Building an ABM Model

The high-level steps that are needed to create an ABM model are delineated below. The level of effort to perform an ABM study may range from days to years, contingent upon the level of complexity of the model and the organization. ABM is a directional tool and requires some judgment as to how the model is created. This type of judgment is a critical success factor for the ABM initiative. The level of detail must be sufficient to provide information to support strategic and operational analysis. On the other hand, complexity needs to be limited to keep costs down and make the model understandable for users who are not part of the tactical processes.

Step 1: Defining the End Result

The key to any successful project is to have a clear understanding of what the end result will look like. Successful implementation of ABM starts with understanding your objectives for the initiative. ABM models should be designed to answer critical questions about cost patterns in your organization.

The first task in an ABM project is to develop a matrix similar to Exhibit 8-3. This matrix captures the questions, the metric that answers the questions, and the category that will be answered by the study. These patterns can be divided into two categories: strategic and operational. Strategic items reveal insights into a company's customers, divisions, products, and units of production. Operational items provide vision into core processes. Robin Cooper states that ABM "software systems should be designed to support two separate systems, one for strategic costing and the other for operational improvement".^[1] The separation of systems assures that each level of management gets the specific information required to make decisions. Splitting systems functions creates a focus and mitigates risks associated with complexity.

Exhibit 8-3: ABM: strategic vs. operational issues.

Question	Answer	System
Is there a difference between the cost of an internet sale, direct mail, or sale person originated sale?	Cost By Channel	Strategic
What is the fully loaded cost of producing a unit?	Unit Cost	Strategic
How does the cost structure on a divisional level compare?	Division Cost	Strategic
Are some customers more expensive to do business with than others?	Customer Cost	Strategic
What part of the process are my costs increasing?	Cost by Task	Operational
What is the true cost of training on a new system?	Fully Loaded Training Cost	Operational
Are my process costs changing over time?	Cost of Process	Operational

Questions should come from numerous levels in the organization. There is usually a difference between what interests senior management and others in the company. It is valuable to capture and prioritize the needs of middle management here to enroll them in the process of building the model You will rely on them heavily to build the activity dictionary, select employees for data gathering, and validate the results. Exhibit 8-3 describes representative questions that ABM can answer. Questions like these will give you an idea of the structure, or architecture, of the ABM model. These systems should enable managers to make forward-thinking decisions, apply the specific operation, and link them together.

Exhibit 8-3 provides examples of both strategic and operational issues. Based on channel, division, customer, and unit costs, senior management can make decisions about Strategic Alternatives. Through an ABM study, a manufacturer may find that product delivery through the Internet is half the cost of selling through a dealership. The manufacturer may choose to increase its Internet presence to improve its cost structure. Operationally focused managers can make decisions about how to improve the costs of varied processes. A closer look into the product manufacturing process may reveal that systems costs are causing expenses to rise.

The list in the exhibit is designed to eliminate similar questions, reduce complexity, and limit the level of time and effort for the development. The final matrix balances a wish list with a level of complexity. This will be the end result for the initial iteration of the model. Additional metrics concerning specific strategies or operational issues can be added in later versions. The level of granularity can be to target specific operational processes where there may be opportunities for improvement. As the model is refined, changes must be guided by a simple value proposition. The benefit of the improvement must exceed the cost of analysis. If a specific task has been identified that has a total cost of $100,000, you would not want to spend $110,000 trying to measure it.

Step 2: Create High-Level Process Maps

The next step is to understand the general flow of your processes by mapping your operation. Highlevel process maps are graphic descriptions of what a company does. These maps are also referred to as value chains. Process maps should include no more than five core processes. Within the core processes, five activities, which are more detailed processes, should be identified (Exhibit 8-4).

Exhibit 8-4: Value chain.

An analysis of a detailed process is depicted in Exhibit 8-5.

Exhibit 8-5: Analysis of research and development.

Activity	Financial Value
Strategic Planning	$300,000
Select Target Products	$500,000
Create Prototype Products	$700,000
Test Products	$400,000
Select Products for Launch	$800,000
Administrative Support	$200,000
IT Support	$50,000
Finance Support	$50,000
HR Support	$25,000
Total	$3,025,000

This step adds value for two reasons. First, operational redundancies are identified that may lead to the development of shared functions. Shared utilities are departments that are created for common activities throughout the organization, such as HR, purchasing, and finance. For example, divisions may need to purchase technology equipment. Some combination of this function on a company-wide basis may increase economies of scale. If all divisions buy PCs, the cost per PC might be improved by ordering larger quantities.

