Activity Based Management (ABM)

Activity Based Management (ABM)

 

  • ·       Activity based costing (ABC) is a method of assigning indirect costs to products or services based on the activities they require.  Activity based management (ABM) encompasses all of the actions that managers take to improve operations or reduce costs based on the ABC data.  To reap the benefits of ABC, managers must use it to manage the underlying activities and identify areas that would benefit form process improvements

 

The first step in any improvement program is to target areas that need improvement.  Managers should start by asking the following questions:

 

  • o      What activities are performed? – This question focuses managers’ attention on activities as the driver of cost within the organization.  Managers who want to manage costs must manage the underlying activities.  Reducing the number of activities required to perform a task can improve profit by either reducing costs (e.g., reduced workforce) or allowing more work to be performed for the same cost (e.g., increased capacity).
  • o      How much does it cost to perform each activity? – This question focuses managers’ attention on those activities that have the most potential for improvement.  The activity rates identified by the ABC system provide insight into how much it costs to perform key activities.  Managers can compare their activity rate with other firms in the industry (benchmarking) and provide managers with incentives to improve operations.  Alternatively, managers might decide to outsource some activities to an outside firm that do the task more cost effectively.
  • o      Does the activity add value to the customer? –  This question relates to one of the most important steps in ABM, which is the identification and elimination of nonvalue-added activities. A non value activity is one that, if eliminated, would not reduce the value of the product or service to the customer.  To the extent possible, managers should eliminate any non-value adding activities.  As part of ABM, managers should attempt to streamline these activities to be performed as cost effectively as possible.  Managers can also rethink the pricing of a product or service and can eliminate a product or service which is not profitable.

 

  • §       Life Cycle Cost Management – This is a part of ABM where managers need to set their cost reduction goals across all stages of the product life cycle (introduction, growth, maturity, and decline).  Even if a product is unprofitable in the early stages of its life cycle, it may make up for it in its latter stages.  Costs tend to be higher in the early stages of the product life cycle, while most of the revenues are earned in the growth and maturity stages.

 

  • §       Total Quality Management – One has to question if quality inspections are a value added activity or a non-value added activity.  In managing quality costs, managers must balance four types of quality costs:

 

  • ·       Prevention Costs – incurred to prevent quality problems from occurring in the first place.
  • ·       Appraisal (inspection) Costs – incurred to identify defective products before they get to the customer.
  • ·       Internal Failure Costs – defects which are caught before the product is shipped to the customer.
  • ·       External Failure Costs – occur when a defective product makes its way into the customers’ hands.

 

In ABM, quality processes should prevent problem for the most part.  Managers must balance this cost of quality with the cost of the product.

 

  • §       Target Costing – The basic idea behind target costing is to determine what the target cost should be to meet the market price and still provide a profit for the company shareholders..  Target costing requires managers to think about costs upfront so that they can design and manufacture products at a cost that will satisfy both customers and shareholders.

 

The goal of target costing is to determine the target cost of a product before manufacturing ever starts, and target costing should reflect all of the costs that will be incurred across the entire value chain.  The value chain is the linked set of activities required to design, develop, produce, market, deliver, and provide service after the sale.  Under target costing, products should not be manufactured unless the estimated cost is less than the target cost.

 

ABM plays a key role in target costing by helping managers find ways to achieve the target cost while still providing the value and features consumers are willing to pay for.  The key is to eliminate activities which do not add value to consumers.  Manufacturers (and service providers) can reduce cost while improving quality and value is by streamlining operations and reducing unnecessary inventory.

 

  • §       Just In Time (JIT) – Under a JIT system, a firm purchases materials and manufactures products based on customer demand.  JIT is a demand-pull system in which materials and products are pulled through the manufacturing system based on customer demand.  In a traditional manufacturing setting, precuts are pushed through the system and many times creates excess inventory because of a mismatch of production and customer demand.

 

Most managers realize that inventory adds many more problems than it solves including inventory carrying costs and quality problems.  To successfully implement a JIT strategy, a company must rethink almost everything it does.  JIT requires an extreme commitment to quality and very strong relationships with suppliers and customers.  Although few firms have realized the full potential of JIT, most companies that implement it experience a substantial decrease in ordering and warehousing costs as well as many benefits related to quality and flexibility.

 

  • o      Summary of ABC and ABM – To gain the true benefits of ABC/ABM, managers must move from simply measuring costs to finding ways to manage costs or reduce costs.  Although ABC/ABM has many potential benefits,  it must be weighed against the costs of obtaining more accurate information.