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What Is Activity-Based Management? Activity-Based Management In A Nutshell
Activity-based management (ABM) is a framework for determining the profitability of every aspect of a business. The end goal is to maximize organizational strengths while minimizing or eliminating weaknesses. Activity-based management can be described in the following steps: identification and analysis, evaluation and identification of areas of improvement.
During the 1980s, many organizations adopted activity-based costing (ABC) systems to accurately calculate the unit cost of a product or service. Soon after, it became apparent that the information produced in each costing could be applied to the thousands of different activities a business performs.
Activity-based management was then born, providing important cost analyses for employees, equipment, distribution, and facilities, among other areas. Cost is evaluated in terms of value chain analysis, where the cost of an activity is compared to the value it adds to operations or strategy. As a result, the ABM method improves profitability and also aids in the creation of more accurate budgets and financial forecasts.
Most businesses perform hundreds or even thousands of activities daily. Therefore it is critical to identify the activities with the most impact on finances. Cost drivers also need to be identified, or the factors most likely to cause the cost of an activity to vary.
If a business wants to replace its entire fleet of rental vehicles, then the cost driver is the size of the fleet. Why? Because the number of vehicles will determine the total cost of maintenance, insurance, and so forth.
2 – Evaluation
Using activity-based costing, management then needs to assign a cost to each activity based on the overhead expenses it incurs. The value of each activity compared to the costs incurred must also be evaluated using a value-chain analysis.
3 – Identification of areas for improvement
After the evaluation stage, the business understands its profitable and non-profitable activities.
Here, there are two choices:
Operational ABM – which involves enhancing value-generating activities while eliminating unnecessary costs and non-value-generating activities. Managers using operational ABM can identify cost anomalies and investigate accordingly. Activities that do not meet a threshold value can be scrapped, with resources redirected to higher-yield activities.
Strategic ABM – where the business uses activity-based costing to analyze the profitability of an activity. For this reason, it is used to determine the most profitable products or customers to pursue. Strategic ABM can also be used for strategic decision-making during product launches, advertising, and target audience formulation.
Limitations of ABM
Despite its obvious benefits to customer relations and profitability, there are a few drawbacks to activity-based management.
These include:
Limited scope – activity-based management only focuses on the quantifiable, financial aspects of an activity. This comes at the expense of intrinsic value, which is much more difficult to measure though no less important. For example, a distribution manager may need to travel frequently to secure supplier contracts. ABM may deem the travel unnecessary because of its high cost, but in reality, the travel is facilitating robust supplier relationships that will benefit the business long term.
Strategic interference – for the same reasons mentioned above, activity-based management can contradict short-term strategy if the benefits of the activity can only be realised over the long-term.
Activity-based costing – in some cases, businesses may find it difficult to perform ABC accurately. Source data is not always readily available, and activity-based costing does not always conform to accepted accounting principles. Furthermore, data produced by this method may conflict with a management team preferring to use traditional costing methods.
Key takeaways:
Activity-based management is a strategy used by businesses to determine the profitability of every activity they perform. The strategy is an adaptation of activity-based costing which became prevalent in the 1980s.
Activity-based management is performed by identifying high-impact activities and assigning a cost to each. The business can then choose strategic or operational ABM based on its specific needs.
Activity-based management does not focus on the intrinsic value of an activity and may conflict with short-term strategy or traditional accounting methods.
The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company balance sheet can be broken down into assets, and how they get sources (either through equity/capital or liability/debt).
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).
The cash flow statement is the third main financial statement, together with the income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing, and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowments from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
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