Time-Driven Activity-Based Costing

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Time-Driven Activity Based-CostingActivity-based costing was introduced in the mid-1980s through several HarvardBusiness School cases and articles. 1 While the settings of these cases differed, they allhad one characteristic in common. The resource expenses assigned to an activity weredetermined through interviews, time logs, and direct observation of the amount orpercentage of time people spent on various activities. For example, the costs ofwarehousing goods would be driven to activities − such as Receiving, Inspection, Putaway,Picking, Packing, and Shipping − based on estimates by warehouse personnel ofthe percentage of their time they spent on each of the activities. The project team thencalculated activity cost driver rates, used to assign activity costs to individual products orcustomers, by dividing these activity costs by the outputs of each activity − such asnumber of receipts, number of inspections, number of items picked, and number ofshipments.This procedure for estimating an ABC model, while feasible for initial pilotstudies, has proved difficult and costly to extend to company-wide applications. Also,even after the initial model has been built, updating the model requires essentially reestimatingthrough a new round of interviews and surveys to reflect changes in acompany’s operations. Consequently, ABC models are often not maintained and theircost estimates soon become obsolete. In this paper, we review the problems associatedwith traditional estimation of ABC models. We describe a new approach that is bothsimpler − for estimating and maintaining an ABC model − and also more accurate. Thenew, time-driven approach allows for more heterogeneity in activities, orders, andcustomer behavior without placing burdensome demands for calculating activity, productand customer costs.Estimating a Basic ABC ModelThe standard procedure for estimating a simple ABC model starts with identifyinga collection of resources that perform a variety of activities. For example, consider acustomer service department that performs three activities:• handle customer orders• process customer complaints• perform customer credit checks.Assume that the cost of supplying resources – personnel, supervision, informationtechnology, telecommunications, and occupancy − to perform these activities is $560,000per quarter. In building an ABC model for the customer service department, the systemdesigner asks employees to estimate the percentage of their time spent (or that theyexpect to spend) on the three principal activities they perform. Suppose they estimate2
these percentages as 70%, 10% and 20%, respectively. The ABC system designer alsolearns that the actual (or estimated) quantities of work for the quarter in these threeactivities are:• 9,800 customer orders• 280 customer complaints• 500 credit checksThe system assigns the $560,000 resource cost to activities, based on the timepercentage, and calculates activity cost driver rates as shown below:Activity Cost Activity CostActivity % Assigned Cost Driver Quantity Driver RateHandle orders 70% $392,000 9,800 $ 40/orderProcess complaints 10% 56,000 280 $200/complaintCheck credit 20% 112,000 500 $224/credit checkTotal 100% $ 560,000The project team then uses the calculated activity cost driver rates to assign theexpenses of the three activities to individual customers based on the number of ordershandled, complaints processed, and credit checks performed for each customer.This approach works well in the limited setting in which it was initially applied,typically a single department, plant or location. Also, many of the initial studies wereone-time events that provided a useful snapshot of the plant’s current economics, such asto identify high cost, inefficient processes and the unprofitable products and customers.Even today, the revelation of high cost processes, products and customers stimulatesnear-term actions (activity-based management) that can lead to near-term and oftendramatic profit improvements.Problems with Estimating and Maintaining ABC ModelsSeveral problems, however, arise when companies attempt to scale up thisseemingly straightforward approach to enterprise-wide models, and to maintain themodel so that it reflects changes in activities, processes, products, and customers. First,the process to interview and survey employees to get their time allocations to multipleactivities is time consuming and costly. Consider the experience of a money centerbank’s brokerage operation. Its traditional ABC model required 70,000 employees atmore than 100 facilities to submit monthly surveys of their time. The company had toprovide 14 full-time people just to manage the ABC data collection, processing andreporting. A $20 billion distributor required several months and about a dozen employeesto update its internal ABC model. The high time and cost to estimate an ABC model andto maintain it – through re-interviews and re-surveys − has been a major barrier towidespread ABC adoption. And, because of the high cost of continually updating theABC model, many ABC systems are updated only infrequently, leading to out-of-dateactivity cost driver rates, and inaccurate estimates of process, product, and customercosts.3
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