Activity based costing: Information without action is vanity

Nobody likes to pay for something they don’t understand. Consider the dreaded ‘admin fee’ on an invoice; the lack of transparency sets the blood boiling and stirs a sense of unfairness embedded deep in our psyche.

Whilst not as personally discomfiting, the same dynamic applies within organisations. Front-office departments have long found the lack of transparency and control over management and back-office overhead charges hugely frustrating. Of course, with these charges typically accounting for around 40% of an organisation’s cost base, frustration should be expected – imagine an admin fee of that magnitude!

In response, Finance functions in many organisations have implemented activity based costing (‘ABC’) style approaches to charge back-office costs to front-office divisions. At a minimum, these methodologies typically show front office consumers the ‘services’ being performed by the back office, the total cost of each, and how the respective front office division’s share of the charge for each service was calculated.

Unfortunately for many, simply implementing these methodologies represents the end of the journey, but transparency is just the first step; information without action is useless.

The real goal of ABC approaches should not be solely to provide better information, but to utilise it to improve the cost and quality of service. However, given the complexity of implementing these methodologies, and a tendency for discussions to focus on relative shares of the cost pie rather than trying to reduce its overall size, these underlying objectives of ABC implementations can often fall by the wayside.

To me, this represents a huge, missed opportunity, and so to set expectations for those embarking on an ABC journey – or to give heart to those in the middle of it! –  in my experience these are the three stages you need to go through before you can realise the full value of activity based costing.

Stage 1: Educate

First, Finance departments need to educate their consumers in the chosen methodology (‘what’) and its value (‘why’).

Moving to a new allocation methodology always creates ‘winners’ (those receiving less cost than before) and ‘losers’ (those receiving more cost than before) and its almost inevitable that those being charged more will resist at first. To minimise disruption, it’s critical to walk the front office through the methodology (‘what’), explain how the charges have been calculated and give them the opportunity to ask questions. This not only builds empathy and trust, it can often uncover methodological improvements that can be made for future periods.

However just as important to emphasise is the ‘why’. It needs to be clear to the front office the opportunities that this new level of transparency presents. By promoting a better understanding of what services are being performed, by whom, and what drives the cost, there’s a real opportunity to use that information to decrease total costs, or provide improved services, for the benefit of the whole organisation.

Stage 2: Collaborate

Once the ‘what’ and the ‘why’ are understood, focus needs to turn to using the data to create shared hypotheses for improvement.

For example, are their non-mandatory services being provided for which the front office receives no tangible benefit? Is there a high volume of simple or low value services being provided from a high-cost location? Are there multiple functions or locations performing the same service or activity that could be consolidated?

Whilst the ABC outputs may not have all the detail required to substantiate a definitive cost save, as a minimum they’re likely to highlight opportunities for further investigation, and sufficient time needs to be made for interrogating and analysing the data to test such questions.

Finance also need to establish regular checkpoints with senior front-office personnel with the sole aim of reviewing the data and agreeing clear sets of hypotheses to be investigated, or even better – integrate this into existing cost governance meetings. Finance must come to these sessions prepared with their own ideas to show willing and initiative, with a secondary, softer aim being to build a collaborative working relationship with their front-office counterparts.

Stage 3: Execute

It may sound obvious but identifying and documenting cost save opportunities is not enough; the hypotheses need to be tested and, if found to be viable, implemented.

The hypotheses formed in stage 2 should be recorded and prioritised, and implementation progress should be monitored and reviewed at the collaboration meetings mentioned in stage 2. Ideally, each initiative should be tagged to one accountable individual from the front-office and the back-office, and they should be held responsible for pushing the opportunities through and ensuring the size of the improvement made is quantified for the purpose of benefits tracking. These objectives can also be embedded into balanced scorecards and tied to variable compensation if necessary.

This structured governance, measurement and incentivisation provides the discipline necessary to ensure that promising ideas become reality.

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By taking these steps, Finance functions can afford their front-office consumers a luxury typical consumers never have: they can not only understand the detail of the charge, they can collaborate with the service provider to reduce it.

This is the real – and too often forgotten – value in ABC. After all, information without action is vanity.

For more information on how BCS can support you on our ABC journey, or our range of Finance consulting services, please reach out to james.smith@bcsconsulting.com