Cost Management Journal of A WARREN GORHAM LAMONT PUBLICATION Vol. 7, No. 1 Spring 1993 Target Costing at Toyota Activity-Based Costing in Cellular Manufacturing Systems Controlling Quality on a Multidimensional Level The Effect of JIT on Management Accounting Activity-Based Total Quality Management at American Express From the Editors / Barry J. Brinker Cost Management Practice / Steven C. Schnoebelen The Factory in Transition / Arun Maira Reprinted with permission from The Journal of Cost Management, Volume 7, Number: 1 c1993 Research Institute of America, Inc. , Warren Gorham Lamont Professional Publishing Division, 210 South St. Boston, MA 02111. All rights reserved. Activity-Based Total Quality Management at American Express David A. Carlson and S. Mark Young Product costing and a quality strategy are related in the sense that both seek answers to difficult questions of how and where information workers spend their time. This article illustrates how activity-based costing contributes not only to the achievement of accurate product costs, but also to improved quality at American Express Integrated Payment Systems (IPS). Activity costs at IPS were determined by asking each manager to estimate the time that his department spends on each activity, then splitting hose activity estimates across each product line. To achieve the objectives of total quality management (TQM), these activity costs were augmented with perceptual data that various stakeholders expressed about the activities. The article suggests how similar approaches to TQM can benefit other service organizations or the service functions of manufacturing companies. A t American Express, a commitment to total quality management (TQM) comes from the top. The Chairman, CEO, and Chief Quality Officer at American Express is James D. Robinson III, who stresses that quality must be integrated with business strategy.
As a result, business unit heads must present their strategy for quality improvements as part of their annual budget and business plans. American Express wants to ensure that its investments in training and technology are paying off. Will the changes at the American Express business units improve the bottom line? The activity-based costing (ABC) method used at American Express Integrated Payment Systems (IPS) in Denver can help answer this question. 1 TQM and ABC at American Express IPS manages one of the oldest financial services American Express has: American Express Money Orders. Introduced in 1882, customers se money orders to pay bills and make mailorder purchases. Money orders provide a stable source of income that has helped support IPS’s entry into markets for similar financial services, including: • American Express MoneyGram, which is a relatively new and rapidly growing service that lets consumers transfer funds around the world, usually within minutes; • American Express Official Checks, which are negotiable instruments that financial institutions use as substitutes for their own disbursement items (e. g. , teller checks and loan checks); and As of 1992, each American Express business unit must undergo a self-assessment based on the riteria specified in the guidelines for the Malcolm Baldrige National Quality Award. Spring 1993 — 48 COST MANAGEMENT • Cash Management Services, a service that works as an electronic clearinghouse to collect, concentrate, and disburse funds and data for corporations and financial institutions. Early in 1990, IPS instituted a TQM philosophy that would involve all 1,000 employees in the Denver metro area. Charlie
Fote, the president of IPS, hired Brian Higgins as director of quality assurance to lead this initiative. Fote and other IPS executives were unaware of any particularly troublesome quality problems; n fact, IPS was (and remains) a service leader in the markets it serves. Instead, the reason for pursuing TQM was to expand IPS’s competitive advantages by improving service and to increase income without increasing costs. Defining continuous improvement. Defining continuous improvement in a service organization is a difficult task. In defining and measuring quality, the quality assurance staff at IPS tried to answer the following questions: • In the spirit of TQM, how do our customers and suppliers feel about the reliability of the activities we perform or about the contribution that those activities make toward their requirements? What do our employees do that contributes value to our services or that advances our company mission? • Conversely, what do our employees do that does not contribute value? The restructuring imperative In an article in the Harvard Business Review, Stephen S. Roach states: Services need an accounting framework that can identify which activities add the most value… Activity-based managerial accounting is a step in the right direction, but much more work in this area remains to be done… It should go without saying that a metric for quality is equally important. Admittedly, quality in the service sector is hard to define. 2
As this quotation suggests, the improvement of white-collar productivity has not been embraced by business leaders, probably because of the nature of knowledge work. Poor productivity is difficult (if not impossible) to remedy. Many people consider knowledge work unstructured, self-directing, and intangible. It is often difficult to relate activity costs to the value provided. Nonetheless, improving whitecollar productivity is not a hopeless task. Many managers simply do not understand the difficulties associated with assessing and improving the productivity of knowledge workers; they also lack the tools needed to adequately address he problem. IPS appears to have made important progress, however. Activity-based TQM The TQM initiative at IPS began by getting all employees involved in continuous improvement efforts. Customer satisfaction, vendor satisfaction, and employee satisfaction were processes that were assessed regularly, and efforts were made to gain a better understanding of the activities and performance measures at IPS. Activity analysis began in the customer service department and telephone operations and quickly became interwoven with concerns about product costing. In particular, senior management wanted to manage growth better y gaining a better understanding of fixed versus variable costs for each product line. Product costing was connected with the quality strategy because both efforts tried to answer the Spring 1993 — 49
