Index

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ABC (Activity-Based Costing)

ABC (Activity-Based Costing): a method for assigning costs to products and services based on the activities required to produce them. Knowing how much products and services really cost allow companies to justify expenditure, identify what’s profitable vs unprofitable and explore opportunities for cheaper alternatives.

ABC is best understood via an example. Let’s imagine a customer service department in a Business-to-Business (B-to-B) telco with a team of multi-skilled call centre agents who handle both external customer enquiries and internal enquiries from the sales force. In addition, they correct orders that have wrong or missing information by calling the customers and doing it on the phone.

You build an ABC model by first interviewing the agents and asking them how much time they spend on these three activities, which they estimate at 60%, 30% and 10% respectively (for simplicity’s sake we will avoid breaking down these activities into “cost pools”). You then count the number of “cost drivers” – ie, the number of external enquiries, internal enquiries and rejected orders – which for our example is say, 10 000, 2 500 and 1 000 per year respectively. Finally you factor in the total costs of the department, which are $1m per year.

This data is then entered into a model in an ABC system, which calculates the following activity cost driver rates (Fig. 6.1 below – NB click on the image to get a full-screen view):

An example of Activity-Based Costing

Needless to say, this simplistic example hides a number of inaccuracies and complexities, the main ones of which are:

• The time spent is based on people’s subjective estimates of their behaviour – and assumes 100% annual productivity, with no idle time.
• Any changes in activities and processes due to new or changed products, or to exception processing, would require re-interviewing and maintenance of the model.
• If the approach were applied to 100 people instead of only three, and across multiple activities more complex than those for a call centre, the effort and cost involved in interviewing people, setting up the model and maintaining it could soon become prohibitive.
• If required, as in IT, it would be difficult to break down people’s activities into capex and opex.

The conclusion is that ABC is more suited to relatively stable, industrial, commodity-type processes with little exception processing. It would also need to be a high-volume activity to justify the overhead of maintaining an ABC system.

Even in a stable industrial environment, the above constraints can still become a barrier to ABC, which has led the inventors of the original model, Robert S. Kaplan and Steven R. Anderson, to propose in 2003 a simplified version called time-driven ABC (see “Further reading” in Appendix 2).

Needless to say, IT projects do not correspond to this type of environment. The most common method for evaluating people costs in a project is through time-entry. ABC in IT is therefore only really applicable to stable production applications and services.

Accruals

Accruals: enable revenue or expenses to be recognized before payment occurs.

If you’ve heard the term accruals before, it was probably associated with the year-end close, when all departments have to ensure that their unpaid invoices are booked to the financial year about to end. But accruals can also be used during the financial year to track costs with respect to budget, as we shall now see.

There are two types of accruals:

• Accrued revenue: revenue is recognized when it is earned, which most of the time is before payment is received.
• Accrued expenses: expenses are recognized when they are incurred, which is usually before the invoice is paid.

This form of accounting is called accrual accounting (the norm in any large company), as opposed to cash accounting (often used in small businesses), which only recognizes revenue and expenses when cash changes hands. Understanding cash accounting helps to appreciate the usefulness of accruals.

Cash accounting

In the following example, Fig. 6.2a  (NB click on the image to get a full-screen view) shows how cost management with cash accounting results in an incorrect situation with respect to budget. Because the invoice for work incurred in January will only be paid in February (assuming payment terms of one month), the snapshot for the end of January shows zero costs. Of course, this is incorrect, because, to take an extreme example, if the project were cancelled at the end of January, the vendor would still have to be paid. Continuing with this cash-based approach, by the time we get to March, the YTD costs give the impression that only $220k has been spent (ie, 150+70), whereas in reality it is $470k (ie, 150+70+250).

Accrual accounting

Fig. 6.2b (NB click on the image to get a full-screen view) shows how accruals capture the true cost situation with respect to budget. January work is accrued at the end of January, thereby recognizing the expense the month it was incurred, regardless of when the invoice is eventually paid. By the time we get to March, the YTD costs are correctly shown as $470k (ie 150+70+250).

Accruals can be thought of as “pre-booked actuals” pending payment, thus enabling more meaningful financial reporting. They are reversed once payment has occurred.

In accounting software systems, accruals can be generated after the corresponding goods or services have been received.

In this simple example, invoices are submitted quickly and paid one month later; in the real world, they could be submitted late and paid late. Without accruals, therefore, your financial reporting would not only be inaccurate, but it could also become unpredictable because it is based on when vendors submit their invoices (surprisingly, not always on time) and when these invoices are eventually paid (dependent on payment terms and on process inefficiencies).

Accruals vs commitments

The alternative to using accruals to track uninvoiced work is to use commitments instead, which is simply uninvoiced work recorded in the management accounting system. An accrual goes one step further and records the commitment in the financial accounting system.

The big advantage of an accrual is that once it is recorded, it is “on the books”, and relieves you of the burden of tracking the commitment through to when the invoice is eventually paid – with the attendant risk of double-counting, ie recording both the commitment and the paid invoice against your budget.

FURTHER READING: for an accounting view of accruals – which is both understandable and entertaining – check out the following article by Michael Sack Elmaleh.

Actuals

Actuals: short for actual costs incurred, as opposed to planned or budgeted costs.

Amortization

Amortization: the technical term for the depreciation of non-material or intangible assets like patents, trademarks or brands.

Asset

Asset: tangible or intangible things that are directly or indirectly able to generate revenue over several years, thus allowing a company to produce goods or services. An asset therefore has a monetary value and can be sold if required. Tangible assets are usually called fixed assets, and include things like plant, property or equipment. Examples of intangible assets include things like patents and brands.

FURTHER READING: for an accounting view of fixed assets check out the following article by Michael Sack Elmaleh.

Balance sheet

Balance sheet: A snapshot of a company’s value at a specific point in time. It contains two parts, assets (cash, accounts receivable, equipment…) and liabilities (accounts payable and other debt). The difference between the two is the company’s net worth (also known as owner’s equity or shareholder’s equity).

Because IT is so capital-intensive (up to 50% of a company’s capital expenditure), it can form a significant part of the balance sheet.

An analogy would be one’s personal balance sheet, which would list one’s assets (car, savings, wife’s house and jewellery…) and liabilities (loans, dubious investment schemes, alimony payments to first wife …).

Note that the balance sheet does not tell us how the company is performing in terms of revenue and expenses each month – that is the role of the Income Statement or P&L (of which the analogy would be your monthly salary and living expenses).

Books

Books: see General Accounting System.

Bottom line

Bottom line: the last line of the P&L or Income Statement, which represents net income – ie, sales minus total costs.

Capex

Capex: see Costs.