time-driven abc in “a bank”
TRANSCRIPT
TIME-DRIVEN ABC IN “A BANK” Using Business Intelligence Capabilities to Allocate the Operational Labor Cost
by Time-Driven Activity-Based Costing
Company Project
Author: Cigdem Simsek / 10839623 Supervisor: Dr. R.J. (Rui) Oliveira Vieira Program: Amsterdam MBA – Part-time
Date of Submission: 31/08/2016
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Abstract
With the increasing complexity and the quantity of business transactions, organizations are
seeking for new solutions for the decision making processes continuously. Management
Accounting is a processes of combining the financial and non-financial data to create a
knowledge-based decision making environment. Technological improvements stimulate the
innovations in Managerial Science as well as in Management Accounting. Innovations in the
design of Cost Structure, as an important component of the business model, contributes
granularity, simplicity and visibility to organizations’ profitability analysis and decision making
processes.
Cost allocation methodologies have emerged from the necessity of an accurate cost calculation
for the products or services in order to estimate the profitability properly after the traditional
costing, and it has increased a substantial attention in the academic environment.
Nevertheless, the application has fallen behind the estimations because of the challenges and
difficulties in the applications of the methodologies in practice. Time-Driven Activity Based
Costing (Time-Driven ABC), as the latest design of ABC proposed by Kaplan and Anderson
(2003), introduced some solutions towards the difficulties and complexity in the existing cost
allocation methodologies.
With this study, first of all, the emergence of the cost allocation methodologies and the
implementation will be discussed in detail. The challenges and the solutions that are provided
by the methodologies will be given based on the current researches from the literature. In the
second part, “A Bank” will be introduced with the business overview and the existing cost
allocation methodology, then the case will be explained and the Time-Driven ABC will be
applied as a pilot study. Finally, the outcomes of the study will be discussed in three sections,
namely, profitability effects, capacity utilization analysis, and the comparison of the cost
allocation rates between the existing cost allocation methodology and the proposed
methodology.
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Table of Contents
List of Abbreviations ..................................................................................................................................................... 3
Table of Figures ............................................................................................................................................................. 4
I. INTRODUCTION .................................................................................................................................................... 5
II. LITERATURE REVIEW ............................................................................................................................................ 8
A. Costing System ............................................................................................................................................... 10
B. Cost Allocation ............................................................................................................................................... 11
i. Relevance of Cost Allocation ..................................................................................................................... 12
ii. Historic Evolution of Cost Allocation Methodologies .............................................................................. 13
C. Traditional Costing ......................................................................................................................................... 15
i. Traditional Costing Implementation ......................................................................................................... 16
ii. The Challenges and Disadvantages of Traditional Costing ....................................................................... 17
D. Activity Based Costing ................................................................................................................................... 18
i. ABC Emergence and Relevance ................................................................................................................. 19
ii. ABC Implementation ................................................................................................................................. 20
iii. Activity Based Management ................................................................................................................. 22
iv. Advantages and Benefits of Implementing ABC ....................................................................................... 23
v. Disadvantages and Challenges of Implementing ABC .............................................................................. 26
E. Time-Driven ABC ............................................................................................................................................ 27
i. Time-Driven ABC Implementation ............................................................................................................ 28
ii. Issues Addressed by Time-Driven ABC ...................................................................................................... 29
F. Cost Allocation in Finance ............................................................................................................................. 30
G. The Role of Information Technology ............................................................................................................. 32
III. TIME-DRIVEN ACTIVITY BASED COSTING IN “A BANK” ................................................................................ 33
A. About “A Bank” .............................................................................................................................................. 35
i. Vision, Mission and Values ........................................................................................................................ 36
ii. Business Model .......................................................................................................................................... 36
B. Research Method and the Scope of the Study .............................................................................................. 37
C. Existing Cost Allocation System in “A Bank” ................................................................................................. 41
D. Time-Driven ABC Application to Operational Labor Cost ............................................................................. 43
i. Customer Transaction Analysis ................................................................................................................. 45
ii. Activity Analysis & Activity Cost Analysis ................................................................................................. 46
E. Results / Managerial Impacts ........................................................................................................................ 52
F. Challenges of the Applied Methodology ....................................................................................................... 59
G. Future Studies ................................................................................................................................................ 60
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IV. CONCLUSION .................................................................................................................................................. 61
V. REFERENCES ........................................................................................................................................................ 62
List of Abbreviations
AA Activity Analysis
ABC Activity Based Costing
ABC/M Activity Based Costing / Management
ABM Activity Based Management
ACA Activity Cost Analysis
CDA Cost Driver Analysis
EDI Electronic Data Interchange
ERP Enterprise Resource Planning
PMMP Professional Money Market Player
TDABC Time-Driven Activity Based Costing
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Table of Figures
Figure 1: A Time-Line of Managerial Accounting and Industrial Developments (Hutchinson 2007, p.27) 14
Figure 2: A Simple Costing System (Horngren 15e, p.154, e.5-1) ............................................................... 16
Figure 3: An Activity-Based Costing System (Horngren 15e, p.162, e.5-3) ................................................. 21
Figure 4: The four levels of activity management (Gosselin 2007, p.647) ................................................. 23
Figure 5: ABM Value Chain (Swenson, 1997) .............................................................................................. 25
Figure 6: Activity-based costing, activity-based costing systems implementation method on the time
differences (Ozyurek and Dinc 2014, p.107) ............................................................................................... 29
Figure 7: The group chart of “A Bank” ........................................................................................................ 35
Figure 8: Product and Service Matrix in “A Bank” ...................................................................................... 37
Figure 9: Cost Allocation Structure in “A Bank” - Profit before Tax = Gross Profit – Operating Expenses . 42
Figure 10: Available Product Groups and Transaction Types for Corporate Banking Customers .............. 46
Figure 11: Transaction Type - Activity Matrix with the Resource Usage in min ......................................... 47
Figure 12: Cost of cash loan opening transactions ..................................................................................... 49
Figure 13: Data Warehouse Tables for the Cost Analysis ........................................................................... 50
Figure 14: Data Warehouse Tables for the Result ...................................................................................... 51
Figure 15: Transaction Level Profitability Analysis ..................................................................................... 52
Figure 16: Customer Level Profitability Analysis ......................................................................................... 53
Figure 17: Capacity Utilization of Corporate Banking ................................................................................. 56
Figure 18: Resource Usage in Customer Service, Corporate Credits and Trade Finance Activities for
Corporate Banking Unit's Customers .......................................................................................................... 58
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I. INTRODUCTION
The competitiveness of today’s business environment forces organizations continuously to
focus and adjust their business models’ according to the market needs and also according to
their resources and capabilities. The Revenue Structure and the Cost Structure are the two
important components of the organizations’ business models. Revenue Structure usually relies
on the pricing strategies and managed by the product related departments such as marketing,
sales, product management. On the other hand, Cost Structure is related to almost all
components that form the organizations.
Traditionally, since the product and service complexity was not as intense as it is today, the
costing used to be done with the simple methods and used for the financial reporting purposes.
Today, the organization structures, product/service diversity and the complexity have been
evolving constantly and it becomes more difficult to oversee the performance of the
organizations.
Management accounting disciplines provide organizations with frameworks such as forecasting
and budgeting, cost allocation and balanced scorecards to create information to ensure the
knowledge-based decision making. With the cost allocation frameworks, organizations become
more aware of how they are doing about what they are doing. The resource usage, capacity
utilization, performance management, inefficiencies have become more visible with the
management accounting cost allocation initiatives. These initiatives can be used in any industry
regardless of the product or service types based on the industry specific drivers.
In financial institutions industry, the products are intangible services, and most of the products
interact with each other, which makes it more difficult to track and trace the performance and
profitability of the products/services. On the other hand, financial institutions are highly tied
with the boundaries of the regulations, which force them to create infrastructures to ensure
the transparency and compliance. Moreover, the financial institutions are mostly tied within
the boundaries of the regulations in terms of pricing as well, therefore, the cost structure is
critically important for their performance and profitability.
