Activity-Based Costing: The Missing Ingredient

Article excerpt

Activity-based costing: Is it as informative and as powerful as so many articles suggest? Are the benefits of activity-based costing and activitybased management really obtainable? The answer to both of these questions is a resounding yes. Activity-based costing is a real phenomenon, and it can be a powerful management tool if the development of the activity-based costs (ABCs) is done correctly.

THE POWER OF ACTIVITY-BASED COSTING

Activity-based costing has been heavily promoted as a new and powerful management tool; however, many initial attempts at activity-based costing have only resulted in activity-based allocations of expense. As a result, management continues to be frustrated with the results. But when the fundamental principles of activity-based costing are maintained, it can be everything it is touted to be. When properly developed, activity-based costing can provide bank managers information, such as the profitability of customer relationships, local markets, products, and delivery channels; the ability to measure and manage available but unused capacity; and the capability to equitably reward department managers for the work their departments perform for others (such as branch work performed on behalf of corporate division customers). Who in today's banking environment would not want to know the answers to these questions? Obviously we all would, and activity-based costing can provide those answers.

But all too often, banks fail to analytically determine how long it takes to perform an activity, which leads to a lack of credibility and accuracy. When this is the case, it will not matter how costs are allocated or aligned with products, activities, cost drivers, or any other cost object -- doubts as to the credibility and usability of the profitability information will be commonplace. In summary, credibility is key, and credibility will be lacking if the methods used to develop cost drivers are not supported by analytically derived activity unit times.

THE MISSING INGREDIENT: ANALYTICALLY DERIVED UNIT TIMES

Everyone recognizes the benefits of activity-based costing, yet many of the banks that try to develop ABCs do not achieve the true potential of activity-based costing. These banks frequently encounter the same old problems in developing meaningful cost information -- questions and doubts regarding the accuracy of the allocated expenses and the methods used to develop the allocations.

Numerous articles have been published that, in many respects, do a decent job of explaining activity-based costing: they may include definitions of activity-based costing terms such as activities, cost drivers, and objects; discussions on the uses of ABCs and why activity-based costing is better than traditional cost accounting methods; and so forth. All of these are informative, yet rarely do any of the articles discuss the most critical element of activity-based costing - the credibility of the methods used to develop the cost information that, in tum, supports the reported results.

Typically there are two missing ingredients in banks' efforts to develop accurate and reliable activity-based costing information:

First, many banks try to assign or allocate expenses to cost drivers rather than measure the amount of resources consumed by customers in transacting business with the bank Allocating expenses to products, profit centers, or customers has several distinct disadvantages. First, the use of allocations precludes the ability to identify how much of the bank's resources were used and, equally important, how much resource is unused and available. Second and more important, since most expense allocations are based on questionable "guessti mates," the use of expense allocations undermines the ability to obtain accurate and meaningful measures of profitability by customers, local markets, products, and delivery channels, to measure managerial performance, and to have accurate cost driver unit costs available for supporting pricing studies. …