COST MANAGEMENT difficult questions of how and where information workers spent their time. ABC is central to recent efforts to redesign cost accounting systems to account for a wide variety of changes that have occurred in high-technology manufacturing and service firms. These changes require accountants and all other employees to alter their mindsets away from cost accounting toward “cost management. ” Cost management emphasizes an active pproach to planning and managing an organization’s costs, whereas cost accounting usually focuses on the historical reporting of costs. 3 Cost management integrates consideration of corporate strategy, which leads to the notion of strategic cost management (SCM),4 which is closely related to the functional administrative control technique (FACT) approach used at IPS (see Exhibit 1). Managers at IPS have explicitly tied the results of FACT studies to achievement of the company’s TQM strategy and its product strategies. Value engineering The FACT approach has its roots not in accounting but in value engineering, which is a echnique for increasing the value of a product or organization rather than simply decreasing its cost. A product-oriented value engineering study, for example, would first create a functional description of a physical product, then map the product’s parts into the functions that those parts perform. Thus, a costed functional description is produced. Customers’ requirements are balanced with the costs of the functions in assessing value. Cross-functional analysis. During the 1960’s General Electric refined some of the value engineering disciplines developed during the 1940’s, which had proved useful in reducing material osts. GE’s refinement, which is called crossfunctional analysis, was designed to examine cross-functional effort applied to organizational activities. Exhibit 1. Activity-Based Total Quality Management Activity-Based Costing (ABC)
Activity-Based Activity-Based Costing (ABC) Strategic Cost Management (SCM) Strategic Cost Management (SCM) •Requires active cost management •Requires active cost management •Encompasses all functions •Encompasses all functions •Matches activities with required resources •Matches activities with required resources •Cost information placed in the context of •Cost information placed in the context of trategic management strategic management Functional Administrative Control Technique (FACT) Total Quality Management (TQM) Total Quality Management (TQM) •Continuous improvement •Continuous improvement •Management by fact •Management by fact •Focus on customer satisfaction •Focus on customer satisfaction •Business and quality strategies integrated •Business and quality strategies integrated Spring 1993 — 50 COST MANAGEMENT Using cross-functional analysis, a business model is constructed that contains the activities performed throughout the entity. Typically, 150-250 such activities are defined and grouped nto major business processes. Effort and cost are then recast into this business model. The contribution of each functional organization is examined to identify specific activities that are unique or that contain duplication, redundancy, or overlap. An organization’s resources are then redeployed – added to some activities or reduced in others – to increase the value of the business to employees and to customers. Brian Higgins worked as a value engineer when he began designing FACT which was introduced a decade before activity-based costing; his efforts began with no knowledge of GE’s cross-functional analysis. 5 1.
If the organization worked in the most efficient and effective manner, how would things be organized, and how would the activity be performed? 2. What inhibits the organization from working in the most efficient and effective manner? 3. How else can the activity be provided? Exhibit 2. FACT Project Plan Project Planning Understand the scope and structure of the organization to be studied Establish the hierarchy of activities Plan the duration of the project and identify critical milestones Data Collection Interview all managers and select customers and vendors Document interviews Enter data into FACT database Synthesis
Phases of a FACT project plan As Exhibit 2 shows, FACT uses a five-phase project plan for analyzing and improving organizational performance. Although the duration of a complete FACT project varies according to the scope and complexity of the organization, a project can usually be completed within sixteen weeks. Project planning phase. The first phase – the project planning phase – is guided by the FACT project leader, who carefully selects a small team to conduct the study. Depending on the scope of the project, from two to ten people may be required, either part or full time. The project leader typically introduces the objectives and lan for the FACT study in a meeting of all managers involved. Data collections phase. In the data collection phase, FACT project team members gather information by using standardized data collection forms. They conduct interviews with three questions in mind: Run reports from FACT database Identify major issues Data Analysis Select opportunities for change Perform analysis using FACT data Identify preliminary recommendations Recommendations Prepare final report Present recommendations to executive management Final three phases. The last three phases of the FACT project plan are crucial for building consensus among the team members and anagement. Specialized corrective action teams are established at the start of the data analysis phase. These teams champion changes through the collaborative participation of all affected individuals, departments, customers, and suppliers. A corrective action team retains control of the project until final recommendations are presented to management, and often until final implementation is completed. Spring 1993 — 51 COST MANAGEMENT As Higgins point out, crucial assumptions are made when (as in many traditional accounting systems) a large proportion of product costs are allocated from pools of overhead expense.