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In “A Bank”, management accounting practices are held by two business units; one of them is a
separate unit under financial control department, and manages budgeting and forecasting, cost
allocation, and other cost related analysis, the other business unit is the risk management
which manages the provisioning, scoring, and the risk assessment of the bank.
The existing practice for allocation of the overhead costs in “A Bank” has been managed on the
business unit level, therefore there is no granularity on the transaction and customer level.
Furthermore, the existing cost allocation depends on the high level estimations of the usage
level of all business units by the business units which generate the revenue. Thus, it does not
reflect the resource usage in the transaction level. The profitability of transactions and
customers include only the revenue and the direct costs. The net income after all expenses and
indirect costs can be observed in the business unit level.
This study aims to break the overhead cost data to the transaction level with time-driven ABC
application by using the business intelligence capabilities in “A Bank” with a pilot study. The
scope of this study will be limited to one unit’s customers and also it will be limited to one type
of overhead cost which is the operational labor cost. The targeted result of this study is to have
a transaction level operational labor cost breakdown, and to re-calculate the transaction and
customer level profitability including the operational labor cost, which will give the information
of how much the resource usage effects the profitability of transactions and customers. In this
study, Time-Driven ABC is going to be used to allocate the overhead cost, as this framework
was proposed as a simpler and more convenient methodology recently. And also the margins
are getting lower and lower with respect to the increasing complexity of the product offerings
that stimulated to initiate this study to develop more accurate cost allocation system.
There has been many studies related to cost allocation methodologies. Traditional Costing as
the oldest framework in the literature provides a very simple, straight-forward methodology to
allocate the overhead costs in the organizations. Over the time, the simplicity of the framework
has become a disadvantage in terms of losing the granularity and visibility, and also it lacks
coherence with the real usage amount of the resources, because the framework basically
proposes an allocation methodology based on one or few number of cost drivers which is
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mostly defined as the volume. Therefore, regardless of the resource usage of different products
or services, the cost is allocated evenly based on the outcome.
This has led academic researchers to find new ways to allocate cost properly to reflect the real
resource usage, and Activity Based Costing (ABC) has emerged. The framework has been
studied continuously. The framework relies on allocating the overhead costs based on the cost
drivers in relation with the overhead cost type, and it also aims to allocate the cost based on
the real resource consumption by the activities that are performed to complete the products.
However, ABC application has fallen behind the expectations because of the application and
maintenance issues. It requires constant adjustments within the numbers of cost drivers, when
the new products and activities emerge.
Recently, Kaplan and Anderson (2003) have proposed a new methodology which has been
derived from conventional ABC, called Time-Driven ABC. It eliminates the complexity and brings
simplicity in a way that can still reflect the effect of resource consumption.
In the literature section, the costing terminology, existing methodologies for cost allocation,
advantages and the challenges of the methodologies will be discussed with a comparative view.
In the application section, detailed information about “A Bank” and the existing cost allocation
system will be given. Afterwards, time-driven ABC will be applied on the operational labor cost
for one pre-selected business unit’s customers. As a result, it is aimed to create a transactional
and customer level cost analysis to contribute to the knowledge-based decision making in “A
Bank”. Furthermore, with time-driven ABC application it is also aimed to derive capacity
utilization analysis for the internal performance analysis.
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II. LITERATURE REVIEW
Activity Based Costing has emerged in the late 80s and early 90s because of the lack of accuracy
of the cost allocation calculations with traditional costing methodology. Traditional costing,
most of the time uses one cost allocation base or a small number of cost allocation bases to
allocate all overhead costs, which usually results with some products carry the weight of cost of
more costly products. The cost allocation base used for traditional costing is mostly labor hour,
machine hour or the volume; when the labor hour is the cost allocation base, the labor intense
products will bear the cost of the products which require intensive machinery expenditure, and
vise-versa for the costing systems where machine hours is used as the cost allocation base and
the machinery intensive products carry the cost of the products which require expert labors
with high salaries such as consultancy businesses. As Horngren, Datar and Rajan (2015, p.179)
explained, the product diversity makes it difficult to capture the differences in resource usage
and creates distortion in the cost information.
Activity Based Costing was proposed as an alternative costing methodology to traditional
costing methodology. Akyol, Tuncel and Bayhan (2007, p.136) stated that “…ABC assigns costs
to activities using multiple cost drivers, then allocates costs to products based on each
product’s use of these activities”. In other words, ABC divides overhead costs to cost pools
which represent the activities/resources and allocates costs based on the activity/resource
usage for each product or any other cost object, by using the related cost driver for each
activity/resource.
Nevertheless, even though ABC gives a more accurate cost allocation calculation, it has some
disadvantages in terms of application which will be explained further in the following sub-
sections. First of all, it is a very complicated framework to establish in the first place, and
secondly, it can be very difficult to maintain and update the ABC with the changes and additions
of activities in the organizations. As Gosselin (2007) mentioned that besides the
implementation difficulties, there has been confusion about what ABC is. As the ABC has been
found as a cost management framework, Activity Based Management (ABM) concept has been
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emerged. Gosselin (2007) framed ABM as “The four levels of Activity Management”, which
includes several levels such as Activity Analysis (AA), Activity Cost Analysis (ACA) or Cost Driver
Analysis (CDA), Pilot ABC, and Full ABC. In the literature, some studies do not mention about
four levels, but introduce ABC as a full framework including all levels, and some studies, like
Gosselin (2007), introduced them as separate frameworks and proposed that companies can
only apply Activity Analysis or Activity Cost Analysis and still considered as ABM implementers
up to some level. Therefore, it is also difficult to distinguish, what kind of ABM framework that
companies apply, when they are asked whether they apply ABC or not.
Gosselin (2007), proposed a comprehensive study, where he analyzed the surveys that were
implemented over the ABC implementation in companies. After a decade of intensive academic
research on ABC, the researches and surveys have shown that the ABC still didn’t get enough
attention from the companies. Even though some companies started applying ABC, many of
them abandon ABC during the project phases because of the application and maintenance
difficulties.
After ABC emerged from traditional costing system, in the late 90s, Kaplan and Anderson (2003)
has introduced Time-Driven ABC, which proposes a simplified ABC framework. Time-driven ABC
identifies the unit costs of activities in terms of time, and it identifies the necessary time period
to perform each activity. With this way, Kaplan and Anderson (2003) provided a straightforward
calculation, where the product costs calculated by the usage time of each activity multiplied by
the unit cost of the activities, which is easy to establish and also maintain.
In the next sub-sections, first of all, costing systems, why it matters, the basic definitions such
as the direct and indirect costs and the use of costing systems will be discussed; secondly, cost
allocation component of costing system, basic definitions for cost allocation such as cost driver
and overhead cost, cost allocation methodologies and the emergence of cost of allocation
methodologies will be discussed; then in the following sections traditional costing, ABC and
time-driven ABC frameworks will be discussed in terms of the implementation, advantages of
the frameworks and the issues addressed with the frameworks, disadvantages and challenges,
and the differences between the frameworks; and finally the information management impact
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on cost allocation implementation, how it effects the evolution of cost allocation
methodologies, and the practicality of costing systems in companies will be discussed.
A. Costing System
Cost accounting system or management accounting system provides frameworks for internal
profitability, forecasting, budgeting and valuation analysis of the companies. Even though it
should be in accordance with financial accounting figures, it can give information from different
aspects which do not exist in the financial accounting reporting.
