Chapter 1

What is ABC?
ABC is an essential part of the functional process improvement and reengineering effort. It captures quantified cost and time data and translates this into decision information. ABC measures process and activity performance, determines the cost of business process outputs, and identifies opportunities to improve process efficiency and effectiveness. Qualitative evaluation and determination alone is totally inadequate as a single measure of improvement. Though quality might determine "better", it does not contribute to other meaningful decisions such as what is "cheaper" and "faster". It is the integration of these two dimensions that is the critical decision support element of the total process. ABC is the mechanism to integrate these two views.
ABC is a technique to quantitatively measure the cost and performance of activities, resources and cost objects, including when appropriate, overhead. ABC captures organizational costs for the factors of production and administrative expenses, and applies them to the defined activity structure. The application can be as rigorous as a definite mathematical distribution or as creative as a selective assignment using a surrogate indicator. Regardless of the method, ABC is a process of simplifying and clarifying decisions required by the process evaluators and senior management using activity costs rather than gross allocations.
What is the comparative advantage of ABC over traditional accounting methods?
ABC is a consistent, disciplined process that is necessary to the functional process improvement effort in both an analytical and evaluation role. It is also a process that requires professional judgement and creativity when applied to a transitional business process model. This creativity does not invalidate the basic integrity of the idea, but is rather a necessity to bridge the gap from the traditional accounting data to the new process methodology. This idea will become more evident when ABC is compared to the traditional methods of costing. Although ABC is still an evolving discipline, it offers great advantages over these more traditional methods. Although evolving, ABC is nevertheless applied with sound accounting principles to translate cost data and to provide a reliable information source upon which to base managerial decisions.
Most current established accounting systems normally capture and distribute resource costs by one of the following methods:

• Organizational element
• Budgetary account
• Traditional cost accounting with direct and indirect cost allocation

Each of these methodologies has advantages and disadvantages which have met the past needs of the organization. Yet, every one of them fails to meet the full requirement for management information that occurs as the result of a redesign of the organization or any part of the organization. ABC is a more representative distribution of resource use since the cost allocations are based on the direct cost drivers inherent in each of the work activities that make up the organizational structure. ABC applies resource use directly to the output products and services based on the actual work activities of the process that produces the output with limited arbitrary allocations of indirect or overhead costs.

Organization Element Accounting
The model at Figure 1 is a graphic representation of the most popular method for applying resource costs to an organization. The accounting system identifies each of the organizational elements of the traditional bureaucratic structure and applies the identifiable costs of that element accordingly. Though overhead costs are sometimes applied, it is more common to find that these costs are ignored at the unit level. The indirect costs are usually captured and paid in a central repository with no attempt to subdivide further. In many traditional organizations, the only costs that are identified to the organizational elements are the direct salary costs. This system was created to provide management with information on the costs of organizational elements, but was never intended to define the output costs either at the element or organizational level. Regardless of the approach taken within this methodology, this model is totally inadequate for making decisions on output variations. There is no application of costs to the ultimate output, activities or process flows of the organization.

Budgetary Accounting
The tracking of program costs by budgetary account is very similar to that of the organizational element (see Figure 2). Historically, DoD elements have been most concerned with ensuring that their total expenditures not exceed the allocated budgetary resources. Consequently, accounting systems became a safeguard mechanism to capture commitments, undelivered orders, and expenditures, normally divided by organizational element to enable tracking of budget execution. The major objective was to fully use the resources assigned rather than enhance productivity or to reduce expenses, because any attempt to conserve resources led to a reduction in the future budget resource level. Like organizational accounting systems, there was no attempt to cost output or in most cases to even define output.

Traditional Cost Accounting
There are organizations that perform tasks that are business-like or industrially-oriented which require a cost distribution to output. Revolving funds involved with industrial operations or depot operations must have full cost accounting systems to support the cost allocation and capturing process. Most of these organizations are customer reimbursed based on sales of their goods and services. Hence, true cost accounting operations were established to capture and distribute costs to the output goods or services. These cost accounting operations use the classic model of cost distribution which was designed around the major factors of production: direct labor, direct materials and overhead. Business and business-like structures have relied upon the historical model of cost accounting for over 100 years. This distribution is represented by the diagram at Figure 3.
With the recent advent of activity accounting, it has been discovered that the traditional cost accounting methodology can create a significant difference in output cost because of the manner in which overhead costs are allocated to output rather than traced to output. This difference in distribution can skew the ultimate price of the output and lead to poor management decisions. The following example will better illustrate how this difference can occur.

