about water quality are on the rise. Some of these concerns are real, and others are not, but all must be addressed.

These conditions have gotten the attention of not only water utility managers but also the politicians at city hall. Such developments are the driving force behind the cost-control movement so prevalent today in the water utility industry.

Water industry looks to privatization. In the midst of these developments (and perhaps partly in response to them), there has been a recent surge of interest by the private sector in owning, or at least operating, municipal systems. The private sector's involvement in the ownership or operation of publicly owned utilities can take many forms, described by such concepts as outsourcing, public-private part- nerships, managed competition, "marketization," "businessization," and plain old privatization. What- ever form it takes and however it is termed, the private sector's participation in the operation of municipal water and wastewater utilities is becoming more prevalent as a way of providing increased services at a reduced cost.

Monopolies go "free market." Over the past decade, a number of US industries have undergone significant transformations. Regulated, monopolistic or oligopolistic enterprises - such as the airline, long- distance telephone, and gas utility industries - have become, in essence, free enterprise markets. The electric utility industry, too, is in the process of a massive restructuring. All of these industries have one thing in common. They have used some form of activity- based accounting and activity-based management to become more competitive, in terms of both cost and customer service.

What's in store for the water utility industry? It is highly unlikely (and physi- cally impossible) that water utilities will enjoy "equal access competition" through the establishment of a regional or national "water grid," as has been proposed for the purchase of power within the electric utility industry. Just as unlikely is the prospect of a sitcom star trumpeting city or metropolis water on national television, in the way that celebrities sell long-distance telephone service.

What will happen, however, is that more politicians and more utility governing

bodies will take a fresh, businesslike approach to providing traditional government services such as water and wastewater. The drive to improve cost-effectiveness will likely lead many utilities to in-house cost reductions or some form of public- or private-sector outsourcing.

Many management techniques are available. A whole host of management techniques are widely used by competitive industries to decrease operations costs and to increase productivity and customer service. Such management tools as total quality management, business process reengineering, continu- ous process improvement, and competitive benchmarking can be very effective if properly developed, implemented, and managed.

These process improvement techniques generally have one common element: for the techniques to work effectively, an organization must be able to first identify and then measure the cost and performance of the numerous activities that make up its core business processes.

Getting a handle on costs is as simple as ABC

Most organizations can readily name those activities that comprise their core business processes. Mea- suring the cost and performance of these activities is not so simple, however.

Activity-based costing (ABC) is a contemporary management tool that effectively integrates measurement of process activities, cost, and performance. A proven operational method, ABC measures the cost and performance of process-related activities as applied to cost objects or services. In the water utility industry, for example, the primary cost object or service is providing customers with a safe, adequate supply of water.

In management accounting terms, ABC (1) measures the cost of activities, (2) provides true costs of goods and services produced, and (3) tells a manager where to look to improve business processes and

64 VOLUME 90, ISSUE 6 JOURNAL AWWA



Financial accounting versus activity-based accounting at Dana Corporation

employee performance, reduce costs, and enhance the quality of products produced and services performed.

Experts look at ABC. In his book Beyond Reengi- neering, 1 Michael Hammer considers companies from a process perspective. He proposes four principles that form the foundation for continual business success.

1. The mission of a business is to create value for its customers.

2. It is a company's processes that create value for its customers.

3. Business success comes from superior process performance.

4. Superior process performance is achieved by having a superior process design, the right people to perform it, and the right environment for them to work in.

Process is crucial to success in business. Activi- ties - the components of processes that consume resources - can be measured and valued in both financial and nonfinancial terms. Because cost is the great normalizer, use of accurate cost-accounting tools is imperative to the design, implementation, and control of superior processes.

Turney2 uses an analogy that compares the pro- ducing organization to a ship afloat on a smooth sea of conventional cost misinformation. The mariner managers are blissfully unaware of hidden "rocks and shoals of poor quality, high cost, lack of respon- siveness . . . and neglected customers . . . the things

that sink the ships of enterprise in today's competitive world." Sinking is bad enough, but "nearby, lurk sharks of all kinds . . . competitors looking for the opportunity to bite off parts of your business . . . hos- tile asset strippers . . . hungry conglomerates."