Many researchers like Akyol, Tuncel and Bayhan (2007) point out the fact that companies, all
around the world, are facing with a global competition in terms of flexibility, pricing,
profitability, organizational structures, value chains, supply chains and many others. Moreover,
the products and services become more complex, and it becomes more difficult to trace each
product and service because of the joint and cross-functional processes. This complex and
competitive environment triggers the necessity of more flexible and automated systems for
cost calculations. It is crucial for companies to identify the costs of the product and services in
order to be able to reduce costs and increase the productivity and profitability. Also, the
complexity of overhead costs increase the necessity of an accurate costing system within
today’s competitive world, as Akyol, Tuncel and Bayhan (2007, p.136) refers “…it is impossible
to sustain competitiveness without an accurate cost calculation mechanism”.
In most of the industries, prices are restricted by the competition or the regulations, companies
spend a lot of resources on their pricing strategies for having the correct pricing for each
product or service line. One determinant of the pricing is the product or service cost. In order to
have a more accurate and competitive pricing, companies need to have an accurate costing
system. Furthermore, when companies are bounded to the limits of competition and
regulations to adjust their pricing, accurate costing system helps them to see inefficiencies in
the processes and it provides ability to make deliberate decisions, such as abandoning
unprofitable products, improving supply chains, deciding on the product mix, or make or buy
decisions, etc. It helps them to decrease the cost levels that stimulate the increase in margins.
Hundal (1997, p.93) stated that “Management accounting is used for internal reporting to
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management for decision-making, planning and control” and also “Management also uses the
cost information to make decisions such as make or buy, pricing the product, to decide on the
product mix, etc.”.
Moreover, cost information has been used for planning and control processes of companies,
such as budgeting. Proper cost division to the related business units is crucial for financial
departments to allocate budget for the upcoming years, otherwise divisions might have a
shortfall or excess budget which critically influences the performance of the divisions. As
Hundal (1997, p.93) stated “Performance of various units is judged on the basis of costs, thus
cost information becomes a means of exercising control”. Not only for the business unit
performance, but also the overall company performance can be affected due to the missing
opportunities arises from budget shortfalls.
Costing system combines two different approaches for two different types of costs, which are
direct and indirect costs. Direct costs are the costs that can be directly linked to the products or
services and can be traced to assign cost to the related product or service. In the costing
system, these costs are traced to products and assigned as cost of goods sold for the sold items
and inventory cost for the unsold items in the accounting system. Indirect costs are the costs
which are not directly linked with particular products or services; depreciation of the plant and
machinery used for more than one product can be example of indirect costs, it can also be
called overhead costs. In the costing system, indirect costs are allocated to the products or
services based on the cost drivers. In the next sections, cost allocation will be described with
more details in terms of historical evolution and the methodologies.
B. Cost Allocation
Cost allocation is the identification and assigning costs to cost objects. It is called “allocation”,
because there is no direct linkage between the overhead costs and the products or services that
are provided for customers. These costs cannot be assigned precisely, therefore cost allocation
frameworks provide approaches to assign costs to cost drivers, by doing so, companies try to
approximate the total cost of the products sold or the services provided.
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Horngren, Datar and Rajan (2015, p.53) explains the necessity as “Managers want to assign
costs accurately to cost objects because inaccurate product costs will mislead managers about
the profitability of different products”.
Horngren, Datar and Rajan (2015, p.56) describes cost driver as “… a variable, such as the level
of activity or volume, that causally affects costs over a given time span. An activity is an event,
task, or unit of work with a specified purpose—for example, designing products, setting up
machines, or testing products. The level of activity or volume is a cost driver if there is a cause-
and-effect relationship between a change in the level of activity or volume and a change in the
level of total costs”. Cost driver is also called “cost allocation base” in some resources. A cost
driver can be direct labor hour, machine hour, headcount, etc. A company can use one cost
driver for all overhead costs, or multiple cost drivers for different types of overhead costs.
Horngren, Datar and Rajan (2015, p.61) describes the overhead cost as “… all manufacturing
costs that are related to the cost object (work in process and then finished goods) but cannot
be traced to that cost object in an economically feasible way.”
i. Relevance of Cost Allocation
Academic researches about cost allocation have been evolved over time. Rasiah (2011)
argued that cost allocation studies date back to 1870s, when the manufacturing
processes were simpler than they are today. Both non-profit and profit organizations
need to analyze their costs for effective resource usage and for fair evaluation of the
performance of organizations. Without a cost allocation methodology, an organization
can only see the direct costs of individual products or services and an overall picture of
the total costs incurred, but that information is only helpful to evaluate whether a
company is making a loss or not as a whole, or whether a product or service have a
margin to carry some of the overhead costs that the company raises in order to run the
business or not, however it does not give information about how much a particular
product or service causes a raise in the overhead costs. Additionally, every coming
business day would be a surprise without the knowledge about the resources of the
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costs. On the other hand, a cost breakdown allows companies to oversee what activities
are imposing extra costs, which activities, products or services are more value added
considering the cost-benefit ratios, and which are not value added in any matter. The
cost information also extends the possibilities of improved, responsive and reactive
decision making.
Therefore, companies and academic researchers have been seeking for fair cost
allocation throughout the decades. There are several frameworks introduced in the
literature to provide a fair cost allocation, which is important, because the cost is one of
the components that determines the profitability and productivity of product or service
lines, business units, customers, or the supply chain processes. A distortion in cost
divisions might easily cause wrong decision for the business.
ii. Historic Evolution of Cost Allocation Methodologies
In the literature there are three well-known cost allocation methodologies which have
been subject to most of the academic researches and which have been the most
commonly used in the companies, namely Traditional Costing, Activity Based Costing
and Time-Driven ABC.
Cost allocation is not a recently discovered concept, most likely, people were using self-
developed simple calculations to assess the costs throughout the history when people
delivered multiple products or services. Before it caught the attention of the academic
researchers, it may have been not called cost allocation, however when there is a
money transfer point at issue, there has been always a necessity to understand the
costs.
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Figure 1: A Time-Line of Managerial Accounting and Industrial Developments (Hutchinson 2007, p.27)
Traditional costing history dates back to 1870s. As Rasiah (2011, p.85) mentioned “in
those days, industries were labor intensive because there was no automation. On other
hand, the product varieties was insignificant and the overhead costs in companies were
generally very low contrast to this new globalization age, where human have achieved
great success in the development of technology.” Therefore, the traditional costing
system was rather simple and easy to implement, it is still used widely in companies.
The distortion of the cost allocation caused by traditional costing system caught the
attention of academic researchers, and the ABC methodology has been introduced in
the late 80s, and early 90s to address the challenges created by traditional costing.
Rasiah (2011, p.85) claims in her paper that “Activity-based costing (ABC) method was
first initiated in an organization, which was called John Deere Company in United States.
Many impressive United States companies such as Hewlett-Packard, Procter & Gamble,
Tektronix and Caterpillar have adopted Activity-based Costing (ABC)”
Time-Driven ABC is a rather recently developed methodology which was derived from
ABC. Kaplan as a strong supporter of ABC, acknowledged the difficulties of ABC
implementation and Kaplan and Anderson (2003) introduced time-driven ABC as a new
cost allocation methodology. Time-driven ABC differs from ABC in a way “…from a ‘rate
based ABC’ to a ‘time-driven ABC’” (Gosselin, 2007, p.649).
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C. Traditional Costing
Traditional costing methodologies might be the most commonly used ones for cost allocations
in the companies in the world. It is a very simple methodology, tend to use one or few volume
driven drivers, such as labor hour or machine hour and allocates all indirect costs from one cost
pool to products, services or units based on the same cost driver. It is not a surprise that this
methodology is the most commonly used one, because it is easy to implement and maintain.
Companies do not need to have the deep know-how, or knowledge transfer through the years
as much as they do with the other methodologies. Furthermore, because of these advantages,
traditional costing is not an expensive methodology to implement for the companies. And also
when traditional costing had the popularity, cost structures were not as complex and
companies used to focus on pricing and revenue structures instead of cost structures. As
Hundal (1997, p.98) mentioned “Traditional costing methods date back to the days of the
beginning of mass production when the products were simple and few. A major part of the cost
in those days was direct labor. Fixed costs accounted for only 10-20% of the total costs. In
today’s complex business and manufacturing environment the overhead costs can no longer be
so easily and simplistically allocated”.
