FINANCE COSTING METHODS

As easy
Time-driven activity-based
costing has a number of
limitations when compared
with the contribution-based
activity approach.
Keith Cleland outlines
the key differences
between the two methods
Time-driven activity-based costing (TDABC)
was presented by Robert Kaplan and Steven
Anderson in their recent working paper as a
“new approach for implementing activity-
based costing that is simpler, faster, cheaper,
more flexible and more easily maintained
than the traditional approach”. 1
Let’s consider the following example of a
traditional ABC process. A customer services
department performs three activities: hand-
ling orders, processing customer complaints
and making credit checks. The cost of the
operational resources that carry out these
activities is £560,000 and there are 9,800
orders, 280 complaints and 500 credit
checks. Based on the percentage of time
absorbed by the activities, the £560,000 is
assigned as in panel 1. Orders per customer
are accumulated for a period, along with any
complaints and credit checks, providing an
overview of cost per customer. But, with no
cost differential between small and large
orders, attempts to differentiate result in a
potentially exponential number of activities
to which costs could be assigned. The process
becomes unduly burdensome.
Moving away from a percentage apportion-
ment of costs to activities, TDABC is based on
a cost per minute of staff time per activity. For
example, assuming that, at 80 per cent capa-
city utilisation, activities costing £560,000
are calculated to absorb 700,000 minutes,
the unit cost would work out at £0.80 per
minute. The £40 per order could then be
adjusted depending on size and complexity
by adding or subtracting £1 a minute for
extra staff time taken. An added advantage
is the ability to identify capacity utilisation
more easily by comparing assigned times to
the total staff time available. Assuming that
there are 10,200 orders, 230 complaints and
540 credit checks, the £560,000 is assigned
as in panel 2. Once managers are aware of
under-utilisation and cost per customer, they
can act to improve efficiency, increase the
size of orders and so forth.

1 TRADITIONAL ABC ANALYSIS IN CUSTOMER SERVICE DEPARTMENT

Activity Time (%) Assigned cost (£) Driver quantity Driver rate
Handle orders 70 392,000 9,800 £40/order
Process complaints 10 56,000 280 £200/complaint
Check credit 20 112,000 500 £224/credit check
Total 100 560,000

2 TIME-DRIVEN ABC ANALYSIS IN CUSTOMER SERVICE DEPARTMENT

Activity Quantity Unit time Total time Unit cost Total cost
(minutes) (minutes) (£) assigned (£)
Handle orders 10,200 40 408,000 32 326,400
Process complaints 230 220 50,600 176 40,480
Check credit 540 250 135,000 200 108,000
Total used 593,600 474,880
Total supplied 700,000 560,000
Unused capacity 106,400 85,120

