SOX + ABC = VALUE!

Whitepaper Seriess

Mitchell Max

Managing Partner

The Performax Group

mmax@performaxgrp.com

www.performaxgrp.com

SOX + ABC = VALUE!

Whitepaper

pg_0002

The alignment of two seemingly unrelated stars in the Finance universe is creating a new

opportunity for CFOs. Recently, companies have invested heavily in documenting and

strengthening controls over business processes to support improved risk management in

accordance with requirements such as Sarbanes – Oxley (and, for financial services

organizations, Basel II), or to support process initiatives such as Six Sigma. At the same

time, a new and innovative approach to developing accurate and meaningful cost

information - Time-Driven Activity-Based Costing, has been evolving which directly

leverages process documentation, dramatically reducing implementation time and cost.

Organizations that have made early forays into Activity-Based Costing (ABC) have often

struggled to capture significant ongoing value from their ABC investments. Traditional

approaches to ABC rely heavily on surveys and estimates, and large staff groups to

maintain the systems, provide reports, and interpret the information for users. While few

question the value of the information, the cost of developing and maintaining it continues

to escalate. The rise of Time-Driven ABC, however, is beginning to provide CFOs with

better information at lower cost.

This paper explores some of the weaknesses of traditional ABC and demonstrates how

the new Time-Driven ABC overcomes many of these problems. At the same time, the

paper shows how Time-Driven ABC leverages existing process documentation to support

development of accurate and actionable cost information in a cost effective and timely

manner.

Limitations of Traditional Activity-Based Costing

Contrary to popular belief, costing is not an exact science. Traditionally, it relies heavily

on estimates and averages. For example, in an ABC study the practitioner will ask

employees to allocate their time across a number of pre-defined activities. The costs of

those activities are then assigned to products and/or customers based on average

consumption for those activities. This approach is appropriate in situations where

peoples’ roles remain relatively constant over time, and where the effort to service

customers is relatively consistent. In practice, the use of averages has been tolerated as

indirect costs have historically been less significant than direct labor (and material) costs.

Today, the opposite is the norm, as centralized costs significantly outweigh front-line

expenses in many organizations, particularly those with a service focus.

Page

pg_0003

Where averages and estimates were deemed to be inappropriate, practitioners introduced

different approaches. For example, if work effort changes significantly from period to

period, then surveys would be done more frequently (e.g., monthly). This requires a

significant investment in costing infrastructure to obtain and process updated time

surveys. In situations where consumption patterns differed, for example, based on ranges

of service complexity, complexity weightings would be estimated and established for

different products or customers.

These approaches are frequently inappropriate in today’s world. As organizations

centralize their business processes (with a corresponding increase in the level of visible

cost), potential variations in costing to meet the unique needs of customers have become

a much more evident.

Change in company operations is a constant. Centralized operational areas make wide

use of flexible work arrangements, shifting resources on an ongoing basis to match work

volumes, aided by cross-training and intelligent technologies. Allocation of effort on this

basis would require much more in-depth time tracking if a traditional ABC approach is

used.

At the same time, our experience continues to point that ‘average’ cost consumption by

products and customers has never been more inaccurate: wide variations from the average

are the new norm, based on the need to meet unique customer requirements to win

business (often with little impact on price).

What has the result been? Some companies have chosen to invest heavily in data

gathering in order to provide the necessary levels of accuracy. For many others, the

reliance on cost averages diminishes the accuracy and transparency of cost and

profitability information, which in turn creates skepticism around the output produced

and distrust of it for decision-making. For these reasons, Finance organizations have

difficulty justifying their ongoing use of the information other than for limited purposes,

and legacy systems are being targeted for “simplification”.

This need not mean that the baby is thrown out with the bathwater. Cost information –

even though expensive to produce - continues to be utilized for specific purposes: for

example, to provide relative product cost information or to support allocations. Few

organizations, however, have been able to make the transition to a comprehensive use of

cost information as the foundation for Performance Management.

The New Alternative

Against this backdrop, we began a search for a different approach which would allow

organizations to derive high value from cost and profitability information, but a

significantly lower cost of development and maintenance. Time-Driven ABC emerged as

a new approach that we have been able to employ in many of our client engagements.

Page

pg_0004

Described at length by Dr. Robert Kaplan and Steve Anderson

, Time-Driven ABC

provides a method which is both simple in concept and powerful in execution.

