ABC Process-Based Capital Budgeting.

How may business managers study the risk involved in a proposed multimillion dollar investment opportunity for the emerging "information highway" market? An activity-based cost (ABC), process-based approach represents one capital budgeting strategy for analyzing such investment opportunities. This approach allows managers to vary the underlying activity drivers in business processes in order to study the impact of different levels in the process itself. Managers have the potential to learn much more about investment risks when they study the uncertainties in the business processes, rather than the traditional overview approach. This traditional approach has typically focused upon highly aggregated revenue and cost items that are merely the result of business processes.

This article describes and analyzes a field study at a division of a telecommunications company (one of the thirty largest domestic companies in the United States), that had recently established a new division to investigate and develop new business opportunities on the information highway. The initial opportunity was a $50 million investment in an electronic mall or "cybermall" to be developed on an interactive television network. The project concept was to generate two major revenue streams: 1) rent revenue, by charging fees for the electronic mall sellers to use the cybermall on the interactive television network to sell their products and services, and 2) advertising revenue, by charging fees for companies to advertise in this cybermall. In order to deploy and operate this cybermall, the company would have to incur various capital and operating costs identified with the following four major business processes: network operations, product research and development, marketing, and content production.

When the division of the company was created in 1995, there were no operational electronic malls on an interactive television network in the United States for this division to benchmark and analyze. The division had to develop its own approach to investigate business opportunities in a new industry (i.e., the "information highway"). This approach included the following innovations: 1) development of a new business process for cybermall revenues (See Figure I) and for the related costs needed to deploy and operate this cybermall (See Figure II), 2) development of a pro-forma activity-based costing (ABC), process-based capital budgeting model to investigate such new business opportunities (See Table 1), and 3) development of a simulation model to analyze the uncertainties in key revenue and cost variables (See Tables 2-4 and Figures III and IV). The following sections of this article describe and analyze these innovations.

ADVANTAGES OF ABC WITH PROCESS-BASED MANAGEMENT

Activity-based costing (ABC) systems were developed to provide more accuracy in assigning indirect and support costs to activities, business processes, products, services, and customers (Kaplan and Atkinson, 1998; Krumwiede 1998). ABC systems have recognized that organizational resources are needed both for direct production of goods and services and for indirect or support activities. The goal of ABC is to measure and then price out all the resources used for activities that generate the production of goods and services for customers.

An ABC system first traces costs to support activities and then to products. Traditional product costing has also involved two stages; however, in the first stage, costs are traced to departments, not activities. In both traditional and ABC cost systems, the second and last stage consists of tracing costs to the products or services. The principal difference between the two methods is the number and type of cost drivers used. The traditional product costing systems used allocation bases that may or may not have been cost drivers. For example, many companies have found that direct labor was not a cost driver and may never have been a cost driver, especially in highly automated production environments. The ABC system uses a much larger number and variety of cost drivers than the one or two volume-based cost drivers typical for a traditional cost system. As a result the ABC method has increased accuracy.

A traditional cost system uses only volume-based cost drivers, such as direct labor and machine hours, and ignores the key role of support activities, such as number of setups and design changes, in producing many modern products and services. Such volume-based cost drivers often lead to one group of products subsidizing another group of products. These subsidies often create the appearance that one group of products is highly profitable, adversely impacting the pricing and competitiveness of another group of products. In a highly competitive environment with complex products and services, accurate cost information can be critical to sound planning and decision making.

ABC also facilitates the use of process-based management that represents an evolving management strategy for highly competitive environments, as opposed to the traditional, departmental management focus (Hammer and Champy, 1993; Rummler and Brache, 1990). Process-based management focuses upon the broader control span of cross-functional processes or the "hidden factory" of how work really gets done in organizations, as opposed to the narrow control span of individual departments or "chimneys" or "turf areas" of organizations. Business processes have been discussed as a series of activities that are cross-functionally linked to achieve specific organizational objectives. In fact, almost every business has at least two core processes: the new product/service development process and the customer order fulfillment process (Ramanathan and Schaffer, 1995). The first core process brings together research and development, marketing, and product/service development. The second core process encompasses the sales, purc hasing, production, and accounting organizations. A big challenge for this cybermall project was how to use ABC to facilitate process-based management for a new business opportunity that involved completely new business processes for the information highway.

An integrated process-based management approach has been advocated for success, and even survival, in today's increasingly competitive and rapidly changing business environment (Daly and Freeman, 1997). This approach breaks down functional or departmental "silos" or "chimneys" and focuses upon optimizing customer value and supplier relationships. It requires an integrated performance planning, analysis, and reward system and enhances the effective management of the interrelationships among both processes and functions. It also helps increase the focus on both the internal and external value chains and makes it easier to eliminate non-value added work which enables the organization to use capacity more efficiently. It also facilitates the creation of intellectual capital through teaming and warehousing information on skills and provides a consistent framework for managing potentially diverse initiatives.

It is equally applicable to both manufacturing and service businesses and also facilitates the understanding of cost relationships (Euske et al., 1998). It is compatible with Porter's value chain framework and activity-based costing as well (Selto, 1995). Changes in the business environment have caused many companies to modify their strategic objectives and redesign their existing business processes (Kershaw and Mahenthiran, 1998). Thus, it may be viewed as an approach to initiate and manage changes in existing business processes. Such change may be either a radical re-engineering of all the business processes or incremental changes indicated by benchmarking.

A process-based management approach has also been advocated to replace traditional functional budgeting with an activity-based or process budget (Sharman, 1996; Schmidt, 1992). The next step would be applying a process-based management approach to capital budgeting and developing this approach with actual company applications which has been advocated as "innovation action research" (Kaplan, 1998). Such an innovative approach to capital budgeting may be needed due to the limitations of traditional capital budgeting, such as failure to recognize all the costs and benefits of the new investment. The typical approach to simulation analysis of capital budgeting projects assumes that such variables as market size, market share, and fixed and variable operating costs are uncertain. The analyst selects a probability distribution for each uncertain variable and performs the simulation analysis (Clark et al., 1989). The problem with this approach is that it does not model the underlying revenue and cost drivers. Breal ey and Myers (1996) offer an excellent critique of the traditional approach to simulation analysis. They note the difficulty of specifying the relationships between the variables in a simulation model. This difficulty is caused in part because analysts use such broadly defined variables in their models. The model developed in this article is built upon the uncertainty in the revenue and cost drivers themselves.

Another major limitation of traditional capital budgeting is the inappropriate adjustment for risk by using excessively high discount rates, especially for new technology projects, and requiring payback over arbitrarily short time periods (Kaplan and Atkinson, 1998).

Analyzing and managing risks in capital investments has been argued to be an identified knowledge void (Klammer, 1994). Contributing to this void was the use of a "black box" approach where computed data were accepted without knowing exactly how they were determined which often led to unexplained results. Accordingly, a disciplined, staged approach to risk analysis has been advocated using sensitivity analysis with probability distributions, as we have done in this study.

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