Comparative Costing Example: Production Site JKJ

Management has been concerned that the cost of Output B, which is above the average market price, makes it noncompetitive, and should be eliminated from the product line.
Managerial Analysis:
Output A is very competitive and is carrying the operation.
Output B is costing too much and should be eliminated from production.
Before the final decision is made, a request was made to provide more analysis using the new activity-based costing methodology as a comparison to the current traditional system. The following information was gathered:
Additional Information:
Direct Costs

Output A	$100 per unit
Output B	$ 10 per unit

Overhead costs:
Purchasing Department
Annual workload - 10,000 purchase orders
Annual cost - $10,000
Purchase orders required per unit of Output A - 30
Purchase orders required per unit of Output B - 5
Cost Distribution Table: Traditional Cost Accounting

Total Output /	Total Overhead	=	Amount per Unit of Output
1000 /	$10,000	=	$10

Activity-Based Accounting

Activity Cost /	Activity Workload	=	Amount per Unit of Activity
$10,000 /	10,000	=	$1

	Activity Units	Amount per Unit =	Total Output Cost per Unit of Output
Output A:	30*	$1 =	$30
Output B:	5*	$1 =	$ 5

Total Cost per Unit Output
Traditional Cost

	Direct Cost	+	Overhead	=	Total Cost
Output A	$100	+	$10	=	$100
Output B	$ 10	+	$10	=	$ 20

Activity-Based Cost

	Direct Cost	+	Overhead	=	Total Cost
Output A	$100	+	$30	=	$130
Output B	$ 10	+	$5	=	$ 15

When a comparison of the two sets of information was presented to management, it resulted in turmoil. The following activity-based analysis yielded results which were entirely different from that of their internal system.
Activity-Based Analysis: When costs are traced to the amount of the activity
actually used, rather than as a straight distribution based on output allocation, Output A is actually more expensive than originally thought and is not competitive in the market. Output B is competitive and should be retained.
Management became skeptical of both systems and complained about "voodoo" accounting practices. It was decided to ignore the new analysis and implement the decision to eliminate Output B.
Results of the Decision:
With Output B eliminated along with all associated costs, the output price for A immediately reverted to the remaining costs. Purchasing was unable to eliminate the costs as anticipated by management and the price for Output A rose to $130 per unit. This new price made Output A impossible to sell. The information below shows how the costs remaining after the elimination of Output B were allocated to the only remaining product.
Direct Material + Overhead = Total Cost / Production = Price
$20,000 + $6,000 = $26,000 / 200 = $130
Alternative Decision: If management has chosen to select their decision based on the new analysis that was available from the activity-based accounting review, then Output A would have been eliminated. Had this decision been made then the following results would have occurred:
Activity-Based review: If Output A had been eliminated and all associated cost had been eliminated, then the output price for B would have been:
Direct Material + Overhead = Total Cost / Production = Price
$8,000 + $4,000 = $12,000 / 800 = $ 15
The elimination of Output A had no effect on the organization since the remaining costs were those associated with Output B and Output B always was competitive within the market.
This simplified example demonstrates that the traditional method of applying overhead directly to the output can overstate or understate the true cost when a full internal review is done of how the costs are incurred. Even though the example was simplified for demonstration purposes, it nonetheless is an accurate representation of how the activity-based methodology more fairly distributes costs with fewer arbitrary distributions normally associated with traditional cost accounting procedures. Activity-based costing gives a more accurate picture of output costs by tracing overhead cost through the activities that are actually used to produce the output rather than straight allocation.
Figure 3 graphically represented the traditional cost allocation process and showed that the overhead was allocated directly to the output based on the amount or share of total output production rather than through the activity utilization. As was shown in the comparative example, this can overstate or understate the actual amounts of overhead that is actually used by each of the outputs. An analysis of the comparative differences between the current methods of accounting and that proposed as activity-based accounting indicates that the new applications are more representative and, therefore, more useful to the managerial decision-making process. Because of hidden, or less than apparent, internal process flow differences and actual resource uses, the traditional distribution does not align the amount of activity that is consumed individually by each output directly to the appropriate output. This difference between the traditional and activity cost accounting is graphically represented when the components of Figure 3 are compared in Figure 4 with a model that represents activity-based allocation of overhead costs.
What does ABC provide to the decision-maker?
The decision-maker is always faced with difficult choices and multiple alternatives. Though decisions can be made with feelings and intuition, this is not the predominant situation. ABC identifies and quantifies activity cost and performance data into a format which stratifies decision variables into a configuration which makes the decision clearer and easier to make. It will be more beneficial to see how this takes place and the benefits that can be obtained by following through an example.