Today, some researchers and companies argue that approximation of cost information is
relevant but spending on the precise and most fair costing methodologies are irrelevant.
Gosselin (2007, p.643) stated that “Nanni et al. (1988) who argued that this emphasis on
overhead allocation was not necessarily helping firms achieve their strategic goals and
Merchant & Shields (1993) who suggested that in some circumstances, managers could use less
accurate cost information. They reminded us that the benefit of a cost management system
was derived from having cost data to be approximate but relevant rather than precise but
irrelevant. This question raised by these authors was probably a relevant explanation for the lag
in the implementation of ABC that was noticed in the early surveys on ABC.”
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i. Traditional Costing Implementation
Traditional costing assumes that the nature of the types the overhead costs does not
affect the distribution of the cost to the products and services. Depending on the
companies’ field of business, they choose a cost driver or in other words cost allocation
base. Let’s assume the cost driver is volume, and based on the proportion of volume of
a particular product, the total overhead cost is assigned to that particular product
proportionally. For example, when mass production creates economies of scale, since
the volume is very high, these products are punished with the higher costs even though
the products that are produced in job production or flow production processes might
require more expertise, time and resources.
Figure 2: A Simple Costing System (Horngren 15e, p.154, e.5-1)
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Rasiah (2011, p.89) explained that “In traditional costing, there is a certain amount of
estimation in cost allocation. The cost systems do not focus on why or where cost
occurred. Generally, there is little insight into the causes of variances. The reporting
methodology is accounting –oriented, inaccurate, not flexible and often not timely. The
operational managers often cannot understand since it is very analytical and does not
relate to the cost of a product or services applied.”
Rasiah (2011, p.89) described the implementation process with the following steps;
1- Identification of indirect cost
2- Estimation of indirect cost
3- Choose cost drivers
4- Estimation of value for cost drivers
5- Computation of overhead rate
6- Application of overhead rate
ii. The Challenges and Disadvantages of Traditional Costing
Rasiah (2011, p.97) explained that “L.Angote, Andrate, Espozel, Maia and Qassim (1996),
highlighted that traditional methods were still functional and precise when an
organization made a few products and indirect manufacturing costs were negligible
relative to direct manufacturing cost”.
However, when the companies have heterogeneous products or services, in terms of
volume, processes, activity and resource usage, it causes distortion in fair costing, and
another costing system might be a better option.
Also, when the cost drivers are not linked to the overhead costs, it fades away the useful
information, about the where the cost comes from, and what causes the increase, which
can be used for improvements of processes, supply chains, or making deliberate
decisions. And also as mentioned earlier, unfair costing might cause unfair budget
allocation which might lead to missing opportunities.
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D. Activity Based Costing
Gupta and Galloway (2003, p.131) stated that “Activity-Based Costing/Management (ABC/M) is
an Information System developed in the 1980s to overcome some of the limitations of
traditional cost accounting and to enhance its usefulness to strategic decision-making”.
In the early 1990s, the academic researches about Activity Based Costing have increased and
the methodology has started to attract attention of the corporate enterprises for
implementation. This rise has continued until the early 2000s. Nevertheless, despite the
extensive academic researches and the increasing popularity, ABC couldn’t become the
commonly implemented cost allocation methodology in contrary to the expectations.
Moreover, in the mid-2000s, the popularity of ABC within the corporate enterprises has fallen.
This phenomena is called “ABC paradox” (Gosselin, 1997; Kennedy and Affleck-Graves, 2001).
Even though the popularity and academic researches hints a tendency towards ABC, the
organizations actually do not implement as it is expected to be, moreover some companies
abandoned the methodology after implementation by the time.
There are several potential explanations of this fall as explained by Kaplan (1986) and Kennedy
& Affleck Graves (2001). The most distinctive explanations are the complexity, lack of interest
and the lack of the evidence that points a linkage between ABC and the shareholder value.
Some studies also show that, in some firms, managers could prefer to work with less accurate
cost data (Merchant & Shields, 1993).
Despite the handicaps, ABC provides a cost allocation methodology to better understand the
cost of the goods/services based on the consumption of the resources, which enhance the
knowledge-based decision making in terms of not only profitability but also resource
management, asset management, budgeting, forecasting and strategic performance
management.
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i. ABC Emergence and Relevance
ABC concept and framework emerged from new cost accounting needs arose from the
more complex organizational features. First of all, while the organizations are getting
more complex and service and customer oriented, it becomes more difficult to oversee
the real costs of the products or services that are provided to customers. That requires
new cost objects and drivers. As Horngren, Datar and Rajan (2015) stated the
complexity and diversity of the products and the market competitiveness led companies
to search for more accurate costing systems to analyze and understand the cost.
Second, the traditional costing system emphasizes the expense categories and allocating
the cost based on the outcome volume or another single cost driver, however, this
blocks the angle of the nature of the activities that incur cost. ABC provides managers
with capabilities of overseeing the activities, cost of activities and the reflection of this
cost to transaction cost. Gosselin (2007) relates this to introduction of ABM, which is
considered as a management accounting innovation that stimulates the activity analysis.
This enables organizations to eliminate unnecessary and costly activities from their
processes. Furthermore, single cost driver does not provide relevant information about
the resource usage of different products or services, and fails to address the real cost.
Gosselin (2007) defines ABM as not only a management accounting methodology but
also a strategic tool to enable the firms to understand their processes and activities,
where the real cost occurs, which products/services can actually be performed to satisfy
the customers profitably.
As opposed to the general opinion, ABC usually cannot be achieved by just changing the
calculation method in the systems, but it has social and behavioral implications as Vieira
(2008) pointed out in his paper. It requires strong management ownership and change
in perceptions and understanding of the costs. While with the traditional costing
system, costs occur and are allocated by the volume, with ABC activities become main
facilitator and the processes become more transparent. These changes can be managed
with commitment and the coordination between departments.
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ABC is considered as one of the biggest innovation in management accounting. Gosselin
(1997) considered ABC not as a single innovation but part of a bigger management
innovation called the Activity Based Management. Activity Based Management is a
strategic management approach to use the activities and resources in the most efficient
way to achieve the business objectives.
ii. ABC Implementation
The most common difference in ABC implementation is dividing overhead costs into
activity cost pools, based on the nature of the activities that are performed to create the
product or service which incur cost. Not only activity cost pools, but also different cost
drivers used to allocate cost of activity/resource usage is another major difference in
ABC implementation. Hundal (1997, p.98) claimed that “The ABC methodology uses a
more rational approach to determining how and why the overhead costs arise and
divides the overhead into several pools”.
First of all, the new cost definitions that ABC introduced will be described, then the
implementation will be explained in detail with some examples.
- Horngren, Datar and Rajan (2015, p.51) defined cost objects was defined as “…
anything for which a cost measurement is desired”. Cost object is the final stage of
manufacturing process that we want to allocate the overhead costs.
- Cost pool is described as “… a grouping of individual indirect cost items. Cost pools
can range from broad, such as all manufacturing-plant costs, to narrow, such as the
costs of operating metal-cutting machines. Cost pools are often organized in
conjunction with cost-allocation bases” in Horngren, Datar and Rajan (2015, p.130)’s
study.
- Cost driver is the same concept as it is in traditional costing, only difference is in ABC
different cost drivers are used for cost allocation for different activities, meaning not
only volume based drivers are used, but also relevant cost drivers based on the
nature of the cost pool can be used.
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The basic flow that ABC was built up on is as below. Products are produced by
performing activities which are consuming resources that incur costs.