One half of IPS’s expenses, for example, were allocated overhead, but the accountants at IPS admitted that they were comfortable with only 15 percent of the allocations. The improvement of white-collar productivity has not been embraced by business leaders, probably because of the nature of knowledge work. For example, data processing expenses were allocated to products based on the volume of transactions. Since IPS processes hundreds of thousands of money orders per day, money orders received the lion’s share of data processing allocations, even though everyone admitted that MoneyGram’s on-line systems were more
CPU-intensive per transaction. Higgins concludes, “You have to question the assumptions people made when their decisions are based on allocating huge overhead pools to products. Such assumptions are often wrong! ” By directly allocating expenses to activities and to products, a more accurate picture can be obtained. Defining activities The foundation of the FACT model lies in the concept of activity – i. e. , a response to the question “What does the organization do? ” An activity can best be stated as a brief verbnoun description of a process: for example, “resolve customer problems” or “coordinate orrective action. ” Unlike GE’s cross-functional analysis and many applications of ABC, FACT derives significant benefits from using a hierarchical structure of activities (see Exhibit 3). Thus, a response to the question “How is this activity performed? ” leads from left to right in Exhibit 3 from the general to the more specific activities in the hierarchy. Conversely, a response to the question “Why is an activity performed? ” leads from specific to more general activities (i. e. , from right to left in Exhibit 3). This structure permits both macroand micro-level analyses of an organization.
The level of detail expressed by these activities depends on the purpose for which the FACT model is used. FACT has been applied to individual work groups as small as five people as well as to organizations having 1,000 employees and overhead expenses exceeding $60 million. In small departments, for example, the activities may address such processes as “document customer problem” or “reconcile invoices,” whereas in large organizations the activities are conceptualized at a higher level (e. g. , “research market,” “establish pricing,” or “identify inventory variation”). Exhibit 3 shows the top levels of an activity hierarchy for IPS.
Linking activities to business and quality strategies FACT begins by defining the costed hierarchy of activities, but it does not end there. An activity structure provides the basis for assembling information that can later be used in creating and evaluating solutions to problems and in linking activities to business and quality strategies (see Exhibit 4). Managers follow an incremental process for constructing an organizational model that begins with the definition of a costed activity set. Each activity’s cost is determined by assigning a fraction of each person’s time (and Spring 1993 — 52 COST MANAGEMENT herefore salary) or a fraction of a departmental expense item to a particular activity. Thus, all the organization’s costs are allocated to the activity hierarchy. The fractions are determined by a variety of methods (e. g. , time sampling or interviews with managers), depending on the scope of the organization. Once costs are allocated, additional information is collected and related to the model. Quantified data consists of rating each activity for its contribution and reliability on ten-point scales. Perceptual data includes verbal comments that provide either favorable or unfavorable opinions about one or more activities.