Process Decision Example
Problem: Determine if a needed wall should be built with personal activity or by a contractor.
The decision-maker is concerned about quality, speed and costs (better, faster, and cheaper). The following flow chart (See Figure 5) represents the process required to construct the wall. (The process was simplified for this example.)
Decision Point-
The entire process has been laid out. It appears to be a very simple and straight-forward process. The decision-maker now has the opportunity to decide whether it is better, faster or cheaper to do the work or have a contractor do it. ----- At this point there does not seem to be enough information for faster or cheaper, though a decision might be made that it is better for someone else to do the work. Regardless, simply knowing the process is insufficient to identify how it might be done more efficiently. There is a definite need to gather more information on which to base a decision.
In Figure 6, the total amount of time for the decision-maker, Personal Time (PT), and the time for the contractor, Contractor Time (CT), are shown for each task.
Decision Point-
If a review is made of just the hours from the two basic courses of action, Contractor versus Personal Time, it shows that it is faster to let the Contractor do all the work. Even this additional data is not enough for the decision required. There is a need for more information.

The analysis requires some dollar information on how much the work is going to cost. (In this example, there is no need for costs on the materials, since the same amount will be needed no matter who does the work.) Below is more data on the costs per hour to perform the various categories of work.

Personal Time = $40 per hour
Design = $150 per hour
Hand Labor = $10 per hour
Concrete Work = $70 per hour

Now that all of the pertinent data has been collected for this decision, it is time to propose and evaluate courses of action.
When the cost per hour of labor is added to the number of hours, it shows that the faster course of action is not the cheapest. The cost effective course of action is to do all of the work personally but that alternative is not the faster nor is it the better if the quality of the work is taken into consideration.

This exercise is for demonstration purposes. It illustrates that the additional information has compounded the decision from the simple decision of "faster" or "cheaper" to one of "better." The ultimate decision will be probably some mixture of the two extremes into a blended action that minimizes cost and time while creating a better outcome, a better decision than that first proposed. This additional alternative is only possible because of the quantified data which is created from the analysis of cost and activity information. The additional activity-based data improves the process and enhances the quality of the final decision.
What Can ABC Do?
ABC provides analysis information for consideration and evaluation of the processes of the organization activity model. It is specifically intended to further the accomplishment of the objectives of the DoD functional process improvement which are to:

• reconfigure the current organization into an activity structure
• select an "as-is" process flow for review and improvement
• make radical changes to develop a "to-be" process flow for dramatic improvements in performance

Activity

• Total Cost of Activity The total amount of direct and overhead charges associated with or allocated to a single activity
• Cost Driver A measurable factor that represents the amount of performance and creates or affects the costs within a single defined activity, i.e. the number of iterations, amount of effort, etc.
• Elapsed Time The total amount of time, to include the amount of time delay created while awaiting processing, consumed to complete the activity or an iteration of the cost driver.
• Cycle Time The amount of time to complete one cycle or iteration of the cost driver without including delay or wait times.

Process

• Total Cost of the Process The total cost of all the activities in a process determined by the amount of the cost driver for each activity in relation to the output of the process
• Cost of a Single Iteration The total cost of a single incident or cost driver allocation for each of the activities in a process flow which may be equal to the total cost when a single iteration occurs at each activity in the flow.

Output

• The Cost of the Output The total cost of the activity model allocated by the applied activity drivers to the output of the activity model.

Identification of Change Opportunities

• Significant Cost Consumption Activities identified which have an evidently larger consumption of inputs and mechanisms or the value of the output is less than the value of the inputs.
• Significant Time Use Activities identified which have evidently larger time periods or use of time or large non-value delay periods.

Evaluation of Change Alternatives

• Cost Comparison Analysis of the allocated costs from the activity model to two or more alternative process methods.
• Time Comparison Analysis of the total time or cycle times of two or more alternative process methods.

How is ABC done?

ABC has a very definite procedural flow, a set of steps that define the performance process. An activity structure of this process is as shown in Figure 8.

Though the process is relatively well-defined as a process flow, each of the activity steps has more than one set of application criteria and individual options. The process has a disciplined approach which is applied as rigorously as the situation allows, but still has flexibility for a certain amount of creativity in the final use and evaluation. The discussion of these steps, the procedures and definitions, is the subject of the remaining chapters of this handbook. It is therefore sufficient at this point to say that the ABC methodology will follow this process flow through each step.