Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Many companies have experienced problems with traditional activity-based costing that have prevented ABC systems from being adopted on a significant scale. The purpose of this paper is to describe a new time-based system where managers directly estimate the resource demands related to each transaction, product, or customer rather than assigning resource cost to activities and then to products and customers.
The Traditional ABC Approach
An example of a customer service department is used to illustrate the difference between the two approaches to ABC. The department performs three activities: processing orders, handling inquiries, and performing credit checks. Estimates for the activities are: 49,000 orders, 1,400 inquiries, and 2,500 credit checks. Total cost for the department is $560,000. Employee surveys show 70% of their time is spent on orders, 10% on inquiries, and 20% on credit checks. Based on these estimates, the traditional cost driver rates are: (.7)(560,000) ÷ 49,000 = $8 per order, (.1)(560,000) ÷ 1,400 = $40 per inquiry, and (.2)(560,000) ÷ 2,500 = $44.80 per credit check. This approach to ABC works in small settings, but various problems arise, particularly in large scale operations.
One problem is that ABC systems need to be updated frequently as things change, and simple ABC models do not capture the complexity of actual operations. Another more serious problem is that employees tend to assign 100% of their time to the activities they perform ignoring idle or unused time. This causes the cost driver rates to be overstated and reduces the accuracy of the cost assignments.
The New Time-driven ABC Approach
The new approach involves three steps:
1. Estimating the cost per time unit of capacity: Managers estimate the practical capacity of the resources supplied. Either assume 80-85% as practical capacity, or review past activity levels to be more precise. In the service department example, assume there are 28 employees who work 8 hours per day, or 10,560 minutes per month, or 31,680 minutes per quarter. Practical capacity of around 80% of that gives us approximately 25,000 minutes per quarter per employee, or 700,000 minutes in total for 28 employees. The objective is to be approximately right, not perfectly accurate. Based on these estimates, the cost per time unit is $560,000 ÷ 700,000 minutes = .80 cost per minute. Note: Kaplan and Anderson refer to this as the Capacity cost rate in their 2007 Cost Management article, i.e., Capacity cost rate = Cost of capacity supplied ÷ Practical capacity of resources supplied. See the summary of that article in the related summaries listed below.
2. Estimating the unit times of activities: Determine the time it takes to perform one of each type of activity. Assume management estimates 8 minutes to process an order, 44 minutes to handle an inquiry, and 50 minutes to perform a credit check. (In the 2007 article noted above these are referred to as Capacity consumption estimates).
3. Determining the cost-driver rates: The time-driven cost driver rates are (8 minutes)(.80 cost per minute) = $6.40 for processing an order, (44 minutes)(.8) = $35.20 per inquiry, and (50 minutes)(.8) = $40 per credit check. Using the terminology from the 2007 article, each Cost-driver rate = (Capacity cost rate)(Capacity consumption estimate).
The time-driven cost driver rates are lower than those calculated for the traditional approach (6.40, 35.20 and 40 versus 8, 40, and 44.80) because idle or unused capacity is recognized in the time-driven calculations.
It is assumed that the service department actually processed 51,000 orders, handled 1,150 inquiries, and performed 2,700 credit checks.
In the time-driven approach (51,000)(6.40) + (1,150)(35.20) + (2,700)(40) = $474,880 is assigned to cost objects revealing 560,000-474,880 = $85,120 of unused capacity cost. Recognizing the unused capacity helps managers determine if they should find ways to reduce capacity or find other ways to use the resources involved.
The authors do not show the following calculation but in the traditional approach (51,000)(8) + (1,150)(40) + (2,700)(44.80) = $574,960 would be assigned to cost objects. This would result in assigning 574,960-560,000 = $14,960 more cost than the total cost supplied by the service department.
Updating the Time-driven ABC Model
The time-driven model can be easily updated to accommodate changes in resource prices or changes in the efficiency of the department's activities. Updating on this basis rather than once per quarter, or once per year provides much more accurate information related to cost assignments.