This data is crucial for satisfying the objectives of TQM. The Malcomb Baldrige criteria place 30 percent of their emphasis on customer satisfaction; the activity hierarchy provides a Exhibit 3. Activity Hierarchy General activities Specific activities Design Products Design Products • •Identify opportunities Identify opportunities • •Develop opportunities Develop opportunities • •Design and test products/services Design and test products/services Establish New Agents Establish New Agents • •Identify prospects Identify prospects • •Market products Market products • •Establish customer contact (sales) Establish customer contact (sales) •Prepare proposal Prepare proposal • •Close sale Close sale • •Process new accounts Process new accounts Process Products Process Products • •Capture transactions Capture transactions • •Process transactions Process transactions • •Resolve exceptions Resolve exceptions Support and service agents/consumers Support and service agents/consumers 88sub-activities sub-activities Manage revenue/funds Manage revenue/funds 44sub-activities sub-activities Support Operations Support Operations 77sub-activities sub-activities Transfer Funds Transfer Funds Non-financial information The principal non-financial information used onsists of attitudes of customers and suppliers – those who receive the outputs of the organization and those who supply its inputs. This attitudinal information includes both quantified variables and statements of perceptions (see the box “Customer and Supplier Comments” in Exhibit 4). framework for comprehensive assessment of satisfaction across the total business. Classifying activities as mission-related or not Each activity is also classified as being either mission-related or not (see Exhibit 4). Information about cost drivers – i. e. , those events or environmental situations that cause costs to be Spring 1993 — 53
COST MANAGEMENT prevention, while “resolve customer problems” is a cost of external failure. ) Computing cost of quality this becomes trivial; all that has to be done is to sum the activity costs in each category. incurred – may also be associated with each activity. These two information sources work in tandem to tell managers which activities contribute to accomplishing business strategies and how costs are generated. Exhibit 4. Activity-Based Organization Model Person Person Expense Expense Customer Customer and Supplier and Supplier Comments Comments Cost of Cost of Quality Quality Activity Activity Activity
MissionRelated Cost Cost Driver Driver Cost of quality Activities may be associated with one of the four “cost of quality” categories (i. e. , prevention, appraisal, internal failure, and external failure) or with the “cost of business” (e. g. , advertising or production). Many companies have spent years developing an accounting system that can estimate the cost of quality (though few service organizations attempt such analyses). Using FACT, however, an accurate estimate can be produced in a matter of hours. Although many people express disbelief that the cost of quality can be computed so quickly, with an activity and cost atabase as extensive as the one developed for a FACT study, the assignment becomes straightforward. The activities are so detailed that each one is simply assigned to a cost of quality category or split between two categories. (The activity “train agents,” for example, is a cost of A FACT study is a relatively short – but intensive process. After data is collected, the information is entered into a proprietary software program, which produces summary reports for analysis. The study of all 1,000 employees at IPS took about two months to gather all the data, then another two months to analyze the ata and to develop initial recommendations. Since the FACT team consisted of twelve parttime members, it was possible to conduct the study without disrupting ongoing organizational processes. Restructuring through FACT analysis In discussions of advanced manufacturing techniques, it is often stated that implementation of just-in-time processes uncovers a “hidden factory” of overhead expenses for logistical, balancing, quality, and change transactions, all of which account for a large portion of the effort expended in production. 6 Similarly, Spring 1993 — 54 COST MANAGEMENT service organizations may discover overhead xpenses that were previously obscure by identifying “hidden service providers. ” This point is clearly illustrated by a situation uncovered through the FACT study at IPS.
The following example provides a fictionalized example of this situation. the Human Resources Department, all managers contribute to the activities “hire exempt employees” or “review employee performance. ” In each of the three examples, the actual cost incurred to provide these activities far exceeds the apparent cost shown in the respective department’s budget. Example of MIS manager. John, the vice-presi- The realization that actual activity costs often ignificantly exceed or fall short of presumed costs is of central importance in promoting and guiding restructuring. Restructuring is promoted by creating disenchantment with the status quo; it is guided by providing a sound basis for restructuring decisions. dent of management information systems at IPS, spends several thousands of dollars each year traveling to customer sites. Under the conventional accounting system, these expenses were charged to the travel accounts in his department. Meanwhile, directors of customer service departments for each product line reviewed their respective budgets and believed they were anaging all costs of customer service. As FACT revealed, however, customer service costs were higher than the costs indicated by the conventional cost system. Since 100 percent of John’s travel was related to supporting customers and resolving their problems, all his travel costs were allocated to the sub-activities “support and service agents and customers. ” As this example shows, IPS discovered that John was a hidden service provider; the true cost of customer service was higher than had been thought. Example of controller. The controller at IPS also discovered hidden service providers. Costs elated to the activity “administer financials” range far beyond the Accounting Department’s budget as it exists in typical cost accounting systems. At first glance, the controller believed that the FACT data were wrong, because the reported costs were twice what he expected. After reviewing the details, however, he agreed that the numbers were right. Managers throughout the company “help” the controller with such activities as “budget/forecast operations” or “document employee travel and entertainment expenses (T&E).
