Activity-based Costing focuses on activities not responsibilities. It depersonalises the cost review and enables management to evaluate the activities performed.
A recent report by KPMG suggests that many companies do not have a clear view of what drives costs with less than half the surveyed companies making costs and profitability of business units transparent across the enterprise.
"Companies need more insight into what drives cost in their business so cost cutting can be targeted in the right places."
Traditionally cost reduction tends to be a short, sharp initiative that may only have a short-term effect because the underlying causes of the problems have not been addressed. In most instances, cost reduction initiatives consist of a directive from the CEO or the CFO stating that costs will be held at last year's levels (a cost reduction in line with inflation) or will be reduced by a fixed percentage. Those cost centre managers who have seen these kind of initiatives in the past will have padded their budgets to ensure reductions can be achieved without damaging the infrastructure of their departments. Other managers, who have managed their costs down already will suffer potentially damaging reductions in service levels that may affect the delivery capability of the organisation as a whole.
An activity-based cost reduction exercise, however, should provide the basis for better ongoing cost management, but will not replace existing methods of cost management. Ways of managing the cost base depend on ongoing planning and control of all aspects of the business. Costs are an integral part of the business infrastructure and any decision made by management will inevitably involve expenditure in either the long or short term. Implementing a new cost management system may have far reaching effects, changing the way in which performance is measured within the organisation as a whole.
Using Activity-based Costing as the basis of a one-off cost reduction exercise provides a means by which management can identify duplicate or extraneous activities and evaluate the benefit to the organisation of the activities performed throughout the organisation. Analysis by activity also allows a fundamental rethink of the way the institution is organised and how it operates and may result in radical reorganisation
The primary benefit of using Activity-based costs rather than any other form of costing lies in the essence of the technique itself. Activity-based Costing focuses on activities not responsibilities. It depersonalises the cost review and enables management to value the activities undertaken in relation to the level and/or quality of service provided and factors which cause the costs to be incurred.
Implementing cost reduction in practice requires strong commitment from senior management and sponsorship at board level. Without this kind of commitment, the initiative is likely to flounder when politically complex decisions must be taken relating to reorganisation and redundancy.