2 8 Financial Management September 2004

 FINANCE COSTING METHODS

as CBA?
3 CONTRIBUTION-BASED ACTIVITY ANALYSIS
The application of time-driven assignable
expenses per activity seems to have the ben-
eficial effect of focusing managers on gross
Week number three for period ending........
profit margins. By extracting the key variable
Invoice no No of sales Sale Cost of goods Gross GP % TARI
of goods plus shipping costs from the overall
£80:
sale price, unprofitable orders resulting from
price (£) and freight (£) profit (£)
distant locations would become obvious from
597 370 250 120 32 +40
the outset. Intent on assigning expenses to
598 190 150 40 21 –40
activities, Kaplan and Anderson exclude
599 430 320 110 26 +30
non-assignable (non-operational?) expenses
600 380 304 76 20 –4
as well as profit. And yet activities identified as
drivers must ultimately bear the weight of
Week’s total 19 0 61,600 46,200 15,400 25 81
both operational and non-operational expen-
ses plus profit – that is, the gross profit of the
Ten weeks for period ending........ company as whole.
Total to date 1,840 625,600 469,200 162,656 26 88 As the following example will show, man-
Target 2,000 640,000 480,000 160,000 25 80 agers with a gross profit benchmark against
which the profitability of quotes or prices can
be measured would immediately be alerted to
the problems of small and unprofitable orders
4 INVOICE ANALYSIS
owing to low gross margins.
Invoice SalesPurchases and outsourced Gross Gross Number Average If you consider the contribution-based activ-
number (£) work at cost (£) profit (£)profit (%)of hours hourly ity (CBA) method, assuming the same opera-
GP tional or assignable expense of £560,000 and
126 2,000 500 1,500 75 20 75.0 adding £140,000 to cover non-operational
138 1,700 500 1,200 71 30 40.0 expense plus profit, the target gross profit
167 900 200 700 78 25 28.0 would be £800,000. Assuming a target num-
183 3,000 900 2,100 70 22 95.0 ber of sales of 10,000, the target average gross
196 2,500 700 1,800 72 30 60.0 profit per sale would be £80. CBA refers to this
210 1,400 400 100 71 28 36.0 £80 as the target average rate index (TARI) to
Total or11,500 3,200 8,300 72 155 emphasise its benchmark status and distin-
guish it from a cost.
Based on 50-week year, the average number
of sales would be 200 per week, giving an
5 CAPACITY UTILISATION ANALYSIS
average weekly gross profit target of £16,000
A Sales for past period (£) 924,000 (200 sales x £80). It’s then a matter of track-
B Materials/purchases at cost (£) 260,000 ing each invoice as in panel 3.
C (A – B) Gross profit (£) 664,000 On the grounds that it’s possible to catch up
D Average gross profit per hour (£) 000,053.50 on a poor week, but far more difficult to catch
E (C ÷ D) Approximate number of hours charged to jobs 12,411 up on a poor month, the number of orders and
F Hours available for charging 20,000 resulting average gross profit contribution are
G (E ÷ F) Productivity 62 per cent summarised weekly and accumulatively for
H (G x 8) Charged hours per person per eight-hour day 4 hours 58 minutes comparison with target. The data invites the
question: why did order 597 do well and yet

