Using Activity-Based Costing to Manage More Effectively

G r a n t R e p o r t
Ja n u a r y 2 0 0 0
Using Activity-Based Costing
to Manage More Effectively
Michael H. Granof
Professor
David E. Platt
Assistant Professor
Igor Vaysman
Assistant Professor
Department of Accounting
College of Business Administration
University of Texas at Austin
The PricewaterhouseCoopers Endowment for
The Business of Government

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The PricewaterhouseCoopers Endowment for
The Business of Government
About The Endowment
Through grants for Research, Thought Leadership Forums, and
the SES Leadership Program, The PricewaterhouseCoopers
Endowment for The Business of Government stimulates
research and facilitates discussion on new approaches to
improving the effectiveness of government at the federal, state,
local, and international levels.
Founded in 1998 by PricewaterhouseCoopers, The Endowment
is one of the ways that PricewaterhouseCoopers seeks to
advance knowledge on how to improve public sector effec-
tiveness. The PricewaterhouseCoopers Endowment focuses
on the future of the operation and management of the public
sector.

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Using Activity-Based Costing
to Manage More Effectively
Michael H. Granof
Professor
David E. Platt
Assistant Professor
Igor Vaysman
Assistant Professor
Department of Accounting
College of Business Administration
University of Texas at Austin
January 2000
Using Activity-Based Costing to Manage More Effectively
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Using Activity-Based Costing to Manage More Effectively

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TABLE OF CONTENTS
Foreword ......................................................................................5
Executive Summary ......................................................................6
Introduction ................................................................................7
The Virtues of ABC ................................................................7
Unique Characteristics of Universities ....................................8
Description of the Study ............................................................12
Reason for Focusing on a Department Rather
Than an Entire University ....................................................12
Features of the Department ..................................................12
Features of the ABC Model ..................................................14
Examples of Problems and Issues Encountered ....................18
An ABC Model for a University Department ..............................21
Finding One: Great Disparities Exist Among
Various Programs ................................................................21
Finding Two: Unused Capacity Is Costly ..............................22
Finding Three: ABC Accounting Provides Useful
Efficiency Information ..........................................................23
Finding Four: Support Services Do Not Benefit
Programs Uniformly ............................................................24
Finding Five: Space Costs Are Significant ............................25
Lessons Learned ........................................................................26
Appendix ....................................................................................28
About the Authors ......................................................................30
Key Contact Information ............................................................31
Using Activity-Based Costing to Manage More Effectively
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Using Activity-Based Costing to Manage More Effectively

