How to Use Activity-based Management to Optimize Your Business Operations

How to Use Activity-based Management to Optimize Your Business Operations

In the 1980s, businesses got frustrated with the inherent flaws in traditional management accounting systems. Traditional systems couldn’t provide accurate cost accounting at the time and often generated misleading numbers.

This led to the introduction of the activity-based costing (ABC) system aimed at more accurate calculations of operational costs. It soon became apparent that the data generated through ABC could have much broader use than just calculating product costs.

That’s how activity-based management (ABM) came to be. The ABM system was created to help businesses make more informed decisions using data from the activity cost system. Better business decisions have helped companies improve their operational efficiency and overall profitability.

In this article, we’ll discuss how the activity-based management system works, examples of ABM in action, and the type of businesses that should use ABM.

What is activity-based management (ABM)?

Activity-based management is a system for analyzing all of the operations of a business to determine the strengths and weaknesses of a company. The system helps you distinguish between profitable business activities and those that are wasting time, money, and effort.

ABM lets you calculate the value addition that each venture brings so that activities with high profitability can be differentiated from non-value producing ventures.

The ABM system takes production costs, operational costs, and the cost of equipment and facilities into account — no cost is ignored. Such a detailed evaluation ensures that businesses have accurate data to determine the non-value activities that should be reduced, improved, or eliminated, and the value-generating activities that management should focus on.

Efficiencies derived from the implementation of ABM insights will lead to greater profitability. ABM analysis can also be used for accurate budgeting and long-term financial forecasts.

Research by National Business Capital shows that 60% of businesses are not happy with their accounting management systems. Fortunately, the ABM system can be used by a broad range of businesses and organizations including manufacturers, service companies, government, educational institutions, and nonprofits.

Infographics Activity Based Management 1

Activity-based management vs activity-based costing

Although ABM relies on data generated through activity-based costing, both management tools serve different purposes.

While ABM is used as a management tool for improving business processes and managerial decision-making, ABC helps you identify and reduce cost drivers through the optimization of resources.

With ABC, you can map business costs to each of your business processes including, manufacturing, distribution activity, supplies, leasing activity, customers, and more. This data helps you see how your resources are allocated, the cost drivers, and ways to improve efficiency and transparency. 

How activity-based management works

The ABM analysis can be broken down into three steps:

Step 1: Identification and analysis

This refers to the process of identifying and listing business ventures and activities that have any sort of impact on finances. This is a very crucial step in ABM.

If your company has hundreds or thousands of activities, you can group them under 20 or more high-level activities. All activities that cause indirect costs must also be included.

This step also involves identifying the cost driver for each business activity. The cost driver for each activity is any factor that causes its cost to vary.

For example, the cost driver for setting up new machines in your factory is the number of machines you acquired. This is because it determines the cost of the machine itself and other indirect costs incurred while setting up the machines (including labor).

Step 2: Evaluation and value-chain analysis

Here, you need to calculate the costs associated with each business activity based on overhead expenses and indirect costs incurred during the activity. 

For example, if a company that manufactures jerseys runs sewing machines for 355 days in a year, their overhead costs will include electricity, rent, labor costs, insurance, administrative costs, and more.

You must also calculate the value generated by each business activity after calculating the costs. Value-chain analysis refers to the process of comparing the value generated by an activity to the costs to determine if the activity is profitable or non-value generating.

For example, the value that the sewing machines generated for the jersey manufacturing company will be the total revenues from the sale of all clothes produced during that 355 days period. These revenues will then be weighed against the total costs of running the machines that were calculated earlier. 

Step 3: Identifying opportunities to improve

The objective when collecting and analyzing information through activity-based management and ABC is to identify opportunities to improve company operations and business strategies.

There are two ways you can use ABM to improve your business, and they are:

  • Operational ABM
  • Strategic ABM

Operational ABM

Operational ABM involves investigating each business activity to identify anomalies in the costing process. This enhances operational efficiency because you will find ways to reduce the costs of each activity and also identify non-value generating activities that must be eliminated.

The goal of operational ABM is higher efficiency. Value-generating activities are enhanced, while loss-making activities are reduced or eliminated.

A good example is the case of Kaplan and Cooper. The company was a producer of technical manuals for the ICT industry. The company ran out of storage space at its factory and decided to establish additional storage facilities at a new location.

The problem was that this new location was several kilometers from its main factory. This meant that the newly produced technical manuals would first be sent to the distant facility for storage before they were returned to the factory to be dispatched to customers.

The company was aware that this process was inefficient and costly. However, they couldn’t discern the actual costs of the activity using traditional accounting systems which only showed the $200,000 transport costs.

Using ABM, the company discovered that the actual costs were much higher than expected, and this pushed the company to adopt a much more efficient solution to its storage problem.

Strategic ABM

Strategic ABM helps you determine the best products to develop and the right customers to pursue to obtain the most sales and profitability.

With it, you can analyze the profitability of a new product in the pipeline or a prospective customer you are trying to acquire.

For example, First Electric used ABM to discover that it was making losses on 20% of its customers and barely broke even on another 30%.

This discovery led the company to implement strategies that prioritized its most profitable customers. Prices were raised for loss-making customers to push them to switch providers, while big discounts were offered to profitable customers to encourage them to remain loyal.

Infographics Activity Based Management 2

Benefits of activity-based management

Here are some of the advantages of ABM:

  • It helps you identify and improve value-generating business activities
  • It helps you identify business activities that generate little or no value
  • It provides data for forecasting budgets and creating financial models
  • It helps you determine customer profitability to identify high-value customers to prioritize
  • It helps you determine the profitability of new products

What types of businesses should use ABM?

ABM can be applied to most organizations, however, it is more beneficial for organizations with a wide range of products and high indirect costs. Manufacturing processes have become more automated and IT-based leading to a sharp increase in overhead costs while direct costs have fallen.

ABM lets companies easily track the many indirect costs among their different products.

The ABC and ABM systems are not very suitable for small businesses because implementing them is complex and expensive. Small businesses tend to have narrow product ranges, and the benefits of implementing the ABM system can not justify the expense.

Potential risks associated with ABM

Below are some potential disadvantages of ABM:

It disregards the intrinsic value of business activities. ABM prioritizes converting all benefits and costs into monetary units, but this may ignore the intrinsic value of activities that are seemingly non-value generating.

For example, data from ABM could show that investing in a fancy office is too costly, and renting a less fancy one will save costs. However, this ignores the value of a fancy office in attracting new talent who prefer modern workplaces.

It hinders long-term strategic thinking. Some activities can be costly in the short term while carrying the potential to create a big payoff in the future.

For example, Amazon’s online retail activities were loss-making for 14 years, but they helped to make the company a household name and an e-commerce juggernaut that now makes billions in profits.

The bottom line

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The ABM system can be a powerful tool for making better strategic decisions and optimizing the profitability of your products and customers. However, implementing the system will require a major organizational change.

You must set up information systems for identifying and tracking the direct and indirect costs of every activity in your company. Doing this successfully will lead to greater business efficiency and profitability.

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