Coincidentally, our work led us to discover the synergies that exist between Time-Driven

ABC implementations and the use of existing process documentation. Recently,

organizations have spent significant amounts of cost and effort to document business

processes. This is a requirement, both for compliance with Sarbanes-Oxley or Basel II,

and also for analysis and ongoing measurement for process improvement initiatives such

as Six Sigma. Time-Driven ABC is able to capitalize on this investment by translating

process flow documentation into a cost flow model, and in turn by placing reliance on

process consistency as the basis for model building.

In essence, Time-Driven ABC works by understanding the amount of effort required to

process any given transaction, and by attaching cost to each specific transaction is able to

accurately measure costs by activity (process), products, customers (and/or segments),

and channels.

Consider a loan processing operation: (An illustrated example is provided later in this

article.) In a traditionally ABC approach, we would interview groups of personnel to

determine what types of activities they engage in (for example, application processing,

credit checks, loan fulfillment, etc.), and what portions of their time are spent in each

respective activity. We would then count the number of times they perform each of these

activities and use that as the basis for allocating activity cost to products, customers,

channels, etc.

In a Time-Driven approach, rather than interviewing personnel, we review existing

process documentation and determine, either through discussion or observation, the

amount of effort required to complete each stage of the business process. Where

complexity occurs, for example if additional steps are required for a given loan type, we

would seek to understand what attribute of the transaction would give rise to that

additional effort (e.g., a secured loan which requires additional documentation). The next

step is to use the operational transaction files themselves as the basis for calculating

costs. Rather than requiring separate extracts of transaction volume counts (or requiring

manual transaction counts by employees), we review the transaction’s attributes and infer

from that the work steps that would have been required to process the transaction. In the

example of a secured loan, we could assume that the required procedures were followed

to verify the loan security of each given type (i.e., drive-by, appraisal, legal review, etc.)

and compute the total amount of effort required from each resource as the basis for

computing cost.

This approach has several advantages over the traditional ABC methods:

Costs are highly transparent and explainable to management. Rather than

indicating that costs are allocated, this is a true consumption model that is able to

Robert S. Kaplan and Steven R. Anderson, “Time-Driven Activity-Based Costing”, Harvard Business

Review, Nov 2004

Page

pg_0005

show the amount of effort required by each product, customer, etc. As such it is

much simpler for management to understand, and facilitates an understanding of

the linkage between costs, activities and outputs. Particularly when cost is used

as a basis for pricing of customers based on the level of service they receive, the

ability to trace and explain costs based on the actual service volumes and costs is

a significant advantage in supporting effective communication. This approach

has provided many of our clients with the ability to significantly improve their

price margins with key customers.

Costs (and profitability) are accurately captured in all dimensions (product /

customer / channel etc.) at the same time. This makes it much easier to model and

analyze cost behaviour and profitability dynamics.

In a traditional model, the costs of the entire resource group are allocated to all

users of that resource. In the Time-Driven approach, only the costs of time (or

effort) expended are assigned to outputs. The cost of unused capacity is not

automatically assigned, but is explicitly reported and made available for

management purposes. In a world with significant fixed levels of capacity, the

ability to better manage the available capacity is critical to profitability. In one of

our clients, this has provided millions of dollars of benefits and has been

recognized as a key driver of their strengthened profitability.

In a similar manner, Time-Driven ABC explicitly recognizes the distinction

between fixed and variable costs, allowing an understanding of actionable cost

can be developed. For example, when developing re-engineering plans, it is

critical to identify the true variable impact on costs. This approach also supports

the utilization of cost information for driver-based planning and forecasting

purposes, and enables effective simulation and what-if analysis based on

underlying changes to business volumes.

Development and maintenance are significantly reduced, in a number of areas:

The use of existing process documentation reduces the need to interview

and map effort;

Since process work levels only change when systems or processes

themselves are changed (i.e., re-engineered), updates to effort levels are

not required on a regular basis. Volume changes dynamically drive

changes to the levels of effort and corresponding costs;

There is significantly less need for time-tracking on an ongoing basis,

except for situations where time is the only driver and the amount of effort

is not predictable (i.e. advisory work); and

System extracts are simplified, as the tools themselves determine the

volumes based on the transaction logs, instead of custom-built systems

queries.

In a practical measure, our experience has allowed us to model business areas and

generate actionable information in significantly less time – and at lower cost - than ever

before. We are building high-quality models in as little as 2-3 weeks with minimal

Page

pg_0006

operational interference, dramatically improving our ability to drive action in

organizations and “strike while the iron is hot”.