Products Activities Resources Cost
Gosselin (2007) defines ABC as a two-stage cost accounting technique. In the first stage,
activities or in another words activity cost pools are defined and overhead costs are
assigned to the activities based on the resource consumption. Cost driver is the
identifier that is used to calculate the resource consumption. In the second stage, the
overhead cost which are assigned to the activities are allocated to the products or
services in proportion of the usage of activities of each product or service based on the
cost driver.
Figure 3: An Activity-Based Costing System (Horngren 15e, p.162, e.5-3)
As an example, in a manufacturing facility, when the machine set up cost and general
factory cost are subject to cost allocation, first of all these two activities are defined as
two separate activity cost pools, and the cost drivers for each activity are defined, which
can be number of set-ups and direct labor hour respectively. Then the overhead costs of
set-ups and general factory is assigned to these activities and unit cost calculated based
on the usage of cost drivers, in this case, unit cost of set-up cost is calculated by the set-
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up times and unit cost of general factory is calculated by the direct labor hour, then the
unit cost of each activity is allocated to the products based on the usage of cost drivers
by each product.
As Gunasekaran, Williams, McGaughey (2005, p.524) mentioned “A measure of the
volume of each activity (cost driver) is used to generate a cost rate for estimating
production cost, and as a performance measure for the activity concerned”. Therefore,
instead of the outcome volume, it focuses on the volume of the usage of the resource in
each activity.
Rasiah (2011, p.88) described the implementation process of ABC with the following
steps;
1- Identify and Classify activities
2- Estimate cost for whole activity
3- Apply activity costs using cost drivers
As Hundal (1997) and Akyol, Tuncel and Bayhan (2007) described, costs can be
categorized in different levels.
- Unit level costs – every production unit increase results with an increase in cost.
- Batch level costs – cost increases with every batch regardless of the batch size.
- Product level costs – costs incurred to support the production processes.
- Facility level costs – costs incurred to support the organization.
iii. Activity Based Management
Gosselin (2007) described Activity Based Management as a four level framework.
Companies should start with Activity Analysis (AA), and continue with Activity Cost
Analysis (ACA), afterwards, first apply a pivot ABC then full ABC for the whole
organization. He argues that for some companies first one or two levels might be
enough to oversee the processes, costs and inefficiencies depending on the company
operations and size. For those companies full ABC might be even an irrelevant cost if the
product portfolios are rather simple and homogeneous. He validates this argument with
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the evidence of researches showing that some companies apply AA and ACA and stop
going forward to implement the ABC. Because AA and ACA already enable them to
eliminate the waste and increase the efficiency of the activities and processes.
Figure 4: The four levels of activity management (Gosselin 2007, p.647)
- Activity Analysis (AA) is the initial level, where the organizations evaluate the activities
performed for the business processes to see the waste and eliminate non-value added
activities. AA does not include financial and accounting aspects, it is used to improve the
processes and increase the quality.
- Activity Cost Analysis (ACA) or Cost Driver Analysis (CDA) is the second level, where
the organizations evaluate how the costs occur in activities, cost drivers and factors that
causes higher costs. In this level, the efficiency of the activities are aimed to be
increased and the costs are aimed to be decreased.
ABC implementation is divided into two by Gosselin (1997) as Pilot ABC and Full ABC.
- Pilot ABC includes implantation of ABC in one aspect of an organization, can be a
product line or a business unit.
- Full ABC is the firm wide implementation.
iv. Advantages and Benefits of Implementing ABC
As described, ABC has been evolved because of a necessity for a more accurate costing
system. The advantages and benefits of using ABC, which are aggregated and
consolidated from the researches that are used during this study, can be summarized as
below;
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- Fair cost allocation through the products or services shows a clear picture about the
product or cost profitability. That sustains a fair decision making in the
organizations. Qian and Ben-Arieh (2008) examined the cost estimation accuracy of
ABC and traditional costing methods and concluded that ABC is a more accurate
cost-estimation method.
- It also helps through the decision process of buy or sell, abandon a non-profit
product, entering a new market based on the information regarding resource
utilization, and the strengths or efficiencies of internal processes. And also customer
profitability can be traced with ABC, and non-value added activities can be avoided,
when organizations distinguish the profitable and non-profitable customers. Many
researchers like Gosselin (2007) and Horngren, Datar and Rajan (2015) argued that,
ABC provides a more clear view of the processes and cost assessment which
contributes to the decision making.
- ABC gives a comprehensive picture of the activities that are performed in order to
provide the product or service, which provides companies with an ability to see and
improve inefficiencies through the processes and also it gives a comprehensive
picture of cost of activities, and that provides them with the ability of cost
management within the supply chain mechanism, as it is illustrated in ABM
framework in Gosselin’s (2007) study.
- The outcomes of cost allocation are used in budgeting processes and performance
management as Hundal (1997) mentions, a more realistic cost structure will enable
companies to make more reliable forecasts for the upcoming years, which highly
affects the ongoing business.
- Gupta (2003) claims that ABC provides employees a better picture of why they are
doing what they are doing, and how it affects the whole organization, how they can
improve the inefficiencies of the components of processes under their
responsibilities.
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Figure 5: ABM Value Chain (Swenson, 1997)
Ness and Cucuzza (1995, p.5) analyzed Chrysler and Safety-Kleen in their research as
one of the most successful implementers of ABC;
“Chrysler estimates that, since it began implementing ABC in 1991, the system has
generated hundreds of millions of dollars in benefits by helping simplify product designs
and eliminate unproductive, inefficient, or redundant activities. The benefits have been
10 to 20 times greater than the company’s investment in the program. At some sites,
the savings have been 50 to 100 times the implementation cost.
Since Safety-Kleen, a midsize waste-recycling company, introduced ABC into its
organization, also in 1991, it has reaped more than $12.7 million in cost savings, cost
avoidance, and increased revenues—more than 14 times its investment in the program.
The company, based in Elgin, Illinois, has used ABC to prune product lines, rationalize
operations, and expand into new markets. Even more important, ABC has helped Safety-
Kleen transform itself from an organization whose individual operations made decisions
based on what each one—rightly or wrongly—thought best for itself into an
organization whose operations now make day-in, day-out decisions that are best for the
whole company.”
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v. Disadvantages and Challenges of Implementing ABC
Even though ABC has addressed many issues related to the traditional costing system, it
has some disadvantages and challenges regarding its implementation and maintenance.
This argument is supported by more than 25 surveys that have been held in different
countries to assess the implementation rates. According to Gosselin (2007, p.641)
“…surveys have shown that the diffusion process for ABC has not been as intense as it
may have been expected.” The phenomena described as “ABC paradox” by Gosselin
(1997) and Kennedy and Affleck-Graves (2001) is still being a subject for researches to
be explained.
There are several explanations provided in several researches. Gosselin (2007) gives an
explanation in response to the ABC paradox with Kaplan’s (1986) explanation for
management accounting lag with four reasons;
- Lack of role model, which suggests that if there were enough role models with
successful practices industries could follow.
- Lack of computerized systems, today this is not relevant anymore, because there are
many consultancy firms providing ABC implementation tools.
- Focus on financial accounting, it can be said that today this is not relevant too,
because researches and studies on management accounting is growing and have a
big impact on companies.
- Lack of top management involvement, this can be still relevant, because some
companies still pursue traditional costing method because they think it is adequate
for their organizations.
Kennedy and Affleck-Graves (2001) explained it with three reasons;
- Organization structure might not require a complex cost allocation methodology.
This argumentation is supported by many researches.
- ABC might not be seen as a value-adding methodology but it might create value with
interaction with other variables.
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- There hasn’t been many researches showing a direct link to profitability increase and
shareholder value.
Ness and Cucuzza (1995) argue that the employee resistance is one of the reason for
low rate in ABC implementation.
Gosselin (2007) suggests that even ABC’s benefits are recognized by researchers and
companies, the complexity of implementation is an obstacle towards ABC diffusion.
