Activity Based Costing
“What are the ABC’s of ABC?”
, L3 P Associates, LLC
In an industry filled with acronyms, now we add another: activity-based costing or ABC. This article
will examine the basics of ABC, particularly in relation to traditional costing methods, and look at how to
begin an implementation of ABC in your organization.
Cost Data is important, as margins become slimmer and risks are increased, we must arrive at a stable,
reliable, cost-finding and reporting methodology that not only gives us accurate data, but also places that
data in the context of day-to-day business processes and service capacity.
First-ABC is only data, but someone must use the data effectively and creatively or the effort is a waste of
time. Although ABC is only data, it can be very powerful and spark project teams or decisions makers to
take new steps or draw innovative conclusions. In the sense just described, ABC is part of change
management. ABC is also an enabler for continuous improvement and decision support. It makes tools
such as just-in-time (JIT), total quality management (TQM), and business process redesign (BPR) more
ABC originated in the manufacturing industry, and it is only now gaining acceptance in the health field.
What makes ABC so fundamentally different from other cost-finding and cost accounting methods is its
ability to recognize the causal relationships between resources (such as staff and computers), activities (the
processes of an organization such as delivery of an hour of counseling) and cost objects (those things for
which we are seeking a unit cost such as that hour of counseling, or the cost of serving a consumer). The
establishment of this causal relationship and the method’s basic links to an organization’s business
processes make the accuracy and usefulness of cost information produced by ABC significantly better than
ABC is currently not a financial reporting system designed to serve regulatory agencies such as the Internal
Revenue Service or Securities Exchange Commission, but it will be in the future. ABC provides managerial
information in financial metric form. Financial denominations, such as U.S. dollars, serve as measures for
the language of business. ABC communicates dollars to non-financial managers better than traditional cost
accounting does, because ABC physically mirrors the activities of people, machines, and equipment.
ABC communicates to people the rate at which activities consume resources as well as why the resources
are used. People need to use common sense in implementing ABC’s clear, relevant data, and then their
understanding of the data will be enhanced; thus, ABC creates benefits.
What do traditional cost systems manage? The best illustration of how ABC differs from traditional costing
method is to begin with a challenge. In the following example, we will use a fictitious intake unit of a social
service agency. Your job as a manager of this department is to reduce costs by 10% as several contract
renewals obtained by your agency resulted in lower revenues. In a traditional environment, the department
manager would normally receive an income statement that might be similar to that below:
Traditional Intake Unit Cost Structure
As a manager charged with the task of cost reductions, the information provided by traditional systems
doesn’t offer much guidance. The foremost problem faced by the manager is the lack of information on the
effect of any cost reductions. For example, it would be easy to focus a 10% cost reduction on “Labor.” In so
doing the manager runs the risk of degrading capacity such that existing and future demand can’t be met.
This dilemma highlights the fundamental shortcomings of traditional cost systems – they manage dollars,
not business processes. Specifically, traditional cost systems suffer:
♦ Arbitrary allocations that can distort product and service costs.
♦ The lack of a relationship between the cost of a service and the actual effort expended to produce it.
♦ A lack of understanding by operational management
♦ A lack of focus on why costs occur
♦ Untimely, inflexible and overly complex information
ABC is fundamentally different from these traditional methods and has the following advantages:
♦ ABC delineates activity and process costs
♦ ABC highlights and assists in focusing on important costs
♦ ABC gives more accurate and reliable cost information
♦ ABC gives managers the ability to manage activities and business processes, not just dollars.
Taking that same cost data and organizing it within an ABC framework produces a very different report for
the unit manager:
Activity-Based Intake Unit Cost Structure
Receive & Process
Armed with this sort of data, a manager is better equipped to address the organizational need for cost
reductions. In our example, the ABC analysis of the intake unit reveals that 40% of the cost of the unit is
consumed by receiving and processing referrals. Therefore as a manager, my cost cutting target of 10% is
clearly defined, and an achievable, understandable target can be set and measured. To help you get started
with ABC, think about the six key steps in the ABC process.
Step One: Identify Activities: Activity identification in work groups is best accomplished by interviewing
those involved in doing the work. There are several things to remember when identifying activities for a
Focus only on significant activities. Most workgroups have only 5-12 significant activities. Over 12 activities
is too much detail. Too much detail makes the project overly complicated and difficult to maintain.
Use a verb noun sequence to describe activities such as the following:
• Receive referral
• Process Intake
• Schedule Appointment
Avoid having management staff identify activities. It has been our experience that management’s view of the
work process is often very different from what actually takes place. You can get the real picture only by
interviewing line staff.