Some organizations have employed detailed time-engineering statistics or “time-wands”

as the basis for costing. Our experience is that, while we can use this information as the

basis for a Time-Driven model, the level of granularity is too detailed to be maintained

effectively. A higher level of analysis, combined with a better understanding of the

sources of process differentiation, can provide the desired level of accuracy at a lower

cost.

Time-Driven ABC may not be appropriate in every situation within a company. In areas

where there is little differentiated complexity or work effort, costs are relatively fixed or

the outputs are homogeneous, (for example, a group responsible for data input or

managing a copy facility) a simple allocation may provide sufficient accuracy. Similarly,

for situations where the amount of time cannot be effectively predicted, such as advisory

work or consulting, a more formal time-tracking system may be required. It is important

that users select a costing system which has the flexibility to adapt to use the most

appropriate method in each situation within the same model.

Leveraging Your Finance Investment

Over the past few years, Finance organizations have made considerable investments in

their infrastructure. While most CFO’s value the information that a good ABC system

can provide, the appetite for yet another project with its associated funding is hardly

appealing.

Based on our client work, we would encourage CFO’s to consider the synergies that

exist, from two perspectives:

First, utilize ABC information to satisfy other business requirements. ABC can provide

new or improved information for other purposes, such as:

•

Cost allocations for Line of Business reporting;

•

Performance Measures (KPIs) for operational scorecards;

•

Process cost information to support re-engineering and continuous improvement

measurement

Too often, the value of ABC information is viewed in a silo. In the past, practitioners

urged their clients to choose between strategic ABC information (e.g., product or

customer segment profitability) and operational ABC information (e.g., process cost and

performance management). Traditional systems necessitated that these two views could

not co-exist in the same application, as the level of detail required for the latter would

make it cumbersome to produce the former. Our experience with Time-Driven ABC is

showing that these two different approaches can – and in fact should – be incorporated in

the same model. Thus, it is truly practical for ABC to be built from the bottom-up and

yet still be used to serve strategic cost analysis. A bottom-up build is critical for

Page

pg_0007

supporting cost allocation models on a basis that satisfies the need for information

transparency within the organization.

Second, as we have discussed, ABC information can be directly developed based on the

process maps and controlled information systems that are being developed to help

organizations comply with Risk Management and/or Six Sigma requirements. We have

been able to demonstrate a repeatable process that directly leverages this investment to

rapidly produce an accurate and transparent ABC model.

In particular, we have found that this methodology is directly aligned with the

management processes and metrics that operational managers use daily in running their

business, and as such they can easily begin to leverage the information in their

operational management programs. For example, operational managers explicitly

manage productivity measures such as the number of applications per hour that can be

directly translated into the effort component in a cost model. This builds quick buy-in

outside of Finance and ensures that consistent information is used across the business.

Conclusion

We have been excited by the ability to leverage our clients’ investments in risk

management process documentation and control to develop and use cost information

quickly and cost-effectively, by applying Time-Driven ABC. This methodology creates

higher value than traditional methods by providing improved accuracy and transparency,

and has a significantly lower cost of development and maintenance. For those

organizations that have abandoned ABC, we encourage you to use this opportunity to re-

evaluate. For those that have not yet embarked on an ABC program, the cost of entry is

now much less than ever before. We encourage you to seek new ways to derive value

from your Finance investments.

Page

pg_0008

Applying Time-Driven ABC – An Example

ARN Financial Corporation undertook an ABC study for the Line of Credit origination

process. Before commencing the study, the ABC team obtained and verified a process

map which had been prepared for the department, and obtained time estimates (in

minutes) for each major step in the process. The process map is shown in Figure 1:

Figure 1

Department: LOC Processing

EXPENSES

GL $

SALARIES AND BENEFITS

PERSONNEL COSTS - FULL TIME 300,000

PERSONNEL COSTS - HOURLY

40,000

BENEFITS

119,000

FACILITIES

80,000

COMPUTER COSTS

130,000

TELECOM COSTS

44,000

POSTAGE, COURIER & FREIGHT

23,000

STATIONERY, SUPPLIES AND REPAIRS 6,000

TRAVEL & ENTERTAINMENT

4,000

OTHER

2,000

748,000

FTE's

Capacity [21 days @ 7.5 hrs/day]

12,915

Capacity Hours @ 80%

10,332

Cost per Minute @ "Normal" Capacity

1.21

The first step was to calculate the cost per

minute for time worked. In this example, we

elected to treat all costs as a single cost pool for

purposes of illustration. Further, all costs were

assumed to be variable. Figure 2 shows the

calculations. Based on a workday of 7.5 hours,

and assuming normal utilization at 80% of

capacity, we calculated a total cost per minute

of $1.21.

