Profit-Margin Math: Leveraging ABM Data for Exceptional BPM Results
Do you know what we think of our cost accounting system? It is a bunch of fictitious lies -- but we all agree to it."
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That's a complaint an operations manager of a Fortune 500 company made to me recently. Unfortunately, his tale of woe -- that his company uses flawed and misleading cost data for price quoting, profitability analysis, and justifying improvement projects -- is more the rule than the exception. And using faulty data diminishes the value of the business performance management (BPM) systems and processes many companies are considering, and implementing, today.
Misleading managerial accounting data and management's lack of deep visibility into what causes costs -- that is, their drivers -- prevent an organization from achieving a full vision of its integrated BPM system. An increasingly accepted solution to this problem is activity-based costing (ABC), which computes the cost data, combined with activity-based management (ABM), which applies the ABC information for better decision-making.
All ABM activities are supported by ABC calculations that provide visibility into the work activities that belong to business processes, particularly those indirect expenses (commonly referred to as "overhead") that are hidden in traditional cost reporting. ABC also provides substantially improved accuracy by tracing and assigning expenses to the calculated costs of outputs, products, service lines, channels, and customers rather than applying arbitrary allocations that use broad-brush averages such as sales dollars or number of labor hours.
ABM is an integral component of an effective performance measurement and management system. ABM information assists managers strategically by informing them (with much greater accuracy than traditional accounting) about which products and customers are profitable. ABM also explains what drives operational costs and how to improve them. Organizations with ABM systems, for example, are discovering that the output of their ABM systems provides excellent, highly accurate key performance indicators (KPIs) for their Balanced Scorecard systems.
ABM Changes Decision-Making Processes
When managers combine ABM with other components of BPM, such as strategy maps and scorecards, employees better understand what their organization's priorities should be and can change their behavior to focus their work efforts on strategic and operational issues. BPM becomes more powerful when managers and employee teams have access and visibility to fact-based intelligence. The fact-based intelligence provided by ABC data increases the likelihood that correct strategies will be formulated and enables employee teams to analyze what is happening and what might happen through what-if scenarios.
In addition to improving corporate decision-making, an ABM system accelerates profit and productivity improvement. Managers can use its repeatable and reliable information to both assess past progress against plans and support future decisions. Exhibit 1 illustrates a generic ABM cost-assignment system. This diagram is not as complex as it initially looks; it is a logical representation of how costs flow from resources. Note how the demands on work move from bottom to top, with the costs reflecting back, measuring the effect. ABM is a consumption model and not a flowchart, although the activity costs do belong to processes, which is an alternative view for displaying ABM cost information.
Executives are trained to focus on financial accounting data, such as period-end reported sales, balance sheet ratios, profits, and spending. But BPM encourages managers to broaden their focus to include profit margin and computed cost data from ABM that can be useful as KPIs found in most scorecards. Regulatory compliance dictates financial accounting, but the issue here is managerial accounting for internal purposes.
The belief that organizations can set up only a single enterprisewide ABM system is a common misconception. In fact, companies can construct multiple ABM systems to suit the needs of their enterprise. In practice, two broad types of users and decision-makers view ABM data: strategic and operational users. A different type of ABM model design serves each type of user, but both types of ABM systems follow the same cost-assignment principles. The difference between them is the scope of organizational expenses included plus the inclusion or exclusion of pricing or revenue data for calculating profit margins.