In the introduction to his book on implementing and sustaining an effective ABC system, Cokins3 states "ABC is becoming increasingly more important for both identifying improvement opportunities and measuring the realized benefits of performance initiatives on an after-the-fact basis. Today's traditional costing practices show very little about the costs of cross- functional business processes and even less about where the non-value-added costs are. Further, when asked to detail their actual cost savings or cost avoid- ance realized from a project, managers cannot ade- quately do so."

Terms defined. Before moving to a detailed expla- nation of ABC, the authors introduce a hierarchy of terms related to activities and processes.4

• Function refers to the aggregation of activities that are related by a common purpose, e.g., engineering or distribution.

• Business process is the network of related and independent activities linked by the outputs they exchange. In a water-related example, mains installation requires engineering design, procurement of materials, installation of the mains, setting of meters, and accounting for the work performed.

JUNE 1998 J.L. EGGERS ETAL 65



• Activity refers to a process element that con- sumes substantial resources to produce an output. More specifically, it is the mechanism by which work resources (e.g., labor and equipment) are converted into an output (either an intermediate or a final output). Examples of an activity are estimating the cost of a distribution department work order or meter- setting by distribution department employees.

• Tasks are the combinations of work elements or operations that make up an activity. Within the distribution department activity of setting a meter, one of the tasks is collecting the necessary hardware from the storage location.

• Operations are the smallest units of work used for planning or control purposes. An operation required for the task of collecting hardware for meter-setting is checking the bill of materials for the job.

ABC applied. In application, ABC is management accounting or internal accounting performed to serve classic management needs such as planning and con- trolling. Financial accounting is defined as accounting that serves external decision-makers (regulators, stockholders), whereas cost accounting serves both external entities (income measurement and inventory valuation in accordance with generally accepted accounting principles) and internal decision-makers (all levels of management).5

Although process costing is not a new technique, its most recent reincarnation as ABC was driven by the changes in modern industrial technology that have resulted in higher indirect or overhead costs in relation to direct cost. Put another way, the direct cost component of a good or service became less and less significant, while total cost was driven more and more by indirect costs (costs of support management, automation technology, and external regulatory factors). When an organization enjoys a monop- oly position, added cost may not pose a problem. Today's market, however, is highly competitive and demands that all players - even monopolies - be as efficient as possible (i.e., incurring the minimum necessary cost to satisfy the customer better than another provider).

Classic cost accounting generally requires that all indirect costs be spread over some direct cost basis. For example, the service industry's direct labor or the manufacturing industry's direct materials are used as the basis for allocating indirect costs. In the past when direct costs constituted the major part of total cost, such allocation methods induced negligible errors. Nowadays, improper allocation can and does under- cost high-volume products and overcost low-volume output. A well-designed ABC accounting system allo- cates both direct and indirect costs based on the actual consumption of those costs by the product, not some theoretical basis of consumption that provides a math- ematically accurate but incorrect end cost.

The service industry issues that apply to utility providers center on work performed in the organization's core processes. Core processes are defined as those processes crucial to customer satisfaction and

continued survival of the organization itself. For water utilities, core processes include such key elements as customer service; water collection, treatment, and distribution; system operation, maintenance, repair, and major component replacement; and revenue billing and collection. Each of these processes is com- posed of numerous activities, operations, and tasks that are performed by functional elements within the organization.

ABC views activities as process components. ABC's basic premise is that costs of organizational resources - an organization's factors of production - are assigned to an activity based on the activity's use of these resources; costs are then finally assigned to cost objects based on the object's use of activities.

As an example, distribution department activities in a typical water utility can be modeled in this manner. Figure 1 shows a model of a utility's resources, activities, and services. In this model, the distribution department's resources include labor, equipment, and materials. Three of the department's many activities - pick materials, travel to job site, and install materials - are component work elements that consume departmental resources. Managers, supervi- sors, and other employees organize and do the activities to generate the end services - in this example, main extension and meter-setting.

The most important aspect of the ABC concept is that the end product, i.e., the service produced, is a result of combined activities that have a known cost. Once the activities and their costs are known, the groundwork is in place for management to mold activities into an effective, efficient production process.

How ABC works First, ABC measures the cost of activities. Identi-

fying the resources that are used in each activity (e.g., costed labor, equipment, and materials) helps determine the cost of each activity. As an example, the activity of reading meters may require labor (salary and fringe benefits for the meter reader), equipment (lease or depreciation costs of the meter reader's transport vehicle and any recording devices used), and materials (cost of vehicle fuels and other expendable items).