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The PricewaterhouseCoopers Endowment for
The Business of Government
Foreword
January 2000
On behalf of The PricewaterhouseCoopers Endowment for The Business of Government, we are pleased
to present this report by Professors Michael Granof, David Platt, and Igor Vaysman, “Using Activity-Based
Costing to Manage More Effectively.”
In this report, Professors Granof, Platt, and Vaysman demonstrate how activity-based costing (ABC) can
be used by executives to manage more effectively. The applicability of the ABC model presented has far-
reaching implications for all organizations. This model can clearly be applied to government and nonprofit
organizations, as well as universities. Instead of measuring traditional “inputs” of salary and administrative
costs, ABC accounting provides a methodology to measure the costs of “outputs.”
This report arrives at an opportune time. Both the public and nonprofit sectors are working hard to quantify
their “outputs.” The federal government is now engaged in dramatically improving its ability to document
“outputs.” This increased emphasis on measurement can be linked to two recent events in the federal govern-
ment. First, the Government Performance and Results Act of 1993 legislated that the executive branch docu-
ment its performance and the cost of its services to the American public. Second, the rise in the number of
franchise funds and reimbursable programs throughout the federal government has now made it necessary for
federal executives to develop new methodologies to understand and document the “true costs” of providing
services within their own organizations and to other units within government.
We trust that this report will be useful to executives at all levels of government who are now involved in
quantifying their performance and financial costs.
Paul Lawrence
Ian Littman
Partner, PricewaterhouseCoopers
Partner, PricewaterhouseCoopers
Co-Chair, Endowment Advisory Board
Co-Chair, Endowment Advisory Board
paul.lawrence@us.pwcglobal.com
ian.littman@us.pwcglobal.com
Using Activity-Based Costing to Manage More Effectively
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Executive Summary
Although universities and other governmental orga-
school, both to make the project manageable and
nizations can boast of elaborate accounting sys-
because in universities key decisions, such as
tems typically featuring thousands of accounts,
whether to add new programs or courses, are
their faculty and administrators often lack the most
typically made at the lower portion of the organiza-
rudimentary cost information on the programs that
tion chart.
they manage and the activities in which they
engage. The systems are almost always based on a
Although our project was a case study, we believe
form of fund accounting and are intended to satisfy
that we learned several lessons that are applicable
legal and donor stipulations rather than to provide
not only to universities, but also to other govern-
information for administrative decisions.
mental and not-for-profit organizations. These
include:
In this project we show how activity-based costing
(ABC) can be applied to a single department of a
•
The primary benefit of ABC may be not that it
major institution of higher education and thereby
is an improvement upon an already adequate
provide more management-oriented information
accounting system, but that it provides the
than the systems currently employed. ABC has an
structure for the establishment, for the first
advantage over conventional accounting systems
time, of a true management-oriented system.
mainly in that it allocates “overhead” costs to pro-
•
To be successful, a system must be flexible.
grams and activities in a way that is more reflective
Rigid allocation rules cannot readily be
of the factors that influence them. Although ABC
imposed upon organizations, like universities,
has occasionally been adopted in governmental
characterized by decentralized management
and not-for-profit settings, it is usually applied to
systems.
repetitive processes rather than the more costly
intellectual activities.
•
ABC, by assigning costs to previously-unmea-
sured factors in decisions and providing a mea-
We chose to apply ABC in a university setting
sure of the full cost of programs and activities,
because of the widespread concern about the rising
helps identify circumstances in which goals
costs of higher education and the unique character-
and objectives are out of line with spending
istics of universities that make for special chal-
decisions.
lenges. Universities are characterized, for example,
by an absence of well-defined products or out-
comes, unusual interrelationships among out-
comes, and capacity constraints that are seemingly
elastic. We opted to focus on a single department,
the accounting department of a large business
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Introduction*
University faculty and administrators, it has been
Despite the unique features of business schools, we
said, know the value of everything but the cost of
believe that our model can be adapted readily to
nothing. Indeed, although they may add new
other colleges and institutions of higher education.
courses, programs, and extracurricular activities
More importantly, our findings can be generalized
after having eloquently set forth the benefits, they
to other government and not-for-profit organiza-
often lack even rudimentary information about the
tions in which personnel routinely engage in multi-
costs. Large universities may maintain intricate
ple activities or programs. These include hospitals
accounting systems, often with thousands of
(especially those associated with medical schools),
accounts. However, the systems are almost always
public schools, police departments, fire depart-
based on a form of fund accounting and are
ments, health departments, social service agencies
intended to satisfy legal and donor stipulations
and governmental agencies.
rather than to provide information for administra-
tive decisions.
The Virtues of ABC
Activity-based costing is now an accepted element
In our study we show how activity-based costing
of the accounting and control systems of industrial
(ABC) can be applied to institutions of higher edu-
and service firms, and it has been employed in both
cation and, we believe, can result in improved
governmental and not-for-profit organizations. ABC
information of benefit to academic administrators,
