Beneath The Surface

Suspicious not all areas of your company are bringing in a profit? Break it down with activity-based costing.
Magazine Contributor
6 min read

This story appears in the October 1999 issue of Entrepreneur. Subscribe »

Among the 1,500 plant varieties Bluemount Nurseries Inc. stocked, Nick Pindale suspected that some yielded profits and some only losses. Unfortunately, Pindale, the CFO and grandson-in-law of the founder of Monkton, Maryland-based Bluemount wasn't sure which was which.

Pindale sought answers from an accounting technique called activity-based costing, or ABC. Dividing nursery tasks into categories such as potting and planting, he assigned costs to each. Then he determined which ones Bluemount performed cost-effectively and which would be better outsourced, trimmed or omitted. The information identified the most profitable plants and even helped provide documentation for a bank loan needed to boost production of moneymaking lines.

Bluemount bloomed with ABC. "Five years later, not one of our original greenhouses is still standing," says Pindale of the 65-person nursery. "We've added state-of-the-art machinery in our potting line. And we've doubled in size."

By focusing on such activities as "processing invoices" instead of departments such as "payables," ABC differs from traditional cost accounting. Advocates say it's an improvement, providing information of far more use than customary ledger reports. Its ability to help companies find and trim money-losing products, customers and processes, as well as identify those with profit potential, has led to its adoption by well-known companies, including Mobil, Fidelity Investments and Coca-Cola.

"Within 10 to 20 years, everyone will have some form of ABC," predicts Gary Cokins, author of Activity-Based Cost Management: Making It Work(McGraw-Hill) and director of industry relations for ABC Technologies Inc., a leading ABC software and services firm in Beaverton, Oregon. "It's a matter of when, not if."

Mark Henricks is an Austin, Texas, writer who specializes in business topics and has written for Entrepreneur for nine years.

Learn Your ABCs

Activity-based costing showed up on the business scene in the early 1980s, largely through the writing of Harvard Business School professor Robert S. Kaplan. Driving the interest in ABC was the growing proliferation of products and segmentation of customers and markets, along with generally tougher competition, says Cokins.

"Kaplan realized that accountants were using a single factor to assign cost to products," Cokins says. "It was usually labor hours, or sometimes gallons or pounds. When product diversity increased, this became nonsensical. Some things inevitably got over-costed, and others got under-costed relative to their true consumption of costs."

Today, ABC is considered particularly useful to companies with diverse products, many types of customers and tough competition. Firms in industries experiencing rapid price reductions are also prime candidates.

The first step in applying ABC is to define cost categories. These may include salaries, materials, utilities and the like.

Next, identify primary processes and key activities for each category. For instance, the process of addressing customer help requests involves activities such as answering the phone and researching questions.

Then calculate the costs of each activity by, for example, dividing the number of help requests processed into the combined salaries and benefits of your help-desk workers. Finally, you assign each activity's costs to the appropriate category.

Done right, the ABC exercise accurately assigns the costs of activities done for specific customers, products and services. That can point to activities that waste time. It can also highlight the customers, products and services that are actually keeping you afloat. It's not unusual, say advocates, for ABC to reveal that most of a firm's customers or products are actually losing money.

Details, Details

One ABC risk is getting bogged down in excessive detail. There's no end to the minute activities that can be identified in the process of conducting business, notes Cokins. The trick is to keep the level of detail manageable, collecting and analyzing useful information without expending too much time and energy.

ABC uses data from several sources. Some firms engage in time-motion studies to analyze complex activities. Others interview workers about what they do in their jobs. Most use information from existing accounting systems. Key data commonly includes figures such as the number of customer orders processed, total purchases and the number of new accounts opened, says Cokins.

Most ABC practitioners find that special-purpose ABC software is required to make the task manageable. At $6,000 and up for one package sold by ABC Technologies, software can add significantly to outlays for this type of accounting technique. There are, however, some pilot packages available for $500.

ABC produces bottom-line results only after practice. Although some companies see results almost instantly, it typically takes three months or so for most businesses to experience the benefits of ABC. And, depending on your product or business cycle, it could take much longer.

Seeing an ABC project through to payoff can be tough because of the time and attention to detail required, Cokins warns. "It fails when it doesn't catch enough people's attention," he says. "When it fails, it means it didn't catch fire."

Cokins recommends starting small with broad cost categories and relatively sweeping assignments of activity costs. For instance, a firm with 10,000 customers might divide them into 15 or 20 types and analyze activities associated with each group rather than each customer. "Think of it as a pyramid, and start at the top," advises Cokins. "Disaggregate costs only as needed. And ask yourself first, `Is the climb worth the view?' "

One way to improve management buy-in while limiting the downside factors is to involve only a small group of well-informed workers in the ABC project, at least in the beginning. These people can be used to gather data and perform analyses, then spearhead the effort to communicate findings back to workers.

Communication is delicate, adds Pindale. Some Bluemount workers feared ABC would result in job cuts as tasks were automated. In fact, automation did take the place of some employees, but those workers were redeployed into activities that added value but were not suitable to automation, says Pindale. At Bluemount, making sure employees understood the goals and techniques of ABC was essential to controlling dissent.

From ABC to XYZ

A little more than a decade after it became widely known, ABC is still in its youth, according to Cokins. He predicts a major upsurge in interest in the technology after the turn of the century, as trends toward product and market proliferation continue and competition steadily increases.

Despite the optimism of ABC advocates, the technique isn't for every business. Companies with only a few products and markets aren't likely to get as much benefit from basing costs on activities as companies operating with diverse products, service lines, channels and customers.

But one of the most attractive features of ABC is that it's something you can experiment with without making a huge commitment. "If it doesn't work," says Cokins, "you just stop doing it." Benefits, on the other hand, can be both big and long-lasting.

At Bluemount Nurseries, ABC helped Pindale determine he could breed some plant varieties at about half the cost of buying from wholesalers. "Using those numbers, we were able to sit down with the bank and borrow to build a new propagation facility," he says. "They were really impressed with our figures and graphs, and that loan went straight to the bottom line."

Contact Sources

ABC Technologies Inc., (503) 617-7100,

Bluemount Nurseries Inc.,

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