Activity-based costing — beware the pitfalls

Judging by the number of customer enquiries about it, we appear to be in the middle of another wave of enthusiasm for activity-based costing (ABC). In theory, ABC is a powerful analytical tool for helping businesses understand exactly what makes them tick. But is the insight delivered worth the extra cost of implementation? Although our software will always support ABC as long as there are customers for it, I’m not convinced that the cost/benefit analysis shows the same results for all.

If ABC is done properly, it helps organisations identify which of their products, clients and activities are most (and least) profitable, and which costs are unnecessary. Resources can then be allocated more efficiently to boost profitable activities and eliminate unprofitable ones.

This is a great idea, much like: “Let’s have a baby!” is a great idea for many couples. But while there are undeniable rewards, they are not always easy to measure; and in both cases it’s a high-maintenance investment that can take a long time to deliver returns.

The first step in implementing ABC is to identify the activities of the business, which can cost six months of expensive consultancy time all on its own. You have to take your business apart to analyse exactly how it works. Then you have to make decisions about how to allocate the costs of activities to different products, services or customers.

For example, let’s say your marketing department takes a stand at a trade show. Apart from the salaries of the people involved in planning and staffing the stand, there will be invoices for the rental of space, for constructing the stand, for printing brochures or making promotional videos, and so on. How do you allocate these costs to products, services or customers? It’s not going to be easy, and at some point someone is probably going to have to make an arbitrary decision or estimate.

The same problem occurs all the way along the line. How do you allocate the costs negotiating with suppliers? Updating databases? Training? One of the key dangers in this process is that you end up with incredibly complex systems and processes, which are expensive to administer and create yet another potential source of bottlenecks and errors.

Then there’s the sticky problem of how to sustain ABC once it’s been implemented. There’s no point at all in budgeting by activity if you don’t also keep accounts by activity: budget spend must be correlated with actual spend or the whole exercise is pointless.

But that is much easier said than done. It means every single invoice has to be allocated to an activity, and frequently to more than one activity – in which case someone has to make a decision about what proportions of the cost are allocated to each activity.

There’s also the hard fact that reality will always undermine your assumptions. Just when you’ve got a clear set of rules and definitions down, something will happen in the world that invalidates them. Then the system will throw up all sorts of exceptions and you’ll have to spend more time explaining them.

The bottom line is: If you implement activity-based costing, will it save you as much as you’re spending? For some organisations it’s been an undoubted success; but just as with babies, it might not be for everyone.