Activity-Based Management (#267)
/In this podcast episode, we discuss the activity-based management (ABM) concept. Key points made are noted below.
Overview of Activity-Based Management
ABM is all about using activity-based costing information to improve the operations of a business, usually through an ongoing process of fine-tuning existing processes. I talked about activity-based costing in the preceding episode.
So, how does ABM work? It can be rolled out in several ways. One of the better ways is to get rid of non-value-added activities. Examples of non-value-added activities are product rework, paperwork approvals, material movements, batch setups, and inventory counts. They don’t do anything to enhance value. There are a lot of these activities in the typical business, and paying attention to them can really reduce expenditures.
Time Reduction with ABM
For example, an insurer might want to cut down on the amount of time required to process an insurance claim. So, it commissions an activity-based costing study that identifies every activity associated with the claims processing staff, calculates the cost of each activity, and how heavily those activities are used. Now that the ABC information is available, ABM is used to create some results. You could examine the list of activities to see if any are unrelated to the basic task of processing a claim. Whenever there is one, such as moving paperwork to another person for more processing, that’s non-value-added move time and queue time, and it should be eliminated, or at least reduced. By doing so, the claims processing staff will have more time available to work on claims, which increases the capacity of the business while at the same time reducing the costs associated with those non-value-added activities.
As another example, an ABC analysis finds that the production staff is spending a total of $10,000 worth of time filling out timesheets. Management decides that the resulting information is pretty useless, and so changes over to a simple in-and-out timekeeping system that uses bar coded employee badges. The time saved increases the effective capacity of the production staff.
Cost Reduction with ABM
Another possible use is just general cost reduction. An ABC analysis might discover that a lot of the activities in the production area are associated with the rework of returned goods. The company has some very sophisticated products with lots of features, and customers tend to break them. So, an ABM analysis concludes that the company can eliminate most of the rework activities just be creating simpler products that don’t have so many complicated features.
Another possibility is that it costs a lot of money to fill each individual customer order. The activity cost is just really high. When this is the case, a logical outcome is to encourage customers to place a smaller number of larger orders, rather than a lot of small orders, maybe by rewarding them with volume purchase discounts.
As another example, an ABM analysis finds that the order entry department is expensive; it uses a lot of resources. If so, a possible option is to set up an online order placement system, so that customers can enter their own orders directly into the company’s production planning system. A small discount might be offered to anyone who uses the new system. The outcome is reduced order entry expenditures.
Or, let’s look at ABM from the perspective of the sales department. An analysis finds that its very expensive to have the sales staff visit customers in person. So, change the type of sales calls made to customers to a lower-cost form, such as switching from an in-person meeting to a phone call. A variation is to increase the interval between sales calls, or to mix in-person contacts with phone calls.
Let’s try another one. An ABM analysis finds all kinds of costs associated with expediting orders through the production process, since it lays waste to the orderly flow of work. Since the analysis comes up with an actual cost associated with expediting, management now knows how big a fee to impose whenever anyone wants to expedite another order through the company.
Profit Enhancement with ABM
ABM is really useful when a company is producing a mix of really complicated and quite simple products, because there’s a good chance that too many costs are being allocated to the simple products and too few to the complicated ones. This means that the profits associated with the simple products are probably being reported lower than they should be, with the reverse being the case for the complex products. By using ABM to figure out which products are actually consuming activities, you can either stop producing some of the more complicated products, or at least raise their prices.
It might also be possible to encourage customers to shift their purchases from lower-profit to higher-products, perhaps with coupon offers or some adjustments to prices.
Customer Service Improvements with ABM
Another way to use ABM is to focus on customer service. This usually means compressing the time required to complete a customer order. So, the emphasis is on analyzing every activity involved with taking a customer order, scheduling production, ordering materials, storing completed goods, and shipping them out. By focusing on eliminating or streamlining every activity in this process, customers can receive deliveries much sooner than had previously been the case. So the emphasis here is not on cost reduction, but rather on time reduction.
Summary of ABM Benefits
In short, this analysis can pick up enormous savings. Even when you think a process is pretty efficient, there’s a good chance that an ABM analysis can strip out another 20% of the cost. This analysis can generate some major results throughout the organization – in accounting, production, sales, product development – everywhere. Some organizations use this one tool as the basis for most of their cost reduction activities.
Problems with ABM Analysis
While ABM might sound like the perfect tool for increasing profits, it can cause an expectation that costs will be reduced when that’s not actually what happens. The trouble is that overhead costs are usually incurred as step costs, so that it takes a large activity reduction to yield any actual cost reduction – though when it occurs, the cost reduction comes in a big lump.
For example, management might figure out that it can reduce the number of phone calls being handled by the customer service department, maybe by eliminating some issues with its products. And by doing so, it manages to actually reduce the number of incoming phone calls by 2%. The problem is that there’s no way to eliminate a customer service staff position unless the number of income phone calls can be reduced by 3%. In the meantime, there aren’t any savings. The activity volume has dropped, but not by enough to trigger a staffing reduction. So unless there’s a way to reduce phone calls even more, the company won’t save any money. This can happen a lot with ABM projects, so be aware of the volume of activity reductions needed to trigger an actual cost reduction. Otherwise, there’ll be lots of disappointment.