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.
How does activity-based management work?
Activity-based management can be described in the following steps:
1 – Identification and analysis
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.
Activity-based management examples
Reducing non-value and improving product costing
In the first example, consider a financial services company with sales revenue of around $3 billion.
The company’s current position, which was placing immense pressure on its profit margins, was characterized by:
Collaboration with a top accounting firm where forward momentum had stalled.
ABM approach
After reaching out to an ABM provider, a seminar attended by 30 of the company’s most senior directors and managers was held.
The provider started with a pilot program that consisted of education, office, and treasury services, with a further 5 workshops conducted for each functional area.
Some of the primary measures included:
Defining activities and then associating expenses with these activities.
Developing a definition for non-value and action plans to eliminate it.
Creating or updating process maps, and
The definition or redefinition of performance standards.
Once the pilot program was deemed a success, it was expanded to other areas of the organization such as management information systems (MIS).
Employees from each of the seven regions where the company has a presence then traveled to a central location to attend the seminar.
Since the cohort chosen represented a diverse cross-section of talent, skills, and experience, it was hoped that this would improve process improvement buy-in across the entire company.
ABM results
To improve profit margins and become more competitive, the CEO of the financial services company established a directive to transfer resources spent on non-value activities to those that would grow the business.
A senior vice president was also tasked with reviewing the cost drivers, activity costs, action plans, and performance measures that were generated by the continuous improvement process.
Improving an outdated management reporting system
The second example also concerns a financial services company.
This time, imagine a company with $70 billion in assets and 26,000 employees whose management system is based on ineffective statutory reporting.
The company was also saddled with almost 6,500 cost centers which the CFO believed was far too many.
To make matters worse, senior executives also felt they did not have access to the information they needed to make sound decisions.
ABM approach
After securing the support of senior executives, an activity-based management provider created a pilot program with 500 employees with five workshops held for each cost center.
Broadly speaking, the content of each workshop was as follows:
Workshop 1 – the ABM provider started by explaining the overarching goal and asked the employees to define their respective activities.
Workshop 2 – each activity was then defined and reviewed in terms of how much time it necessitated. In some instances, time studies were performed to obtain more accurate numbers.
Workshop 3 – where cost drivers and non-value were identified, and process maps were defined and created.
Workshop 4 – where action plans were devised to reduce instances of non-value.
Workshop 5 – lastly, performance measures for cost, time, and quality were defined, discussed, and redefined as required. Each team was asked to present its action plans and performance measures to superiors.
Another pilot program was developed to analyze $150 million in expenditure on MIS components such as middleware, security, disaster recovery, internet, distributed processing, and research.
The provider took more of an active role in this pilot since the product-based language of management information systems sometimes hinders activity identification.
Once both pilot programs were completed, the financial services company performed an activity analysis and asked the ABM provider to review the results.
ABM results
The company managed to identify approximately $1.6 million in cost reductions from the first pilot program.
Management selected a software product to replace the existing cost accounting system which enabled them to forecast costs more accurately.
The software also allowed them to automatically download information to serve as the basis for all activity costs.
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.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