September 2004 Financial Management 2 9


600, a similar-sized order, do badly? Although
the poor performance of 600 may be a result of
inept quoting, discounting, higher shipping
costs than expected or bad buying, there is no
evidence that, even if TDABC were operative,
the internal juxtaposition of costs to activities
would change things. The addition of £3 for
more lines per invoice or £6 for difficult pack-
aging or £200 for a credit check would have no
effect on a gross profit based on the difference
between market price and cost of goods.
TDABC doesn’t indicate how market price
is calculated, but it’s most unlikely that its
proponents would suggest adding £200 to
the cost of goods for say, handling a complaint
by the customer in question. More important
for managers is the need to minimise repeats
of orders like 598 and 600.
The positive variance seen after 10 weeks is
consistent with CBA experience in several
businesses across the resale, manufacturing
and service sectors. Once managers are given
a clear focus such as TARI, improvement
flows in the first place from an increase in
the gross profit per sale. An improvement in
numbers of sales takes more time, generally
because more is involved in changing internal
systems and processes. It is at this point that
TDABC can play a key role in sorting out the
causes of inefficiencies.
The above example relates to businesses
engaged in reselling activities, such as whole-
sale distribution and retail, where the key
driver is seen to be the number of sales and the
gross profit per sale. Without a time factor,
however, capacity utilisation is not so easily
measured as it can be in manufacturing,
trades, services, the professions etc.
CBA identifies staff or machine hours as the
key activity driver. Four steps are involved:
l Invoice analysis. Identify the average gross
profit per hour actually charged to jobs by
choosing a representative sample of at least
six invoices (some people prefer 10 invoices;
others use 50) and extracting the cost of
materials plus any outsourced work. Apart
from giving a close approximation of the
average gross profit per hour, the sample
also reveals a wide range in contribution per
hour: from £95 down to £28 (see panel 4,
6 INVOICE INFORMATION FROM THE KITCHEN UTENSIL PLANT
Invoice Invoice Cost of Gross
£80
number price (£) materials (£)
profit per hour (£)
5374 100,000 70,000 30,000
6894 350,000 247,000 103,000
7925 270,000 183,000 87,000
previous page). CBA experience across a
wide sample of businesses suggests that the
range of contributions comes as a complete
surprise to all but 2 per cent of managers.
This mainly results from the method by
which cost and prices have been developed
over the years, varying from standard man-
ufacturing costs and percentage add-ons to
material to a multiple of three or four times
hourly rates. The revelation is a point at
which a process of re-education often starts.
The answer to those who argue that higher
contributions result from mark-ups on jobs
using more material than jobs with little or
no material input is that, whatever costing
system is used, jobs with a higher than aver-
age contribution per staff hour add more to
the bottom line than jobs with a lower than
average contribution. Providing that allow-
ance is made in expenses for loss or damage,
mark-ups on materials or goods have no
divine mandate.
l Time charged to jobs. Divide the average
gross profit per hour into overall gross profit
to get a close approximation of the hours
charged to jobs/products.
l Capacity utilisation. Divide the hours
charged to jobs by the hours available to be
charged. Available hours will normally be
hours paid, less time for breaks, holidays
etc. Multiplying percentage productivity
by eight hours will give a more meaningful
results of hours charged out per person per
eight-hour day (see panel 5, previous page).
l Looking ahead. Target ongoing perfor-
mance using the same process as for
wholesale/distribution using target char-
geable hours instead of the number of sales
or orders. In this case, you would target
extra net profit as well as an increased
number of chargeable hours to deliver a
TARI very close to the average gross profit
of £53.50 that was previously achieved.
The following five examples demonstrate
the application of CBA in both resale and
time-related activities.
The ships’ victualler
With a £50 million turnover, 19 per cent gross
profit margin, 12 branches and 60 sales
Hours Average gross TARI:
profit (£)
1,000 30 – 50
3,000 34 – 46
2,800 31 – 49
FINANCE COSTING METHODS
representatives, this company showed nil
profit at the time of a management buy-out.
In response to my query about its “average
sale”, managers said there was no such thing in
a company that supplied the QE2 with orders
worth £150,000 and also supplied tugboats
with orders of bread and milk worth £50. But,
accepting that it would be hard to improve an
unknown amount, they co-operated by ana-
lysing a random sample of sales to reveal an
average figure of £5,000, which, when divided
into £50 million, indicated around 10,000
sales. Given a 19 per cent gross margin, the
average gross profit per order was £950.
The immediate objective was to improve the
gross margin from 19 per cent to 25 per cent
and target a TARI of £1,250. Sales reps were
made responsible for costing their own orders
– a task previously done by office staff. Bran-
ches were instructed to send weekly reports
showing the number of sales made, along with
the gross profit per sale and per representative.
The branch managers’ quarterly meetings
focused on ways of improving the product mix
and adding value per order. One branch, using
brochures from a local jeweller, sold opals to
ships’ crews, adding value to the food and
other supplies. Another branch arranged a
deal with a local video shop and sold cassettes.
By the end of the financial year, 10 and a half
months after the management buy-out, net
profit had blossomed from zero to £2.5 mil-
lion. In effect, this was equivalent to 10,000
sales x £250 added value per sale.
The jeweller
This firm was persuaded to maintain weekly
reports of the sales, gross profit and number of
sales as recorded on the cash registers. (A cash
ring-up of several items counted as one sale).
An accountant processed the reports and
handed back a weekly comparison of the aver-
age gross profit per sale with TARI as well as a
comparison of the number of sales with target.
Profit increased from a break-even situation
to a net figure of £80,000 within six months.
The manager told me the following:
l He liked the idea of having a benchmark by
