I came across the term “Activity Based Costing” (ABC) when I was doing my MBA. It is a technique to understand how each activity in an organisation costs. For example, if a Pizza costs $5, we should be able to estimate that making the pizza costs $2 and delivering costs $3. Simple!
We had to do a presentation on ABC in front of the class. At that time, I found some limitations of the technique. ABC proposed that we do a staff survey to get the percentage split of the activities. For example, we go to the Pizza shop and ask the employees “Dude, how much percentage of effort you spent in creating the pizza and delivering it”. Of course, in a larger organisation this data will be gathered by conducting a customer survey.
Well, do you see the problem now? If we have to do ABC every few years imagine the effort involved in adminstrating a survey. Imagine the response from employees, “oh, no! One more survey!”.
Today morning I was brushing my concepts on ABC. Guess what! What I thought were the limitations were acknowledged by the originator, Professor Kaplan and he has proposed a solution too. (see the reference section for the full article)
To illustrate Time Driven ABC, let us employ 3 cooks and 1 delivery person in our Pizza business. (by the way, have you seen the chefs throw the dough up in the air which returns in a perfect circular shape! Amazing! ) .
Let us assume the Pizza business costs $6000/month to make Pizza. The 3 cooks spend 5 hours each day. (100 hours a month * 3 cooks). Similary the delivery person may spend 4 hours a day and it costs the business $2400 to maintain the vehicle and pay the wages. The delivery person spend 80 hours a month.
The first step in Time Driven ABC is to determine the “unit cost” of each activities.
unit activity cost = total resource cost allocated to the activity/ time spent on the activity.
Pizza making unit cost = $6000/(300 hours) = $20/hour
Pizza delivery unit cost = $2400/ 80 = $30/hour
The next step is to estimate the unit time of activities. We will ask the employees to estimate the time it takes to prepare the Pizza and delivery. They may say it takes 30 minutes to prepare a Pizza and 1 hour to deliver it. Please note that this information is more accurate than estimating the percentage split. Kaplan also suggests direct observation of activities can be employed to improve the accuracy.
Unit time for Pizza making = 0.5 hour (30 minutes)
Unit time for delivery = 1 hour
Then we get the volume data – how many Pizzas were delivered and h0w many trips have been made. Assume the business delivered 400 pizzas and made 50 delivery runs.
cost of activity = Unit cost * Unit time * volume
cost of pizza making = 20 * 0.5 * 400 = $4000
cost of pizza delivery = 30 * 1* 50 = $1500
Actual cost to business is $6500
Please note the actual cost $6500 is less than the total resource cost of $8400. The difference is coming because of the resource utilisation. A resource (people or machine) can not be utilised 100%.
TD-ABC as independent verification of Continual Improvement initiatives:
Both business and quality practitioners find it difficutl the quantify the benefits of various improvement initiatives, Lean, Six Sigma, ITIL, CMMI, ISO etc etc. Unfortunately the continual improvement professional do not articulate the benefits in financial terms. Even if they articulate, no body trusts the figures. So we need an independent verification. Why cannot we use the elegant TD-ABC?
Let us assume we apply Lean techniques in our Pizza business. By moving the dough kneeding place closer to the oven, let us say we save 5 minutes.
Unit cost of pizza making is (25/60) = 0.42 hour
Cost of Pizza making is 20 * .42 * 400 = $3360
Cost saving due to Lean initiative = $4000 – $3360 = $640
Great ! Now the business will know how much their CI program has saved the bottom line! They can use that savings to replace the spanish black olives with kalamatta olives!
Time-Driven Activity Based Costing, Robert S Kaplan and Steven R Anderson, online reference http://hbswk.hbs.edu/item/5436.html, viewed 11 Feb 2011