Time-Driven ABC
Companies have shied away from activity based costing, because it was not an accurate assessment of operations, time consuming and too expensive to build and maintain. As a result managers have veered away from using traditional ABC in their organizations, and needed to find a solution to the problem. The new approach relies on informed managerial estimates rather than on employee surveys. It also provides managers with a far more flexible cost model to capture all the complex details of their operations. The way people traditionally constructed the ABC model was the root of the problem with it.
To build a traditional ABC model a department would survey employees to estimate the percentage of time they spend on activities and then assign the department's resource expenses according to the average percentages you get from the survey. Armed with figures, known as the cost-driver rates, managers could assign the costs of the department's resources to the customers and products that use its services. This worked well in the limited setting in which it was initially applied, typically a single department, plant, or location. The problem arises when you try to roll out this approach on a large scale for use on a continuous basis. The systems that are put in place are updated infrequently; the model's estimates of process, product, and customer costs soon become inaccurate. What's more, people waste their time arguing about the accuracy of cost-driver rates that are derived from individuals' subjective beliefs rather than addressing the deficiencies the model reveals: inefficient processes, unprofitable products and customers, and excess capacity. Traditional ABC models also often fail to capture the many details of actual operations. As the activity dictionary expands, the demands on the computer programs used to store and process the data escalate. This expansion has caused ABC systems to exceed the capacity of generic spreadsheet tools, such as Microsoft Excel, and even many ABC software packages. When people estimate how much time they spend on a list of activities handed to them in an interview or survey, they invariably report percentages that add up to 100, and did not account for time that was idle or unused. This contributed to inaccurate cost driver rates, causing it to reflect much higher costs.
However, the ABC concept cannot be abandoned, because of it still had advantages, and helped some companies identify cost and profit opportunities. A simplification of traditional ABC is now possible through an approach that we call time-driven ABC. In the revised approach, managers directly estimate the resource demands imposed by each transaction, product, or customer rather than assign resource costs first to activities and then to products or customers. For each group of resources, estimates of only two parameters are required: the cost per time unit of supplying resource capacity and the unit times of consumption of resource capacity by products, services, and customers. At the same time, the new approach provides more accurate cost-driver rates by allowing unit times to be estimated even for complex, specialized transactions. The capacity of most resources is measured in terms of time availability, but the new ABC approach can also recognize resources whose capacity is measured in other units. Having calculated the cost per time unit of supplying resources to the business's activities, managers next determine the time it takes to carry out one unit of each kind of activity. These numbers can be obtained through interviews with employees or by direct observation. The surveying of employees is no longer needed. Precision is not critical, because rough accuracy is sufficient. Deriving cost-driver rates is also important. Once you have calculated these standard rates, you can apply them in real time to assign costs to individual customers as transactions occur. These rates are lower than those estimated using traditional ABC methods. This alleviates the technical drawback of traditional ABC systems. Analyzing and reporting costs with time-driven ABC, enables managers to report their costs on an ongoing basis in a way that reveals both the costs of a business's activities as well as the time spent on them. By updating the model, managers can easily update their time-driven ABC models to reflect changes in operating conditions. To add more activities for a department, they don't have to re-interview personnel. They can simply estimate the unit time required for each new activity. Managers can also easily update the cost-driver rates. Two factors can cause these rates to change. First, changes in the prices of resources supplied affect the cost per time unit of supplying capacity. When permanent, sustainable improvements in a process have been made, the ABC analyst recalculates the unit time estimates to reflect the process improvements. By updating the ABC model on the basis of events rather than on the calendar, you get a more accurate reflection of current conditions. Traditional ABC relied on an important simplifying assumption that all orders or transactions of a particular type are the same and require the same amount of time to process. However, time-driven ABC does not demand this simplification. It can accommodate the complex details of real-world operations by incorporating time equations. This is a new feature that enables the model to reflect how order and activity characteristics cause processing times to vary. They greatly simplify the estimating process and produce a far more accurate cost model than would be possible using traditional ABC techniques. The ability of time-driven ABC to identify and report complex processes also provides a powerful negotiation tool when it comes to dealing with customers.
As a result in the past, activity-based costing has enabled managers to see that not all revenue is good revenue and not all customers are profitable customers. Difficulties of implementing and maintaining traditional ABC systems have prevented them from being adopted by companies, but time-driven ABC has overcome these difficulties, offering a transparent, scalable methodology that is easy to implement and update.