Vieira (2008, p.217) argued the issue of power as an obstacle towards ABC
implementation in a Portuguese family-owned bank in his paper in terms of involvement
and resistance issues and conflicts between departments, “The issue of power is crucial
for the development of initiatives such as ABC, since their needs are not initially defined
in terms of resources and responsibilities, so there is a level of voluntarism in the
behavior of the participating departments.”
Besides the complexity and organizational issues, ABC is a very expensive framework to
implement, it is both time and money consuming process. It requires commitment of
the organization, time for surveys, identification of activities, identification of resource
usage for each activity, and a sophisticated software system. Moreover maintaining ABC
is as difficult, because in the big organizations there can be hundreds of activities, and
the resource usage of each activity might change any time in any level, furthermore
activities might change, be removed or new activities might be added.
E. Time-Driven ABC
After two decades of intensive study in ABC methodology, it became evident that ABC did not
get enough attention in practice, even though companies start to apply ABC, there are many
problems they have to face and many of them abandon the ABC implementation projects, or
sometimes they have to abandon even after completing the projects due to the maintenance
issues (Gosselin, 2007). Therefore, Kaplan and Anderson (2003) came up with a new version of
ABC, which is called Time-Driven ABC. The most distinctive difference of Time-Driven ABC is,
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while conventional ABC was built on overhead rates which are determined by the nature of
each activity performed to assign costs to activities, Time-Driven ABC was built on time based
rates. As Kaplan and Anderson (2003, p.1) described “Time-Driven ABC requires estimates of
only two parameters: (1) the unit cost of supplying capacity and (2) the time required to
perform a transaction or an activity.”
i. Time-Driven ABC Implementation
Time-Driven ABC implementation is a rather simple method. First of all, unit cost of the
capacity of resource supplied should be assessed. Kaplan and Anderson (2003) suggests
that the practical capacity should be used in the cost allocation calculation instead of
ideal capacity in order to fully allocate the total cost of the resource that was hired to
produce the goods or provide service. To calculate the unit cost, they suggest to find the
total cost of capacity supplied and divide it by the practical capacity of the resource.
As the first parameter is defined as above, secondly, it still requires activity
identification and activity analysis. After identifying the activities, the time required to
perform these activities needs to be assessed, but it does not require surveys or
interviews to understand what the distribution of the time the employees spend for
each activity is. Instead of long surveys and interviews, approximate estimations of time
to perform the activity can be assessed by observation, or average times can be
obtained through Enterprise Resource Planning (ERP) systems.
The challenging part of Time-Driven ABC is activity analysis and the estimation of time
required to perform the activities. Nevertheless, these challenges and even more
challenges already exists in conventional ABC. Another advantage of Time-Driven ABC is,
most of these parameters can be derived from the existing ERP systems. Therefore it
does not requires as complex systems to perform the cost allocation process as
conventional ABC does.
As Ozyurek and Dinc (2014, p.107) summarized the steps for conventional ABC and
traditional ABC as follows.
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Figure 6: Activity-based costing, activity-based costing systems implementation method on the time differences (Ozyurek and Dinc 2014, p.107)
ii. Issues Addressed by Time-Driven ABC
Time-driven ABC is newly developed methodology, it might require more research and
application to see the issues that are driven by Time-Driven ABC, and it can be
developed further. In this section the issues addressed and the benefits of Time-Driven
ABC, which are aggregated and consolidated from the researches that are used during
this study, will be summarized.
- Ozyurek and Dinc (2014) summarized the advantages of TDABC, one of the most
practical and effective benefit that Time-Driven ABC bring is the simplicity. It
overcomes many definition related questions of ABC and reduce the complexity of
terminology to simple terms.
- They also stated that it is time and resource efficient framework to implement.
Existing ERP systems and data structures of companies can provide the information
needed and with simple equations the system can be established, instead of long
projects involving consultancy.
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- It is cost efficient, in view of the fact that, the simplicity might eliminate the cost of
consultancy and complex software.
- Vieira (2008) illustrated in his paper that ABC requires high commitment and strong
ownership from all levels in an organization in order to ensure the collaboration
between the departments to collect the required information, with Time-Driven ABC
the rough estimations can be handled by assigned responsible people from required
business units, which also ensures less effort for maintenance.
- Since ABC is based on distribution of the cost of the resources used, it does not give
a fair picture of real capacity utilization. As Kaplan and Anderson (2003) indicates the
conventional ABC over-estimates the costs of activities because it incorporates the
used capacity and unused capacity. In Time-Driven ABC, instead of estimated
distribution, there is an estimation for time spent for an activity for a single unit, and
ERP systems -assuming most of them- already keeps how many units have been
produced or served. As long as we have these information, with a simple
multiplication the time spent for all production or total service can be calculated and
the unused capacity can be identified. Therefore, Time-Driven ABC creates
contribution to capacity management.
F. Cost Allocation in Finance
The financial services sector has become highly competitive and the complexity comes from the
regulations forces them to focus on the profitable businesses. Since there are high limitations
on the price side, cost drivers are as important measures to control the profitability.
Vieira (2008, p.206), mentioned about this shift as “The financial services sector is one that has
developed dramatically on a global level over the past two decades. There has been a shift
toward fewer and larger entities both at a global level, with the growth of global capital and
money markets, and in many countries at a national level as well. In this regard the US has been
a conspicuous mover of change, with the final revoking in the 1980s of 1930s laws, passed after
the 1929 Wall Street Crash, setting regional limits to banking conglomerates. One major
outcome in the realignment process, which has been largely prosecuted through merger and
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acquisition activity, has been a greater focus on revenue generation alongside cost and
manpower control in banks of all sizes.”
This drives banks to focus on the basis of the cost drivers. And also, the sector itself is highly
service oriented and it makes it harder to track the profitability of the transactions and
customers. ABC enables banks to allocate the overhead costs based on the resource usage,
which provides ability to see which customers and services are indeed profitable.
Cost allocation methodologies have evolved around manufacturing industries, and been
adopted to the service industries. Even though, the finance products/services are not visible as
they are in manufacturing, there are still costs that can be linked to individual products or
services, and there are overhead costs incurred in all four levels, namely unit level, batch level,
product level and facility level. The global competition in financial services sector encourages
finance companies their management accounting initiatives. Vieira (2008, p.207) pointed out
three areas where financial institutions can benefit from ABC, “First, it can calculate
“meaningful” product costs. Second, this can then help dramatically in analyzing profitability
and understanding cost behavior as part of the strategic management project. Third, it
becomes possible to develop more effective budgeting, forecasting and performance
measurement systems in traditional “overhead” departments. Since, as they argue, financial
institutions’ services do not have cost information requirements for external financial reporting
or stock valuation, the major purposes for ABC introduction will be decision-making and cost
control.”
The necessity of accurate cost allocation systems in financial institutions is explained in
Horngren, Datar and Rajan’s (2015, p.179) book as “Banks, such as Barclays Bank in United
Kingdom, offer many different types of accounts and services: special passbook accounts,
ATMs, credit cards, and electronic banking products. Producing these products places different
demands on resources because of differences in volume, process, technology, and complexity.
For example, the computer and network resources needed to support electronic banking
products are much greater than the computer and network resources needed to support a
passbook savings account. The use of broad averages fails to capture these differences in
demand and leadsto distorted and inaccurate cost information.
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G. The Role of Information Technology
Information technology improvements have had a large effect on innovations in management
accounting. Traditional costing is a simple and old framework which could be delivered with old
technology, by the time with the technology improvements, the ERP systems enable companies
to integrate the information throughout the organization and gives ability to transform
information to knowledge which can be used for decision making, performance evaluation, and
application of new disciplines. Gunasekaran, Williams, McGaughey (2005, p.524) suggests that
“It is widely believed that the large-scale use of EDI leads to improvements in the
communication infrastructure between organizations, and that this, in turn, strengthens the
economy of a nation and possibly a group of nations. It is also widely recognized that EDI
enables organizations to redesign their processes significantly, because of its main capabilities:
high speed, reliability and ease of data capture.”