” Similarly, in Many managers simply do not understand the difficulties associated ith productivity of knowledge workers or else they lack the tools needed to adequately address the problem. Promoting efforts to restructure Managers resist change7 – or, at least, they resist unfounded or unjustified change. Once a foundation has been laid and changes justified, however, resistance quickly breaks down and may even turn into enthusiasm. The examples of hidden service providers given previously illustrate one way that resistance to change was overcome at IPS. Other means were used that were also based on the data collected during the initial phases of FACT. Pareto analysis, which is commonly taught as an nalytical technique in quality circles, involves sorting a set of items into descending order and focusing quality improvements on the top of the list – i. e. , on the largest items. Spring 1993 — 55 COST MANAGEMENT A Pareto analysis of activity costs is illuminating; managers are often surprised to discover how large the fraction of total costs occurs because of only a few activities. It is also surprising to note which activities show up at the top of the list. Managers often have an intuition that the cost of some activity is too high, but intuition alone cannot justify significant investments.
The relative positions of activity costs, however, can provide information that was previously unavailable for justifying corrective investments. A similar list of activity costs can be produced for each category of the cost of quality. Having this list allows managers to focus on the top offenders in each area. Focusing attention on the top of a sorted list, difference between value analysis and cost reduction. Cross-functional and cross-product summaries of activity costs. Perhaps the most powerful analysis enabled by the FACT process are crossfunctional and cross-product summaries of activity costs.
A matrix is constructed with an indented list of activity hierarchy on the left side and with the major functional areas or the product families across the top. As the fictionalized example in Exhibit 5 shows, the percentage of cost allocated to the activity “support and service agents” has a wide variance across products. Exhibit 3 shows that the total Exhibit Exhibit 5. Cross-Product Analysis however, tells only one half of the story. When Higgins gave one IPS executive an eight-page list of activity costs for the MoneyGram product, the executive was prepared to through away the last seven pages and focus on reducing he largest activity costs on page one. Higgins, however, pointed out that the activities at the bottom of the list are also candidates for attention, because important activities may not be receiving enough resources. For example, a costly activity at the top of the list may represent an internal or external failure cost, while an ignored activity at the bottom of the list may represent a preventive item that, with a small investment, could dramatically reduce the failure-related activity. This example illustrates the cost of this activity divided among eight subactivities. By itself, this bservation is interesting, but of limited value. The obvious next question is “Why? ” Fortunately, the FACT model provides a response. A FACT study includes a record of how each person’s time (and therefore salary) is allocated to activities. A department’s expense items (other than personnel) are also allocated to the activity. (Note that a department does not allocate its personnel costs as one cost pool. ) Thus, if an activity’s total cost is out of line or if the cost is oddly split between product lines, the supporting data is easily available for explaining these anomalies. In general, this audit trail of
Spring 1993 — 56 COST MANAGEMENT detailed data is crucial for investigating activity costs. Comparing ratios of activities. If the old cliche “numbers speak louder than words” applies anywhere, it applies here. The numbers are arrived at through a logical estimation process that is validated through a structured interview with each manager. Although the numbers may be only estimates, the ratios of activity costs provide powerful information. Suppose, for example, that the ratio between the activities “resolve agent problems” and “train agents” is 20:1. Even if the respective costs are off by 10 percent or even by 5 percent, the size of the ratio still suggests a potential problem and a way to solve it – namely, to reduce agent problems by increasing training. A similar conclusion may be drawn from an analysis of the cost of quality. Agent problems (a cost of external failure) may be reduced by investing in agent training (a cost of prevention). The data provided by FACT support either of these analyses. Cost of quality has been faulted by the quality expert W. Edwards Deming, who asserts that if you focus on process improvement, the cost of quality will take care of itself. The ease of computing cost of quality within the FACT ramework, however, can motivate efforts to change the status quo and to restructure. One of the most useful mechanisms for guiding restructuring is cost driver analysis. Cost drivers cause activities to be performed. They may be positive (customer orders) or negative (customer complaints). By eliminating negative cost drivers, the associated activity costs are also reduced. During the data collection phase of FACT, each activity is identified as being either missionrelated or not (see Exhibit 4). Employees may spend disproportionate time on activities that are not directly related to the mission of their work group.