A way of analyzing and evaluating a company’s business activities through activity-based costing and value-chain analysis
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Activity-Based Management (ABM) is a way of analyzing and evaluating a company’s business activities through activity-based costing and value-chain analysis. In other words, the ABM method is used to analyze the cost of an activity in relation to the value added by the activity, with the goal of operational and/or strategic improvement.
ABM – How it Works
1. Identification and Analysis
Identification refers to finding and listing a company’s significant business activities – especially since companies are typically involved in hundreds of activities on a daily basis. Identifying activities that have the most impact on finances is an important step in activity-based management.
The next step involves identifying cost drivers for each activity, based on the costs incurred during the activity. Cost drivers are the factors that cause the cost of an activity to vary.
For example, if the activity is setting up new machines, the cost driver is the number of machines set up – because that is what determines all the associated indirect costs of labor, equipment, and the machinery itself.
2. Evaluation and Value-Chain Analysis
The manager also needs to calculate the cost of each activity by appropriating all the indirect and direct costs related to the activity. This is known as activity-based costing and is a method used to assign the costs of each activity according to actual consumption, based on overhead expenses incurred during the activity.
For instance, if a cloth manufacturer runs sewing machines all day for most of the year, that will be considered a significant activity. The cost calculation of this activity will include the cost of labor, electricity, and space required to run the machines.
Along with activity-based costing, the value generated by each activity must also be quantified so that it can be compared to the cost and allow for an evaluation of the activity. This is called value-chain analysis, which is an analysis of the value added by a particular activity.
For example, in the case of running sewing machines, the value generated will be in terms of the value of clothes the machines generate over a certain period. Then, the value added by running the machines can be weighed against the cost of running the machines, and allow the company to identify whether the activity is profitable or problematic.
3. Identifying Opportunities to Improve
The information analyzed and collected through activity-based costing (ABC), and value-chain analysis can be used to identify and implement processes that can improve the company’s operations and/or strategies. This divides ABM into two potential sub-categories:
Operational ABM involves scrutinizing the cost of each activity and increasing operational efficiency by enhancing value-generating activities and eliminating unnecessary costs and non-value-generating activities. It allows managers to identify anomalies in the costing process and investigate accordingly.
Activities that do not generate adequate value can be ceased, and resources can be allocated to other activities – leading to higher efficiency.
Strategic ABM uses activity-based costing to analyze the profitability of an activity – which may even be the unrolling of a new product or acquiring a new customer. It allows the company to obtain a strategic picture of which products and customers to develop and/or pursue in order to boost sales and profitability.
Strategic ABM is used for strategic decision-making when it comes to advertising through a certain channel, launching a new product, or targeting a certain demographic group of customers.
ABM – Advantages and Disadvantages
As listed above, activity-based management offers several advantages related to improving the economic efficiency of operations, as well as the strategic decision-making process of a company.
By allowing managers to enhance value-generating activities, it also offers the potential to improve the experience of a customer, increasing profitability in the long run. Furthermore, the costing information from activity-based costing can be used to forecast and determine crucial financial information for future fiscal years, enabling the company to plan a more accurate budget for upcoming years.
However, one of the primary risks associated with using the ABM method is that it ignores the intrinsic value of activities and focuses only on the quantifiable and financial aspects of each activity.
For example, suppose a manager holds a lot of meetings with the company’s primary supplier to establish a healthy relationship, and this builds up to make a significant portion of weekly expenses due to transport costs. It may be seen as a non-value generating activity simply due to the high costs, but the value of the relationship being built between the company and the supplier is not accounted for.
Therefore, although activity-based management comes with a few advantages, it is important to also examine the non-quantifiable side of activities while using the ABM approach to make operational and strategic changes.
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