Every new implementation in management accounting requires control and monitoring
mechanisms. Information technologies enable reliability, speed, and transparency with the ERP
systems. For ABC framework, many sophisticated software programs were developed, which
can be fed and run separately from the companies’ other systems. With time-driven ABC, the
necessity of establishing another system was removed, and the usage of the existing ERP
system was enabled instead.
The role of information technology improvements in the increasing necessity of accurate cost
allocation systems is explained in Horngren, Datar and Rajan’s (2015, p.179) book as “The use
of product and process technology such as computer-integrated manufacturing (CIM) and
flexible manufacturing systems (FMS) has led to an increase in indirect costs and a decrease in
direct costs, particularly direct manufacturing labor costs. In CIM and FMS, computers on the
manufacturing floor instruct equipment to set up and run quickly and automatically. The
computers accurately measure hundreds of production parameters and directly control the
manufacturing processes to achieve high-quality output. Managing complex technology and
producing diverse products also require additional support function resources for activities such
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as production scheduling, product and process design, and engineering. Because direct
manufacturing labor is not a cost driver of these costs, allocating indirect costs on the basis of
direct manufacturing labor (as in Plastim’s simple costing system) does not accurately measure
how resources are being used by different products”.
III. TIME-DRIVEN ACTIVITY BASED COSTING IN “A BANK”
Cost allocation improvements, innovations and researchers have been evolved around the
manufacturing industries over time, nevertheless, finance sector has been growing enormously
and the complexity and the number of available services have been increasing immensely. As
Chea (2011) mentioned, “Financial institutions have recently been at the forefront of
implementing ABC. Even though the use of ABC has evolved from original user, manufacturing
companies, to services companies, the financial sector remains virgin territory.” The
technological and business wise improvements give hint about the possibilities of future
expansion of the financial services.
When the financial transaction amounts and diversity increased and caused the invisibility of
risk exposures, financial institutions saw the necessity of securing the transactions, the
collateralization has come into the picture. And also businesses and financial institutions
needed protection for their financial transactions against the market changes that derived
hedging transactions. Connor and Woo (2004) described hedging as “The nomenclature “hedge
fund” provides insight into its original definition. To “hedge” is to lower overall risk by taking on
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an asset position that offsets an existing source of risk. For example, an investor holding a large
position in foreign equities can hedge the portfolio’s currency risk by going short currency
futures. A trader with a large inventory position in an individual stock can hedge the market
component of the stock’s risk by going short equity index futures. One might define a hedge
fund as an information motivated fund that hedges away all or most sources of risk not related
to the price-relevant information available for speculation”.
These improvements have complicated the management of the services that are provided for
customers, transactions costs and the exposure that the financial institutions are facing.
Moreover, the liability of financial institutions towards the regulatory bodies for their services
have been increasing significantly, regulations force financial institutions to be more
transparent and work responsibly towards society in order to avoid financial crisis and frauds.
This brings lots of additional activities to be performed in their businesses, such as compliance
with the generally accepted sets and rules like Basel III rules, auditing, financial reporting, and
data sharing with the central data hubs like national banks or the credit bureaus that calculate
the credit risks.
In this complex and service oriented business environment, management accounting
implementations have critical importance for the deliberate decision making. The fact that the
services provided in the financial institutions are mostly intangible makes the necessity for the
robust systems to oversee the operations vital. Management accounting implementations may
include budgeting and planning, costing, balanced scorecards or any other application that is
systematically prepared for internal management of business performance.
The effect of the high competition and regulations on the pricing structures forces financial
institutions to focus on the cost structures. It can be very difficult to estimate the profitability of
customers or product groups considering the complexity of transactions performed for a single
customer. Therefore, cost allocation frameworks carry vital importance for financial institutions
to estimate the costs.
Nevertheless, it is not an easy task to implement a complicated cost allocation framework
because of the complexity of the nature of services and activities performed. The aim of this
35
study is to analyze the product groups and transactions that are being carried on for customers,
the activities and the business units that are involved for each transaction types, and the time-
driven ABC based cost allocation to each transaction based on the activities and the business
units involved in “A Bank”.
A. About “A Bank”
“A Bank” was founded in the early 90’s, and headquartered in the Netherlands. It operates over
one hundred thirty branches, six hundred eighty ATMs, about twelve thousand sales points and
more than twenty three thousand point of sales terminals. The bank employs more than four
thousand two hundred employees in ten countries and has more than six million customers
around the world.
“A Bank” offers to its corporate customers a wide range of banking products, which include
international trade and commodity finance, project finance and working capital loans. The bank
operates in the key trading hubs such as the Netherlands, Switzerland and the United Arab
Emirates, as well as in Russia, Turkey and Ukraine.
And “A Bank” offers to its retail and SME customers non-complex and transparent products in
seven Western and Eastern European countries as Belgium, Germany, the Netherlands, Malta,
Ukraine, Romania and Russia.
Figure 7: The group chart of “A Bank”
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i. Vision, Mission and Values
“A Bank” defines its vision as to be the preferred bank in its core markets, and the
mission as to provide financial services that create value for its customers.
“A Bank” shapes its strategy based on its core values which are Customer Focus,
Integrity, Professionalism and Transparency.
“A Bank” values the customer centric business and cooperation with its partners for a
win-win strategy. In that respect, it provides innovative, tailor-made, effective products
and services to enable its customers to succeed in reaching their targets.
For “A Bank”, integrity is the driving force behind everything to generate trust and
confidence through ethical behavior and by complying with laws, regulations and
guidelines, and by caring about the preservation and promotion of the highest
standards of professional conduct in its work place and community.
“A Bank” recognizes the importance of continuous self-development. Professionalism
embraces and stimulates the necessary skills, qualifications, knowledge and diversity.
It also strives to make its products as transparent as possible. Transparency is a key
business best practice, for its products and services, accounting standards or
management decision-making.
ii. Business Model
In “A Bank” several business models have been incorporated based on the need of the
respective global and local markets.
- Trade and commodity finance, bank relations, treasury, compliance, risk
management, IT and financial control are located in the Netherlands.
- Direct retail banking in the Eurozone for saving products to retail customers is
managed by Germany branch.
- Russia and Romania are operating as retail banks and commercial banks.
- Ukraine is a centralized office for corporate, commercial and SME banking.
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- Private banking and portfolio management are located in Switzerland.
- Dubai supports trade and commodity finance.
- Malta supports Marine Finance services.
Figure 8: Product and Service Matrix in “A Bank”
B. Research Method and the Scope of the Study
In the holding company, the profitability of all banks are evaluated separately and also
consolidated for the evaluation of the group profitability. In this study, the operations of
Netherlands (“A Bank NL”) and its branches will be subject to time-driven ABC application. “A
Bank” will refer to A Bank NL hereafter.
In order to evaluate the profitability, “A Bank” uses the Cost Center and Profit Center
definitions. All business units are considered as cost centers, which is another interpretation of
cost pools, since they all incur cost during their operations. Profit centers are the business units
which generates the deals with customers and create revenue/loss from the deals, Corporate
Banking, Retail Banking and Treasury units are the examples of profit centers. Cost centers are
divided into three groups based on the nature of their operations, namely; Cost of Operations
Group including Corporate Banking, Treasury, etc.; Support Unit Costs Group including IT, HR,
etc.; and Overhead Costs Group including Financial Control, Audit, etc. This division makes it
easier to observe where the cost is incurred the most, it also makes it easier to allocate the cost
from cost centers to profit centers.
Profit Centers Cost Centers
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Corporate Banking Corporate Banking
Corporate Credits Corporate Credits Cost of Operations
Treasury Treasury
Retail Banking Retail Banking
… IT Support Unit Costs
Human Resources
Financial Control Overhead Costs
Audit
…
The revenue is only generated by the profit centers and the cost can be generated in different
ways by all cost centers. The cost might be incurred as a direct cost or an indirect cost based on
the nature of the cost.