Step Two: Determine How Resources are Related to Activities: Once activities have been identified, the
next major task is to determine how resources flow to activities. Remember these basic concepts:
♦ Resources are used (consumed) as activities are performed
♦ The relationship between resource costs and activities is called a “resource driver”
♦ Analyze the general ledger to determine how costs are currently reported
Once these relationships have been defined, both costs and utilization data must be collected to apply to the
model. Much of the financial data can come from the general ledger and income statements, while some
utilization data will often have to be collected if it is not routinely gathered by the organization. Questions to
ask in quantifying the relationship between resources and activities include:
♦ How much time is spent performing each activity?
♦ What equipment is used to perform activities?
♦ Do some activities have dedicated equipment?
♦ Do some activities require more space than others do?
Then, when data on resources has been collected, the next step is to try to find cause and effect
relationships between resources and activities or resources and cost objects. There are generally three
methods of associating costs to activities:
Traced Costs - These are costs that can be traced directly to activities or cost objects based on specific,
data (such as supplies).
Assigned Costs – These are costs that can be associated with activities or cost objects based on logical
cause and effect relationship (suck as employee time spent on an activity or cost object).
Allocated Costs – These are costs that are associated with the activities or cost objects based on an
estimate of how these costs are incurred. This method is used only as a last resort. One informal rule is
that no more than 10% of all costs should be allocated. If the allocation exceeds this amount, then either
the organization has excessive overhead, or there are missed opportunities for directly tracing or assigning
Step Three: Calculate Activity Costs: The next step in the process is the calculation of activity costs. In
our simple example, the intake unit, we used the following activities:
Based on interviews with staff and logical associations, we were able to assign the following drivers to the
Employee Time %
Employee Time %
The labor and fringe costs were logically assigned based on the amount of time staff spent on each activity.
The supply costs were assigned based on directly tracing supply costs to each activity and depreciation and
other costs were assigned based on logical assumptions. Given these cost assignments, we were able to
produce the estimated cost per activity outlined on the following page.
Step Four: Identify Cost Objects: Next, we identify two major cost objects of interest:
1. Processing Internal Referrals (Basic demographic Information is currently on file)
2. Processing External Referrals (No data currently exists)
Interviews with the staff and our general observation of the intake unit indicated that there might be a
significant difference in time and thus cost between processing a referral from an internal source versus an
external referral source.
Step Five: Determine How Activities are Related to Cost Objects: Using the cost information and staff
interviews we determined the following about these cost objects:
Percent of Time (Resource) Per Activity
% of Processing Time
spent by staff
% of Time collecting
As we can see, staff spend a significantly higher percentage of their time collecting intake data from external
referrals (brand new clients w/ no pre-existing data on file), which consisted of about 16% of the total
Step Six: Calculate Cost Objects Costs: The first step in calculating the costs of the internal and external
referrals was the adjustment of the resource drivers as follows (Due to the size of the table, we are
presenting only the Labor and Fringe drivers):
Summary of Cost and Percentage for Labor and Fringe for Resource Drivers/Activity
Resource/ Activity Drivers
Receive & Process Referrals
Receive & Process Referrals
Combining all of the cost object costs into a summary table yields the following:
Summary of Total Cost of Processing Inpatient and Outpatient
Receive & Process Referrals
As we suspected, the cost for processing an external claim is as much as ten times that of an internal claim.
The analysis and remediation of this diparity fall into the realm of ABM, in which we attempt to answer the
question, “What causes the external cost to occur at such a high level?” Further analysis may yield cost
drivers that include information system problems, poor provider compliance, overly complex intake process
for external referrals, etc.
In any case, our intake manager has powerful information for achieving the 10% cost reduction goal. In
addition, the model developed can be replicated on a quarterly basis to measure results and continue to
provide management with important and actionable information.
In short, ABC provides management with cost, utilization, and capacity information that is directly related to
the business process of the organization. Unlike traditional financial statements and cost finding
methodologies, it presents information in manner most managers can understand.
There is, however, one shortcoming inherent to the model described above, and it serves as a caution to
organizations considering an ABC project. The model described did not give sufficient emphases to the
“process” features and capabilities found in most ABC models primarily because it was constructed using a
spreadsheet tool. This limited the analysis to what is referred to as a “Cost Decomposition” approach. It is
strongly recommended that organizations use software specifically designed to for ABC modeling.
Cost and Percentage Per Activity
Benefits Supplies Depreciation
Receive & Process Referrals 137,500
67,500 18,900 5,000 15,000 8,000
20,000 5,600 20,000 18,000 9,600
7,000 5,000 9,000 4,800
Receive & Process Referrals
L3 P Associates, LLC is a consulting firm with headquarters in Concord New Hampshire. L3 P Associates
focuses on all aspects of behavioral health care and social service reform. They can be reached through
their website at www.L3PAssociates.com or by calling at 603-224-4687.