is a product of the technological era. Conventional
legislators, voters, and consumers. We conducted a
managerial information systems can trace their roots
field study of a large college of business that is part
to the industrial age, when labor was the dominant
of a major state university. We compared the infor-
factor of production. Within these systems, over-
mation that was available with that which we
head cost is first allocated from service departments
believed to be decision-relevant. On the basis
to production departments and then distributed,
of our findings we developed and tested an ABC
using an “overhead charging rate,” to specific prod-
model to provide the decision-relevant data. The
ucts. This method was developed to measure manu-
purpose of our study was not to develop a com-
facturing processes in which overhead was either
plete, working model, but rather to demonstrate the
immaterial or was mainly a function of direct labor,
feasibility and benefits of applying ABC in an acad-
which, in turn, was dependent upon production
emic environment. We also sought to identify the
volume. Moreover, in a conventional industrial set-
obstacles that colleges would face in applying ABC
ting, production departments were mainly responsi-
and to discern the limitations of our approach.
ble for the key manufacturing activities and were
clearly distinguishable from service departments,
* The authors gratefully acknowledge The Pricewaterhouse-
which provided only ancillary support.
Coopers Endowment for The Business of Government for
their support of this study.
Using Activity-Based Costing to Manage More Effectively
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In the service economy (as well as in modern,
The differences between ABC and traditional cost-
computer-driven manufacturing facilities), direct
ing are highlighted in Figure 1.
manufacturing labor is no longer the overriding fac-
tor of production and the distinction between pro-
ABC has now been adopted by governmental, acad-
duction and service departments has become
emic and other types of not-for-profit organizations.
decidedly blurred. Overall product and service
However, it has been applied mostly to these institu-
costs are more influenced by research, materials
tions’ repetitive processes, rather than to their intel-
handling, procurement, equipment maintenance,
lectual activities.2 For example, two recent articles
quality control, and customer service requirements
that describe the application of ABC to universities
than by direct labor.
concentrate on the activities of the support depart-
ments. These articles discuss ways to allocate the
To compensate for the deficiencies of the conven-
costs of libraries3 and computing support4, as well as
tional information systems, ABC requires firms to
other services. In fact, many of the activities carried
collect costs in specially constructed “activity pools”
out by these types of organizations are similar to
rather than service departments or overhead cost
those carried by businesses. Clerical functions, for
centers. Each of the pools corresponds to a group
instance, such as procurement and payroll process-
of similar business processes or activities that are
ing, are common to all types of organizations. Thus,
homogeneous in that all costs assigned to the pool
as noted in the books and articles promoting the use
are influenced or driven by a common factor. The
of ABC in the government and not-for-profit sectors,
activity pools can cut across departmental bound-
ABC is no less applicable to those sectors than to
aries and can include overhead costs incurred by
businesses. But these books and articles are directed
production as well as service departments.
mainly to the functions that governments and not-
for-profits have in common with businesses, not to
After collecting the costs in the activity-based cost
the unique, often “intellectual,” activities in which
pools, the firm distributes them directly to its vari-
they engage.
ous products or services by means of a “cost driver.”
A cost driver is similar to an overhead charging rate,
In many governmental and not-for-profit organiza-
but it should represent the factor that has the great-
tions ABC systems did not merely replace conven-
est influence on the behavior of the overhead costs
tional cost accounting systems that provided
within a particular activity pool.
reasonable, if not necessarily optimal, measures
Common cost drivers include production-oriented
of costs. These organizations previously had either
drivers such as cycle times, setups, number of pur-
no, or inadequate, costing systems. For these orga-
chase orders, number of machine hours and num-
nizations, ABC was the first real measurement
ber of inspections. Other cost drivers address the
system, and the primary benefit of ABC was in
cost of providing service resources by measuring
providing the structure for needed accounting
specification changes, ordering characteristics, and
reforms.
other measures of clients’ needs for attention.
Unique Characteristics of
While direct labor is often a cost driver, it should
Universities
be used only when, in fact, the causal relationship
between labor and the costs in the activity pool is
We chose to apply ABC to universities rather than
stronger than that between the pool and any other
to another government or not-for-profit organization
potential cost driver. The total costs in each pool
for two primary reasons. First, the costs of higher
are distributed to the products on the basis of each
2
See, for example, Brimson, J.A. and Antos, J. Activity-Based
product’s cost driver volume. Thus, if a particular
Management for Service Industries, Government Entities and
product requires 60 percent of the quality control
Nonprofit Organizations (New York: John Wiley & Sons,
inspections (a cost driver), then it is assigned 60
1994), and Kehoe, J., Dodson, W., Reeve, R. and Plato, G.,
Activity-Based Management in Government (Washington,
percent of the quality control costs (the related
Coopers & Lybrand, L.L.P., 1995).
activity-based cost pool).1
3 D.D. Acton, and W. D. J. Cannon. “Activity-based Costing in a
University Setting,” Journal of Cost Management (March
1 This description of ABC is adapted from M.H. Granof, P.W Bell
1997): 32-38.
and B.R. Neumann, Accounting for Managers and Investors
4 J.M. Trussel, and L. N. Bittner. “As easy as ABC,” NACUBO
(Englewood N.J, Prentice-Hall, 1993).
Business Officer (June 1996): 34-39.
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