Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
This article represents the first chapter of the 2007 book by Kaplan and Anderson. Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits. Harvard Business School Press. The illustrations in this article are nearly identical to those in their 2004 Harvard Business Review article. See the summary of that article in the related time-driven ABC summaries listed below.
The purpose of this paper is to introduce time-driven activity-based costing as a much improved version of the ABC approach. Kaplan and Anderson begin with a discussion of two firms' first attempts to use activity-based costing, Charles Schwab's and Hendee Enterprises. Both of these systems were time-consuming, costly, and not easily updated. More recently, Charles Schwab implemented a new time-driven ABC system that is much less costly and much more useful. The previous system required 700 employees to submit monthly estimates of how they used their time, and fourteen full-time employees to collect and process the data needed to prepare monthly reports. Their new time-driven approach requires two people to maintain the system.
Brief History of Activity-based Costing
Traditional standard-cost systems were popular until the 1980s but became less useful as the direct labor content of products decreased and companies began to offer many new services. The new services created value and loyalty among customers, but significantly increased support (overhead) costs resulting from the requirements for more engineering, scheduling, receiving, inspecting and handling associated with the new services. Applying overhead the traditional way based on a single basis such as direct labor hours became less accurate and simply no longer reflected economic reality. Activity-based costing assigned support cost to the activities performed and then to orders, products, and customers. These new systems offered much more accurate cost, but created many new problems. They were expensive to build and maintain, and difficult to modify as conditions changed.
Conventional ABC systems involved surveying employees to determine how they spent their time. This was time consuming and costly. The data used to build the models were subjective and difficult to validate. The data were also expensive to store, process, and report. Most of the ABC models were local and not easily updated. An even more serious problem is that the surveys of employee time tended to ignore unused or idle time.
The new time-driven activity-based approach is simpler, cheaper, and more powerful than the conventional ABC model. It eliminates the need to interview or survey employees to allocate resource cost to activities before assigning them to cost objects. In the conventional approach resource cost are assigned to activities and then assigned to cost objects. In the new time-driven approach resource costs are assigned (driven) directly to cost objects that only requires two sets of estimates. These include an estimate of the capacity cost rate and the capacity consumption estimate.
1. Capacity cost rate = Cost of department resources supplied ÷ capacity of resources, or time of employees performing the work
2. Capacity consumption estimate = unit time required to perform each instance of the activity
Then the cost driver rates are calculated:
Cost driver rate = (Capacity cost rate)(Capacity consumption estimate)
Then assigning cost to a particular customer requires applying the cost driver rate to the customer service time where
Customer service time = (Capacity consumption estimate)(Number of times the activity is performed)
A customer service department performs three activities: Process orders, Handle customer inquiries, and Perform customer credit checks. The total cost of operating the department is $567,000 per quarter. The estimated quantities of work during the quarter are:
49,000 customer orders,
1,400 customer inquiries, and
2,500 credit checks.
To keep the initial example simple, it is assumed that each order requires the same amount of work, all inquiries require the same amount of time, and all credit checks require the same amount of effort.
The Conventional ABC Approach
Kaplan and Anderson do not list steps, but I found it useful to list the four steps involved in these calculations.
Step 1: Determine the total operating or resource cost of the department. This is given above as $567,000.
Step 2: In the convention ABC approach interviews and surveys of employees are needed to establish the work-time mix related to the three activities. The surveys show that:
70% of their time is spent processing customer
10% handling customer inquiries, and
20% performing credit checks.
Step 3: Use the survey percentages to assign the department's operating cost ($567,000) to the three activities:
(.7)($567,000) = $396,900 to processing orders,
(.1)($567,000) = $56,700 assigned to handing inquiries, and
(.2)($567,000) = $113,400 assigned to performing credit checks.
Step 4: Calculate the cost driver rates based on the estimated quantities of work. The conventional cost-driver rates are:
Order processing = $396,900 ÷ 49,000 orders =
$8.10 per order
Handling customer inquiries = $56,700 ÷ 1,400 inquiries = $40.50 per inquiry
Performing credit checks = $113,400 ÷ 2,500 credit checks = $45.36
The Time-driven ABC Approach
Two estimates are required to calculate the cost-driver rates: These include the capacity cost rate, and the capacity consumption estimates or the time required per transaction. Kaplan and Anderson do not list steps, but I found it useful to list the five steps involved in these calculations.
