Control Cost through Activity Based Costing

When it comes to controlling costs, most organizations control costs by general ledger account; i.e. they look to their Income Statement. So when you have to cut costs, you look at your expenses and say to yourself: "Payroll is $ 100,000 and utilities is $ 5,000; we can't cut off our utilities, but we can sure cut payroll."

This short-sided approach to cost control often leads to the destruction of value within the so-called value chain. When you cut people, the activities they perform may still be there, but no one's around to perform the activity. So you end-up creating black holes in the organization that destroys employee value. Once you've destroyed employee value, this leads to poor customer service and hence, the destruction of customer value. Now that you've lost your customers, this translates into the destruction of shareholder value. So you end-up destroying value within the entire value-chain: Employee, Customer, and Shareholder.

A better approach is to control your costs by activity. Under this approach, you now look at your expenses by activity; such as costs to process customer orders, costs to run payroll, costs to recruit new employees, etc. The key is to reduce costs that fail to serve internal or external customers. You can easily do this by simply focusing on RE-type activities. For example, Retype the letter, Re-inspect the pipe, Re-enter the accounting entries, etc. Try to eliminate RE-type activities and you will improve your process immensely and cut costs at the same time.

The formal system for controlling costs by activity is referred to as Activity Based Costing . Activity Based Costing (ABC) is not easy to implement, but once working it can open your eyes to a whole new approach to cost control. You leverage ABC information by making management decisions - this is called Activity Based Management (ABM). And once you have ABM working, you can implement Activity Based Budgeting and ultimately build a model to look at both costs and revenue drivers. For now, I highly recommend that all organizations think in terms of activities, not in terms of general ledger account. Otherwise you run the risk of destroying value within the value chain.