Using actual volumes for each step in the study

period, we (1) determined the total minutes of

time consumed by the resources for each step,

(2) multiplied the minutes by the cost per

minute, and (3) calculated the amount of used

and unused capacity (Figure 3):

Figure 2

Task

Time Volume Minutes Cost Unit Cost

Request LOC

2 30,000

60,000

72,396

2.41

Receive LOC via Fax 6 6,000

36,000

43,438

7.24

Receive LOC via W eb 1 15,000

15,000

18,099

1.21

Receive LOC via Phone 8 9,000

72,000

86,876

9.65

Manual check

3 6,000

18,000

21,719

3.62

Perform rush request 5 4,500

22,500

27,149

6.03

Perform credit check 10 27,000

270,000

325,784

12.07

Setup new customer 5 9,000

45,000

54,297

6.03

Complete LOC

2 22,500

45,000

54,297

2.41

583,500

704,055

Actual Cost

748,000

Difference (unused capacity)

43,945

Time-Driven Analysis

In our example, although costs

in aggregate are $748,000,

only $704,055 can be directly

attributable to work performed.

The balance of $43,945

represents unused capacity

which is available to handle

additional work volumes.

Figure 3

Page

pg_0009

Next, each the activity costs are applied to each loan transaction. For illustration, we

have pre-aggregated the transactions. ARN’s interest is in analyzing costs by Product

and Channel. The volumes for each product/channel combination are costed out

separately (Figure 4). In addition, we segregated the loans into two groups: funded loans

and those which dropped out as they moved through the origination process.

Unit Cost 2.41

$ 7.24

$ 1.21

$ 9.65

$ 3.62

$ 6.03

$ 12.07

$ 6.03

$ 2.41

Total Vol 30,000

6,000

15,000

9,000

6,000

4,500

27,000

9,000

22,500

Product Channel Loan $

Secured Direct

2100 600 1200 300 600 300 1200 0 0 32,216

Secured Direct 703,107,000

4500 1800 2100 600 1800 660 4500 1200 4500 115,110

Secured Broker

900 0 900 0 0 120 300 0 0 7,602

Secured Broker 731,231,280

3900 0 3900 0 0 540 3900 3600 3900 95,563

Unsecured Direct

2700 2400 0 300 2400 180 1500 0 0 54,659

Unsecured Direct 600,547,200

4800 1200 1800 1800 1200 840 4800 900 4800 124,160

Unsecured Broker

1200 0 1200 0 0 300 900 0 0 17,013

Unsecured Broker 474,807,630

3300 0 3300 0 0 240 3300 3300 3300 81,084

Overdraft Direct

600 0 0 600 0 120 600 0 0 15,203

Overdraft Direct 38,940,000

6000 0 600 5400 0 1200 6000 0 6000 161,444

30000 6000 15000 9000 6000 4500 27000 9000 22500

2,548,633,110

704,055

Figure 4

Finally, we summarized the costs and

the originated loan values by Product

and Channel, and determined a number

of key metrics associated with this

process (Figure 5). As a result, vastly

different unit costs and cost per dollars

of loan originated are apparent under

each product / channel combination. In

addition, recall that the cost of unutilized

capacity has not been applied to these

dimensions, but is reported separately

for management.

Product

Direct Broker Total

Cost of Sales 147,327 103,165 250,492

Unit Cost

$32.74 $26.45 $29.82

Cost/Rev 0.0210% 0.0141% 0.0175%

Cost of Sales 178,819 98,097 276,916

Unit Cost

$37.25 $29.73 $34.19

Cost/Rev 0.0298% 0.0207% 0.0258%

Cost of Sales 176,647

176,647

Unit Cost

$29.44

Cost/Rev 0.4536%

0.4536%

Cost of Sales 502,793 201,262 704,055

Unit Cost

$32.86 $27.95 $31.29

Cost/Rev 0.0374% 0.0167% 0.0276%

Total

Channel

Secured

Unsecured

Overdraft

Figure 5

When examining any particular cost, it is completely transparent to understand which

activities and costs gave rise to any particular item by referencing the associated volumes.

This facilitates a proactive discussion of the opportunities available to better manage cost,

and ultimately profitability.