Step 1: Determine the total cost of the department, i.e., cost of capacity supplied. This is given above as $567,000.
Step 2: Determine the service department's practical capacity in minutes.
The department employs 28 people, each works 27,000 minutes per quarter. Subtracting time for breaks and training the practical capacity for each employee is 22,500 minutes per quarter. This provides (28)(22,500) = 630,000 minutes of practical capacity per quarter.
Step 3: Calculate the Capacity cost rate:
Capacity cost rate = Cost of capacity supplied ÷ Department practical capacity
of resources supplied in minutes
= $567,000 ÷ 630,000 minutes = $.90 per minute
Step 4: Determine the capacity consumption estimates, i.e., time required per transaction either by observation or interview. These estimates are:
8 minutes to process customer orders
44 minutes to handle customer inquiries
50 minutes to perform a credit check
Step 5: Determine the Time-driven cost-driver rates:
Time-driven cost-driver rate = (Capacity cost rate)(Capacity consumption estimate)
Order processing = ($.90)(8) = $7.20 per order
Handling customer inquiries = ($.90)(44) = $39.60 per inquiry
Performing credit checks = ($.90)(50) = $45 per credit check
Note that determining the total operating or resource cost of the department ($567,000) could be listed as step 1 in both approaches. Also note that the time-driven cost-driver rates are lower than those calculated for the traditional approach (7.20, 39.60 and 45 versus 8.10, 40.50, and 45.36) because idle or unused capacity is recognized in the time-driven calculations.
End of Period Reports
It is assumed that the service department actually processed 51,000 orders, handled 1,150 inquiries, and performed 2,700 credit checks.
Cost assigned in the Conventional ABC approach:
($8.10)(51,000) + ($40.50)(1,150) + ($45.36)(2,700)
= $413,100 + $46,575 + $122,472 = $582,147
Cost assigned in the Time-driven ABC approach:
($7.20)(51,000) + ($39.60)(1,150) + (45)(2,700)
$367,200 + $45,540 + $121,500 = $534,240
The conventional approach overestimates the cost of performing the activities because the cost-driver rates do not recognize the unused capacity. However, the time-driven approach provides a much more accurate picture of the cost of resources used as well as the cost of resources unused, i.e., Cost of resources provided less the cost of resources used = 567,000 - 534,240 = $32,760 cost of unused capacity.
The main power of the time-driven ABC approach is to make predictions useful in negotiating prices with new customers and making decisions related to unused resources, e.g., reduce capacity or reserve the unused capacity for future growth.
The simplifying assumptions mentioned in the initial example (i.e., that each order requires the same amount of work, all inquiries require the same amount of time, and all credit checks require the same amount of effort) are not a requirement for the time-driven ABC approach. In fact, time equations can accommodate a variety of activity characteristics and complexity. An example is given that involves packaging customer orders where some orders include special handling, some include shipping by air, and some include hazardous materials. A time equation incorporating these characteristics is as follows:
Packaging time = .05 + 6.5 [if special handling required] + 0.2 [if shipping by air] + 30 minutes [if hazardous material]
The conventional approach would consider the various types of packaging in this example as four activities. The time-driven approach considers this as one process with one equation that can incorporate more variety and complexity. In addition, the time-driven model can be easily updated for changes in prices or the efficiency of the activities involved.
Old wine (duration drivers) in new bottles?
In this section Kaplan and Anderson point out that duration drivers have been used in conventional ABC systems, but they have been used in a fundamentally different way than how time is used in timed-driven ABC systems. They are used in the second stage of the conventional ABC cost assignment approach. So the time-driven approach is not old wine in a new bottle. The time-driven approach does offer something entirely new. The key difference between the two ABC approaches is that the time-driven approach drives costs directly from resources to cost objects without first assigning them to activities.
The time-driven ABC approach:
1. Is easier and requires less time to develop,
2. Integrates with available ERP systems,
3. Uses specific characteristics of customer orders,
4. Can produce accurate monthly reports of operations,
5. Shows efficiencies and capacity utilization,
6. Can provide forecast of resource demands,
7. Is easily scalable,
8. Provides inexpensive and fast model changes,
9. Provides granular information for problem analysis, and
10. Can be used in any industry.
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. 2004. Time-driven activity-based costing. Harvard Business Review (November): 131-138. (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).