True costs of goods and services produced are then ascertained by determining the consumption of activities (previously costed) that are collectively used in processes that generate these products. This tracing or assignment of cost is based on whatever drives the activity, e.g., customer requests, purchase orders, work orders, or complaints. Once the product costs are determined, then management can act to improve processes and attain better performance, enhanced quality, and reduced costs. The better, cheaper, or faster the output, the higher the operation's efficiency and effectiveness.

The net effect of this form of cost accounting is not to place emphasis on the type of cost (e.g., dollar use) as in classic financial accounting but to focus on the actual activities for which the dollars are ex-




^m|| Schematic representation of utility and factors measured by ABC

pended. Figure 2, taken from Fortune magazine, shows the changes that occurred when auto parts manu- facturer Dana Corporation installed activity-based accounting systems at its plant in Plymouth, Minn.6

Costs for the materials control department are viewed according to traditional accounting methods and ABC. At the bottom line, there is no difference in the amount of money expended when viewed either by traditional accounting or by activity-based accounting. With ABC, however, management can clearly track where dollars are going in the supply-chain process and take action to make the process more efficient.

Performance and output are measures of efficiency. Change for excellence centers on gains in efficiency, usually defined as an increase in output for a given input or, more simply, getting more bang for the buck.

In ABC methodology, the objective is greater efficiency for a given process. Attaining more efficient processes begins with identifying and defining component activities and measuring their consumption of resources in terms of cost per dollar. Making the process and its elemental activities more efficient should lead to one of three results:

• output remains constant (value unchanged) with less input resources,

• value increases with no change in input, or, optimally,

• output value increases with less input resources. An accepted truism in management holds that

what gets checked gets done. This applies to process

performance measures; management needs to ensure that the measures apply to processes across functional "stovepipes," i.e., organizational units. Costs- per-unit output, e.g., dollars per million gallons, illus- trate this point. Data on costs per customer type can provide excellent insight into rate sufficiency. All the tasks, operations, and activities in the water supply organization are combined in the process of produc- ing water of desired quality at the right place and the right time.

Performance measures take many forms . Other types of performance measures that may be appro- priate include the following: workload, output-to- cost ratios, transaction ratios, error rates, consumption rates, inventory fill rates, timeliness measures, completion and backorder rates, quality, responsive- ness rates, and user satisfaction rates.

Business model approach recommended A business model of an organization must be

developed from a specific perspective. The best perspective for any organization, from a large municipal water utility to a 50-person advertising agency, is that of the customer the organization serves - the user or buyer of goods and services.

Identify customers and the products they consume. Who are the customers of a typical water utility? Obviously, individual consumers of water are key customers. Water sustains life, of course, but it serves other needs as well. Businesses comprise another segment of the utility's customer base; many industrial processes require large volumes of water to




Cross-functional model of processes and activities

produce products for their customers. Still other customers may be less apparent, but they are no less demanding; these include stockholders, regulatory agencies, and local governments who need mandated reports, meeting participation, and other require- ments of governance.

Once all stakeholders have been identified, the next step is to identify the utility products these customers consume. The commodity of water is just one of many products generated by a water utility. Other products range from annual financial state- ments to customer service request processing to environment reports.

At this point, the modeling effort requires a bit of strategic gamesmanship. Product generation performance measures need to be structured to evoke desired results from customer-oriented processes rather than functional stovepipes. As an example, average unit costs of service work order processing (start to completion across the utility's functional organizational elements) is more meaningful than the simple cost of customer service department processing. Additionally, performance measures should be attuned to some attribute of customer demand. One such example is the unit cost for million gallons

of water delivered per day; the performance measure is easily understood by producers and consumers.

Now that services have been defined, the next step is identification and definition of activities. As stated earlier, activities are process elements that consume substantial resources to produce an output. It is at this stage that the process model generation needs both a strategic and tactical view. The activities should be managerially useful for senior management, yet recognizable to the process performers, i.e., first-line managers and employees.

The ABC model builder must first apply cost attributes to the activities by assigning resource val- ues (costs of labor, equipment, materials, or other resources) to each activity and, second, identify drivers or cost-tracing mechanisms for the activity. The drivers serve as the link between the costed activity and the activity-consuming product. For example, the indirect costs of administering per- sonnel may use number of employees as an activity driver.

