Management And Accounting Web

Kaplan, R. S. 1992. In defense of activity-based cost management. Management Accounting (November): 58-63.

Summary by Jeffrey S. Price
Master of Accountancy Program
University of South Florida, Fall 2001

ABC Main Page | ABM Main Page | Cost Management Main Page

The purpose of this article is to defend the merit of the ABC model by showing how ABC plays many different roles to support a company’s operational improvement and customer satisfaction programs.

Many critics view Activity Based Costing (ABC) as an accounting model that looks backwards rather than forwards, which fails to navigate managers into the future. Kaplan states that these critics, surprisingly, fail to see the internal inconsistency of their beliefs. They advocate studying historical data to learn about the persistent, repeatable causes of defects, but criticize the analysis of historical information on product and customer profitability. The analysis of past costs and profits reveal why certain activities are unexpectedly costly and why specific products and customers are profitable. Kaplan also points out that an ABC model is not limited to the past financial information. Nothing in the theory of activity based cost management implies that it is a system based on historical cost data. Asset values and expenses can be based on replacement cost, budgeted cost, or target cost. This concept supports the fact that an ABC model is not a general accounting model, but rather an economic model of the organization that integrates data from many information systems, both financial and operational.

Critics accuse ABC’s term “allocation” as arbitrary, and argue that costing systems do not help but actually hinder companies from becoming world class competitors. Kaplan addresses these concerns by replacing the term allocation with accurate "estimations". In principle, you can install elaborate measuring and monitoring devices to learn exactly the quantity and cost of resources required to perform each setup or process each customer’s order. But such instrumentation is rarely justified; Kaplan has found that estimates based on interviews, employee judgments, and available operating data, are sufficiently accurate for the managerial use of the information from an ABC mode. Kaplan states there is no conflict between a company’s improvement programs and an economic model that accurately identifies the costs of activities and business processes. Mangers want to see information about the quality, prices, time, and cost of their activities. The ABC model provides the cost part of the picture.

Kaplan feels the statements made by critics about ABC invariably impairing companies’ long-term performance is nonsense. ABC models can play many different roles to support an organization’s operations improvement and customer satisfaction programs. ABC systems signal to managers that cost of activities and business processes that can be the target for future improvement activities. Kaplan feels that organizations need to set priorities for where the improvement programs should be implemented. Otherwise, the efforts could be scattered and unfocused with disproportionate attention devoted to small problems that can be solved easily rather than to where big economic payoffs can be produced from process improvements. Kaplan does admit that ABC model is not an effective mechanism for providing short-term feedback to employees and operators making process improvements. ABC can only assess whether operating improvements have been translated into financial benefits that can be estimated quarterly or annually, and it is not needed daily or weekly to support operating activates.

Critics claim that ABC leads companies to charge their customers higher prices for customized products. Kaplan says there’s a big difference between being customer focused and being customer compelled or sales obsessed. Attempting to meet all customer needs, without regard to the economics of the customer transaction, can lead a company not to the promised land of world class performance, but to bankruptcy. The ABC model helps to identify the segments and customers that can be satisfied profitably. Also, it signals which customers may require significant price increases or changes in demands or terms of trade for the relationship to benefit both parties.

Kaplan concludes the article with a question, can managers make good decisions with out a detailed understanding of their economics provided by ABC? The answer is maybe occasionally, but they also can make big mistakes. Kaplan says ABC is not magic! It is just one of many information systems to help managers make better decisions.

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