Time Equations to Capture Complexity
Time equations can be used to simplify the estimating process and create a much more accurate cost model when transactions become more complex. For example, a process involved in packaging a chemical for shipment is different depending on whether the shipment is air versus ground. If an original package takes .5 minutes, a new special package requires an additional 6.5 minutes, and placing it in an air worthy container takes another 2 minutes, a packaging time equation could be used as follows:
Packaging time = 0.5 + 6.5[if special packaging required] + 2.0 [if shipping by air]
The authors show another example related to order entry processing time. The equation is:
Inside sales order entry process time = 5 + (3)(number of line items) + 15 [if new customer] + 10 [if expedited order]
The company in this example reduced the number of items tracked, added complexity to the model, significantly improved their cost assignments, and can easily validate the model by reconciling the total process time to other measures of resources supplied such as head count. This provides a considerable advantage over the traditional ABC approach where validation is difficult when time estimates do not include unused capacity. Another advantage of using time equations is that they provide a negotiation tool when dealing with customers. An example is provided to show the cost of engineering changes to replace parts or reconfigure a product's design.
The Bottom Line
Another example of a food company is provided that shows the company's use of time-driven ABC allowed them to establish a minimum order, recover vendor rebate processing costs, conduct what-if profit analysis on new business, and perform vendor reviews.
Time-driven ABC has overcome the problems associated with the traditional ABC approach and provided a transparent, scalable methodology easily implemented and updated. Organizations that previously tried and subsequently abandoned ABC should try again using the time-driven model.
Related Time-driven ABC summaries:
Kaplan, R. S. and M. E. Porter. 2011. How to solve the cost crisis in health care: The biggest problem with health care isn't with insurance or politics. It's that we're measuring the wrong things the wrong way. Harvard Business Review (September): 46-64. (Time-driven ABC applied to health care). (Summary).
Kaplan, R. S. and S. R. Anderson. 2007. The innovation of time-driven activity-based costing. Cost Management (March/April): 5-15. (Summary).
Kaplan, R. S., M. E. Porter and M. L. Frigo. 2017. Managing healthcare costs and value. Strategic Finance (January): 24-33. (Summary).
Porter, M. E. and T. H. Lee. 2013. The strategy that will fix health care: Providers must lead the way in making value the overarching goal. Harvard Business Review (October): 50-67. (This article shows how the time-driven ABC approach fits into the strategic value agenda for a high-value health care delivery system). (Summary).
Other Related summaries:
Anderson, S. W., J. W. Hesford and S. M. Young. 2002. Factors influencing the performance of activity based costing teams: A field study of ABC model development time in the automobile industry. Accounting, Organizations and Society 27(3): 195-211. (Summary).
Brausch, J. M. and T. C. Taylor. 1997. Who is accounting for the cost of capacity? Management Accounting (February): 44-46, 48-50. (Summary).
Church, A. H. 1995. Overhead: The cost of production preparedness. Journal of Cost Management (Summer): 66-71. (Reprint of Church, A. H. 1931. Overhead: The cost of production preparedness. Factory and Industrial Management (January): 38-41. (Summary).
Cooper, R. 1990. Implementing an activity-based cost system. Journal of Cost Management (Spring): 33-42. (Summary).
Cooper, R. and R. S. Kaplan. 1992. Activity-based systems: Measuring the costs of resource usage. Accounting Horizons (September): 1-13. (Summary).
Debruine, M. and P. R. Sopariwala. 1994. The use of practical capacity for better management decisions. Journal of Cost Management (Spring): 25-31. (Summary).
Gantt, H. L. 1994. The relation between production and costs. Journal of Cost Management (Spring): 4-11. This is a presentation Gantt made in 1915. (Summary).
Kaplan, R. S. 1990. The four stage model of cost systems design. Management Accounting (February): 22-26. (Summary).
Krumwiede, K. R. 1998. ABC: Why it's tried and how it succeeds. Management Accounting (April): 32-34, 36, 38. (Summary).
Mangan, T. N. 1995. Integrating an activity-based cost system. Journal of Cost Management (Winter): 5-13. (Summary).
Martin, J. R. 2000. The advantages of teaching three production volume variances. Journal of Accounting Education 18(1): 35-50. (Example of ABC variance analysis based on an example from Kaplan, R. S. and R. Cooper. 1998. Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance. Boston: Harvard Business School Press).
Martin, J. R. Not dated. Chapter 7: Activity Based Product Costing. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. http://maaw.info/Chapter7.htm
McNair, C. J. 1994. The hidden costs of capacity. Journal of Cost Management (Spring): 12-24. (Summary).
Mecimore, C. D. and A. T. Bell. 1995. Are we ready for fourth-generation ABC? Management Accounting (January): 22-26. (Summary).