Costs also have a time parameter sometimes referred to as a period cost. Depending on the needs of the model builder to satisfy management require- ments within specific time constraints, activity costs




can be determined for monthly, quarterly, or other time segments.

The final component of this approach to building the organization's ABC model is linking the activity to the functional component. Activity matrixes are built for each organizational element cost center or responsibility center. This serves to tie activity performance (and custody for activity structure, design, and redesign) to the functional element managers. This is nothing more than an instance of the classic management loop - planning, direction, feedback, and control.

ABC requires activity-based management. All the components for ABC are in place; all that remains is for management to shift to a process-centered method of management. Activity-based management happens when managerial decisions are based on feedback from the ABC matrix shown in Figure 3. Now that product-generating work is measured in cost terms and tied to the functional elements of the utility, efficiency improvements can be planned and directed, and their effects can be measured as feedback for further action.

ABC reaps benefits, avoids blind action ABC provides managers with previously un-

available information that can be used to more effectively manage operations. The costs of work processes are collected in such a manner that process owners can become responsible for the costs of the process. ABC shifts the organizational focus to business processes and their value and productivity. Once cost becomes the means of measurement, a common basis of reference is estab- lished for all management areas to use in improv- ing the organization.

Figure 4 shows some typical activities that a water utility organization may perform in response to a customer's request for service. The steps in the process have been defined, but how can a manager be sure that this is the best way to provide better, faster, cheaper service? No manager can know for sure until the process parameters have been measured and the effects of changes can be tracked. Current management literature is littered with examples of downsiz- ing, rightsizing, and resizing that could all be classi- fied as "dumbsizing." Most of the fault can be attributed to management actions that were taken without a means of measuring their effect on customer-oriented production processes.

More to the point, ABC serves as the basis for activity-based management - the management of organizational work through management of process cost. ABC can help utility managers

• contain rate increases by enhancing efficiency in organizational processes,

• stave off competitors through better in-house performance, and

• improve customer perceptions of cost, quality, and timeliness with cleaner, leaner processes that yield better results, faster and more economically.

Conclusion Today's competitive business climate requires the

water industry to become more cost-effective while delivering high-quality products and services. To achieve this, water utility managers, just like their counterparts within the private sector, must be con- cerned with what efficiency is and how to measure it. As management maven Peter Drucker writes, "We need to measure, not count."7

A proven management tool, ABC enables an organization to quantify cost and performance in terms of the process activities that make up its core business. This provides a true measure of how much goods and services produced actually cost. With this information, management can pinpoint areas where costs can be reduced and business processes and employee performance can be improved.

ABC and its corollary, activity-based management, give managers an accurate picture of organizational efficiency and help them avoid hit-and-miss attempts to improve performance. For water supply managers requiring a more definitive look at ABC, the references cited in this article have been selected to provide a solid introduction to activity-based accounting and activity-based management.

References 1. Hammer, M. Beyond Reengineering. HarperCollins,

New York (1996). 2. Tzurney, P.B.B. Common Cents: The ABC Perfor-

mance Breakthrough. Cost Technology, Hillsboro, Ore. (1991).

3. Covins, G. Activity-Based Cost Management: Mak- ing It Work. Irwin Professional Publ., Burr Ridge, 111. (1996).

4. Brimson, J. A. Activity Accounting : An Activity-Based Costing Approach. John Wiley & Sons, New York (1991).

5. Horngren, C.T. & Foster, G. Cost Accounting: A Managerial Emphasis. Prentice -Hall, Englewood Cliffs, N.J. (7th ed., 1991).

6. Par£, T.P. A New Tool for Managing Cost. Fortune (June 13, 1993).

7. Drucker, P.F. Editorial. Wall Street Journal (Apr. 13, 1993).

About the authors: John L. Eggers is a senior cost analyst with Manage- ment Analysis Inc., 8150 Leesburg Pike, Suite 1100, Vienna, VA 22182. He has more than 20 years of line and staff experience in operation and logis- tic process improvement and since 1993 has specialized in activity-based cost-

ing and productivity studies with emphasis on public works organizations. Eggers holds a BS in chemistry from Davidson College, Davidson, N.C., an MS in organic chemistry from Clemson University, Clemson, S.C., and an MS in management information systems from George Washington University, Washington, D.C. Charles E. Bangert is a principal in Orr & Boss Inc., 13600 Otterson Ct ., Livonia, MI 48150.




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