Lean Accounting & Activity-Based costing
by Brian H. Maskell
Professor Robert Kaplan is the "father of activity-based costing". His book Relevance Lost; the Rise & Fall of Management Accounting 1 introduced ABC to American business in 1988. This has spawned an entire industry of training, consulting, software, research, and analysis. Thousands of organizations from manufacturers through hospitals to government agencies have experimented with ABC over the last 10 years or so.
In an article published in November, 2004, in the Harvard Business Review, 2 Professor Kaplan acknowledged what we in the business have known for a long time. He states that ABC is too much work and too complicated for a company to use and sustain over time. He specifically points out that ABC is unsuitable for a complex, mixed model environment.
The article then goes on to present a "new ABC" that is based upon time and capacity. The approach he is suggesting has striking similarities to the methods used in Lean Accounting. He suggests an approach that bases the cost of a product on the time it takes to flow through a process. He also recognizes the need to understand how capacity is used within the flow. And he suggests that product "features and characteristics" be used for complex processes with mixed-model flows.
Problems with Activity-Based Costing
At the beginning of the article, Professor Kaplan explains that while many companies have experimented with activity-based costing, most have abandoned the method because it is too complicated and burdensome. He suggests that "the approach works well in a limited setting" but that "difficulties arise when you try to roll this approach out on a large scale for use on an ongoing basis". He cites one large organization employing 70,000 people over 100 locations requiring 14 full time people to manage the data collection. Hardly a lean approach.
He explains that this complexity and work-load leads to companies allowing the information to go out-of-date and that "process, product, and customer costs soon become inaccurate". Furthermore, "people waste their time arguing about the accuracy of the cost driver rates ... rather than addressing the deficiencies the model reveals".
In other words, instead of ABC leading to ongoing continuous improvement, it leads to a complicated bureaucratic mess, out-of-date information, unedifying arguments between departments, and meetings, meetings, meetings. Those of us who have worked with ABC readily recognize the truth of this diagnosis.
Professor Kaplan goes on to show that ABC is unsuitable for a mixed-model process. He asserts that "traditional ABC models fail to capture the complexity of operations". Some of the problems are caused by limited technology. "As the activity dictionary expands ... the demands on the computer programs used to store and process the data escalates. ... Such expansion has caused ABC systems to exceed the capability of generic spreadsheets, and even many ABC software packages." He cites a company called Hendee Enterprises, a manufacturer of awnings, whose "automated ABC model took 3 days to calculate the costs of its 40 departments, 150 activities, 10,000 orders, and 45,000 line items". He then goes on to say that "these problems have become obvious to most ABC implementers".
On a personal note, I have myself worked for many years with accounting, control, and measurement systems for lean manufacturing organizations. It was these "obvious problems" with the ABC approach that lead me (and others working in the field) to develop simpler and more lean-focused methods. We owe a great deal to Professor Kaplan and also to his one-time colleague, Professor Tom Johnson. They laid the framework with their ABC research and other innovations. But over the last 5 or 10 years Lean Accounting methods have emerged that are much more suitable for lean manufacturers -- both repetitive manufacturers and mixed-model manufacturers.
The "New ABC"
To overcome the complexity and burden of traditional ABC methods, Professor Kaplan posits a new approach to ABC. This new approach has much in common with the methods of Lean Accounting; particularly features & characteristics product costing and value stream cost analysis.
- Costs are collected by departments within processes; this is similar to reporting the costs of each step within the value stream.
- The cost of a product is calculated according the amount of capacity required to perform the work within the process; this is similar to recognizing the rate of flow through the bottleneck operation.
- The capacity of each process is calculated and reported as "used capacity" and unused capacity"; this is similar to the "productive capacity", the "non-productive capacity" and the "available capacity" shown on the box score.
- This cost information is used to calculate the process cost (value stream cost in lean parlance), the product cost, and to report the available capacity throughout the flow.
This "new ABC", according to Dr. Kaplan, will make it much quicker and easier to calculate costs, and will require very little data entry. Changes to the spreadsheet are no longer done every month (or week); the changes are made only when there is a "significant shift in resource costs, practical capacity, or a change in the resources required to perform an activity". This is similar to our recommendations for value stream cost analysis.
Mixed Model Complexity
Professor Kaplan recognizes that the simplifications associated with the "new ABC" are based upon some simplifying assumptions. "But time-driven ABC does not demand this simplification. It can accommodate the complexities of a real-world operation by incorporating ... activity characteristics that cause processing times to vary."
This approach is very similar to the features & characteristics method used in Lean Accounting to determine the cost of individual products as they flow through the value stream. There is no discussion in Kaplan’s article of how the costs are affected by bottlenecks in the flow, but the emphasis given to the use and availability of capacity will undoubtedly lead in this direction.
I am not claiming that Professor Kaplan's article in the November 1 Harvard Business Review is promoting Lean Accounting. The methods presented by the authors are applicable to a wide range of business processes, and do not restrict themselves to manufacturing; let alone lean manufacturing. But it is pleasing to see that these experts in the field have recognize the severe difficulties and restrictions of the much-heralded activity-based costing. Moreover, it is pleasing to see that the solutions suggested in this short article reflect the principles of Lean Accounting methods.
The article is too short to provide a comprehensive explanation of the authors’ idea for "new ABC" but it appears very much to reflect methods useful to lean manufacturers. Indeed Lean Accounting (particularly features & characteristics costing and value stream cost analysis) may well be regarded as a particular usage of the approach Kaplan and Anderson are suggesting.
1 Relevance Lost; The Rise & Fall of Management Accounting by Robert S. Kaplan & H. Thomas Johnson, Harvard Business School Press, 1988 Boston, MA.
2 Time Driven Activity-Based Costing by Robert S. Kaplan & Steven R. Anderson, Harvard Business Review, November 2004.