This will give you an understanding of how your processes fit together and how the connection between business-sustaining functions interrelate with the line functions. For many managers, this will provide an initial insight into day-to-day operations. The important aspect of this step is to understand at a directional level how the processes fit together so that the appropriate resource flow is determined. Many organizations have extremely detailed maps and procedures concerning their processes. These documents can serve as a starting point to derive activity-based maps. Activity-based maps are comprehensive enough to capture the entire activity as well as organizational breadth. Too much detail will increase the time it takes to get results and will not be valuable at the management level. You may choose to increase the level of detail to unearth potential processes after the costing has been completed.

The mapping must be comprehensive of all line and business-sustaining activities. Line activities involve any process or activity that directly contributes to the creation of your product or service. Business-sustaining functions are those that support line functions such as information technology, human resources, and finance.

Step 3: Develop an Activity Dictionary

An activity dictionary is a document that explains your processes in terms of activities and tasks. The purpose of an activity dictionary is to create a repository for costs in an activity form.

An activity may be comprised of numerous tasks. Within the recruiting activity you would find the following tasks:

• Placing advertisement

• Contacting and discussing opening with headhunter

• Receiving phone calls from applicants

• Receiving phone calls from head-hunters

• Scheduling interviews

• Interviewing candidates

• Selecting candidates

• Notifying candidates

Activity dictionaries are created through interviews with management. As mentioned above, the amount of detail is dependent on the complexity of the organization and the strategic/operational results to be gleaned from the study. The activities and tasks described in the dictionary should capture 95 percent of what employees do on a day-to-day basis. Creating a dictionary is no longer a large undertaking. Standard dictionaries are available for most business through the International Benchmarking Clearing House. The standard format can be modified to fit your specific operation. This exercise is valuable because it gives senior management a view of the business processes. Many times there is a disparity between what happens to get the job done and the executive team's perceptions of day-to-day activities and tasks.

Step 4: Map Costs into Activities

Drivers need to be selected to map costs into activities. Drivers fall into three categories: events, time, and variable rate.

• Events. Event drivers are simple to use and easy to understand. They are used effectively when events have homogeneous cost characteristics. That is, they require the level of effort from the same type of employees or resource. If events are specialized in nature, then time or variable rate drivers are recommended. Building a car is an example of an event that will trigger costs. Each car requires labor, parts, and the use of facilities, information systems, and electricity. It makes sense that as the number of cars manufactured increases, costs will increase as well. Hypothetically, each automobile may consume three dollars in systems costs. If 100,000 automobiles are built, then $300,000 of information systems costs would be driven into the manufacturing activity.

• Time. If an electrician spends ten hours at twenty dollars per hour on production line repairs, and then his time at his labor rate is driven into the manufacturing activity ($200), repairs may range from five to thirty hours in duration. A time driver is a better choice because the cost of a repair varies from $100 to $600. The underlying assumption here is that the labor rate for an electrician is in a tight range.

• Variable Rate. Suppose that an electrical production line repair requires staff with variable experience and labor rates, say from twenty dollars to fifty dollars per hour. The architect of the model would need drivers that would allow for differing labor rates. This type of driver may also apply to different types of assets. Suppose that you were performing an ABM study in a printing company. Different printing presses would have different usage rates based on the age of the press, the size of the paper it was printing, and the number of colors the press was capable of producing.

Step 5: Create Cost Attributes

The beauty of ABM is that it allows you to see your business in numerous ways. Cost attributes are created to capture information to create these views. For example, an attribute can create an analysis of costs driven by separate information technology systems. Attributes are used to make a distinction between fixed and variable costs. A high fixed cost component of an activity indicates that activities would not benefit from reengineering.

Understanding the cost of using and maintaining a system gives you the data to perform an upgrade analysis. One of the benefits of software operation is reduction in operating time.

Step 6: Drive Costs into Strategic Elements

This phase will deliver the strategic intelligence of the ABM initiative. Normally, strategic costing unearths counter intuitive results. Costs are driven into products, customers, channels, and divisions based on the drivers and attributes established in the prior phases of the ABM methodology. The major criticism of ABM is that the entire process is arbitrary and based on subjective rules—the driver selection and consumption. Traditional cost accounting would make allocations based on sales or number of employees, for example. The technique is subjective, but costs do not necessarily link to the metrics used by traditional methods. Doing a product costing for a company may show that its products have a wide range of operating profit margins, say from 53 percent to –7 percent. This differs vastly from a gross profit range of 55 percent to 67 percent. Product number three is a newer product that has required more organizational support because of the staff-up phase, both for line and information technology functions. This information is critical in making decisions about the development of new products in terms of new costs and the additional capacity required for a successful launch.

^[1]Robin Copper and Regine Slagmulder, "Activity-Based Costing Management System Architecture", Strategic Finance, October 1999, vol. 81, p. 4.