which to gauge performance every week.
l It helped to identify whether the contribu-
tion was above or below the TARI bench-
mark when developing product mix.
l It provided immediate feedback on the
effectiveness of advertising.
l It gave him a better understanding of the
cycles affecting his business.
The kitchen utensil plant
The chief executive of this business had
recently spent over £500,000 on a full-blown
costing system. Given the profusion of data
September 2004 Financial Management 3 1
FINANCE COSTING METHODS
pouring out of this new IT, he felt unable to see
the wood for the trees. Feeling that all was not
well, he called for help. In the conference
room, he wrote the following information on
the whiteboard in answer to my questions:
Annual gross profit = £20 million.
Staff hours charged to jobs = 250,000.
Average gross profit per hour (TARI) = £80.
A sample of invoices from a customer
buying 55 per cent of the company’s output
revealed the information set out in panel 6.
By taking 55 per cent of the output at an
average gross profit per hour of £32, the major
customer contributed only £4.4 million of the
£20 million total gross profit. It was highly
unlikely that the required contribution of
£15.6 million could be gained from the
remaining 45 per cent of customers. This sim-
ple analysis took less than 20 minutes – and it
would have taken less time had the informa-
tion been more easily accessible.
The furniture manufacturer
An international consulting group had been
working with this company for six months in
order to improve its production and mar-
keting activities. Knowing the consultant in
charge of the project, I asked whether it had
tried CBA or not. The answer was no, because
the company was well set up with standard
costing and able to identify any variances.
Apart from that, productivity was running
hot at 75 per cent, owing mainly to a newly
designed suite that was in great demand in
continental Europe.
The consultant agreed to co-operate in pin-
pointing the average gross profit contribution
per hour, which turned out to £130. Because
the costing system did not give the hourly
gross profit for each product, it was necessary
to write a simple program to extract that
information. With the data processing section
employing 26 people, all busy with other
Keith Cleland, a professor at the institute of International
Business Relations, is founder of the concepts underlying
contribution-based activity, now run in conjunction with Trevor
Watters of Focus Based Management (www.fbm.com.au)
3 2 Financial Management September 2004
projects, it was two weeks before it was possi-
ble to review the range of contributions from
each of the firm’s 150 products.
The gross profit contributions per hour
ranged from £225 down to £57, with the
product in high demand and driving produc-
tivity showing up at £81. Noting with some
alarm that the products contributing £225
and £195 were in fact disused, the consultant
said that there must have been an undetected
change in the product mix. It was to his credit
that he immediately referred the findings to
the senior management.
A meeting of key people spent the next few
days discussing how to boost the contribution
of the £81 product, mainly by improving
efficiency and reducing material usage with-
out affecting the product’s quality. CBA soft-
ware was installed to monitor progress.
Within three months the downturn in the
firm’s bottom line began to level out. Within
six months it was rising steadily. It proved to
be a salutary lesson for all concerned. From
that time on, all new designs had to pass the
contribution test before being approved.
The fabricator
Posting a loss of £133,000 for the previous
financial year and £80,000 for the seven
months to 31 January, this firm decided to start
applying CBA. Later that year, the accountant
who had introduced it to the concepts told me
that from February to September the business
had made a net profit of £138,000.
When I asked him what he thought about
this dramatic turnaround, he replied: “I dev-
eloped confidence in quoting, because I knew
the contribution compared with TARI. I got
my weekly results each Friday and my monthly
results in four days instead of six weeks.”
Positive outcomes relating to customer and
product profitability are substantially avail-
able to all types of business without the instal-
lation of a TDABC system, helpful though that
process may be as a means of improving
efficiency and capacity utilisation.
The assumption underlying TDABC that
most expenses are fluid and can be assigned to
time-driven activities seems to ignore non-
assignable expenses and profit; overlook the
basis of cost upon which mark-ups are applied
in cases where no market price already exists;
and bypass the fixed nature of assignable
expenses such as complaints and the need to
spread them across the total time available.
All of these factors call into question the
extent of “fluidity” of assigned expenses and
the consequent impact on profitability.
The only expenses treated as fluid in CBA
are the cost of what is sold, plus any clearly
direct variables such as shipping costs and
outsourced work. While not excluding any
overtly direct costs that may sometimes occur,
all other expenses are treated as fixed for all
practical purposes, to be adjusted as expenses
rise or fall. Although these findings run con-
trary to the basic tenets of TDABC, the advan-
tages become apparent in the application.
TDABC calls for a categorisation of activi-
ties and an assessment of time per category in
order to get a close estimate of time-driven
costs. It is a process that, depending on its
complexity, could take days or even weeks.
Once established, several more weeks may be
required to assess capacity utilisation. By con-
trast, CBA can establish capacity utilisation
and give an overview of the contribution of
services, products and customers from a sam-
ple of invoices in a matter of minutes.
TARI, in conjunction with a targeted
volume, lies at heart of CBA. Along with a
weekly comparison of results with targeted
gross profit, they provide a focus at the point of
quoting/pricing/invoicing and a benchmark
for monitoring performance that offers early
alerts for timely correction. The application of
CBA does not exclude the need for TDABC
once it becomes clear that capacity ultilisation
and expenses need closer attention. FM
REFERENCE
1 Robert Kaplan’s and Steven Anderson’s working paper,
Time-driven activity-based costing, can be downloaded from
www.hbs.edu/research/facpubs/workingpapers/abstracts/
0304/04-045.html