- In the Profit Centers, each deal’s revenue/income and the direct cost/expense is traced and
assigned to the related deal number and the related profit center. Therefore, the gross profit
can be observed in the deal level, customer level or the profit center level.
- In the Cost Centers, the indirect costs are assigned. Indirect costs include the labor cost,
building cost, license cost, and many other overhead costs. These overhead costs are being
assigned to the cost centers with different methods and parameters. For example license cost is
assigned equally to all cost centers since it is related to the existence of the bank and is not
effected by the operations that the business units are performing, on the other hand, labor cost
is directly assigned to the cost centers based on the employees’ business units, some overhead
costs are assigned based on the headcounts of the business units.
Once all the overhead costs are assigned to the cost centers, the total overhead cost of each
cost center is allocated to the profit centers based on one cost driver which is the usage level of
the cost centers by the profit centers and this usage level is determined in the very high level
with the percentages. Therefore, net income after deducting the operating expenses can be
observed in the profit center level, because the overhead costs as operating expenses come
into the picture in the profit center level not in the deal level -transaction and deal as a
terminology can be used interchangeable in the following sections-.
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This might cause misinterpretation of the cost of transactions provided to customers in terms
of the profitability of the each product group since the transaction level profitability includes
only direct costs. It is not possible to observe how the overhead costs effect each transaction’s
profitability, some deals require more complex activities to be performed than others do. Also
each deal types require different business units to perform different activities to complete the
deal that means some transactions might cause higher overhead costs than others do. For
example, some deals, based on the amount of the transaction or based on other identifiers,
might require executive management involvement which currently does not have any effect on
the cost of the deal.
With the current costing system, there is a lack of understanding about profitability of each
product line in “A Bank”. Even though, the business intelligence capabilities and the data-
warehouse contains very detailed and specific information about the transactions, there is no
clear indication of the resource usage of each transaction type and the reflection of the cost of
the usage of resources to transaction cost.
With this research the operational labor cost of the cost centers under Cost of Operations
group will be allocated to customer transactions with the time-driven ABC methodology by
using the business intelligence capabilities in “A Bank”. The reason that the study limits the
labor cost allocation with the operational labor cost of the cost centers under Cost of
Operations group is because the labor cost under these cost centers are more related to the
customer transactions, because operational labors process activities to complete the
transactions. The other labor costs under other cost centers such as support unit costs like IT, is
not directly related to the customer transactions. And also other overhead costs such as G&A
and depreciation will be out of scope. This research will be also limited with modeling the Time-
driven ABC for the deals of customers of one specific business unit which is Corporate Banking.
First of all, the transactions of the current year that are performed for the customers of
Corporate Banking unit will be analyzed and gathered, there will be different product groups for
this group of customers such as loans, derivatives, time deposits, etc.
40
After that, the activities that are proceeded for different transaction types (Activity Analysis)
and how much resources are used for each activity (Activity Cost Analysis) will be analyzed.
Here, the activity means the operations of different business units that are performed to
complete the customer transaction. For example, for a customer of corporate banking, if a loan
is going to be issued, corporate banking is the leading unit, but it also requires corporate
credits, trade finance services or money transfer units to perform in order to complete the deal.
Each business unit will represent an activity. And the labor usage from each business unit will
represent the resource usage in the related activity/business unit. Meaning, if the money
transfer unit is an activity, then an employee from money transfer unit performs for 30 minutes
for a loan issuance represents a 30 minutes of resource usage for that transaction during that
money transfer activity. A matrix of the resource usage during each activity for each transaction
type will be formed with the interviews with the business unit heads.
And finally based on the resource usage in each activity for each transaction will determine how
much of the operational labor cost was incurred in a specific customer transaction.
This is important, because while some overhead costs like licensing, building, electricity etc. is
not effected by the difference between the nature of transactions, operational labor cost is
highly effected by the nature of transactions. And it is an important determinant to observe if
the gross profit of a specific transaction is high enough to cover the overhead costs that are
caused by the nature of the transaction.
With this study, the profitability of the each transaction will include the effect of the complexity
of the transaction type. Also this study aims to stimulate the effective usage of business
intelligence of “A Bank”, which will contribute to the knowledge-based product and customer
related decision making.
This project is going to be applied as a pilot project in “A Bank” and held by the MIS and
Budgeting department. At the end of the pilot study the results will be discussed with the
Corporate Banking department. I will have a role as an analyst and will have responsibilities to
coordinate the analysis of transactions and activities with consultation of Corporate Banking
41
department manager, to write the queries to generate the necessary data from data
warehouse and to prepare the final report to show the results.
C. Existing Cost Allocation System in “A Bank”
In “A Bank”, in the profit centers each deal’s revenue/income and the direct cost/expense are
traced based on the following income and expense breakdowns.
- Fee and Commission Expenses: The fees and commissions that are paid to customers.
- Fee and Commission Income: The fees and commissions that are paid by customers.
- Funding Interest Expense: Funding for the operations of profit centers is done through the
fictitious funding desk unit. Each profit center fund their operations from funding desk
based on the funding rates. When a profit center fund a transaction with a funding rate
above the rate of return of the transaction, the transaction incurs funding interest expense.
- Funding Interest Income: Funding for the operations of profit centers is done through the
fictitious funding desk unit. Each profit center fund their operations from funding desk
based on the funding rates. When a profit center fund a transaction with a funding rate
below the rate of return of the transaction, the transaction generates funding interest
income.
- Interest Expense: Interest that is paid to customers.
- Interest Income: Interest that is paid by customers.
These income and expenses recorded in the general ledger in the transactional level, thus “A
Bank” is able to calculate the transaction costs, gross profit and the margins with these income
and expense general ledger items. Operating expenses include all other overhead costs such as
administrative expenses, marketing expenses, operational labor expenses and support unit
labor expenses, and they are recorded in the general ledger in the high level. Even though,
operational labor cost is directly related to the deals made, there is no infrastructure to trace
the operational labor per cost transaction, therefore it is also subject to cost allocation as
overhead cost.
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Figure 9 shows how “A Bank” calculates the profit center level Profit Before Tax. The profit
center level aggregated Gross Profit is shown in the bottom box, and cost center level Overhead
Costs are shown in the top box, Operating Expenses box shows the allocated overhead costs
from cost centers to profit centers, and finally Profit Before Tax box shows the result of
operating expenses deduct from the gross profit.
Figure 9: Cost Allocation Structure in “A Bank” - Profit before Tax = Gross Profit – Operating Expenses
The structure of assigning the overhead costs to cost centers based on different parameters,
and allocating the total overhead cost of each cost center from cost centers to profit centers
based on estimated percentage of time spent by each cost center for each profit center hints a
beginning level of ABC application on a profit center level, because each overhead cost type has
its own cost driver to be assigned to the cost centers and after being assigned to the cost
centers ‘time’ as a cost driver is used to allocate these costs to profit centers. Nonetheless, it
remains in the profit center level and it lacks the visibility of details of overhead costs that are
at the end allocated to the profit centers. Meaning, after assigning all overhead costs to cost
centers, since the total cost of cost centers is allocated to profit centers on time basis, “A Bank”
does not know anymore how much of the electricity, depreciation, labor cost is assigned to
each profit center.
There are also some advantages of existing cost allocation system, first of all, it is very easy to
maintain. As long as the departmental structures do not change, the system can assign each
43
overhead cost to cost centers automatically based on the given rules. Since the organizational
structure change does not happen frequently, this automated system does not require high
maintenance. In order to allocate the cost of cost centers to profit centers, the estimated time
spent by each cost center for profit centers is maintained from the business units, which is
called ‘Interdepartmental Service Matrix’. Every year, this matrix needs to be updated, it is
usually done by the unit heads, and it does not require much time and resource.
D. Time-Driven ABC Application to Operational Labor Cost
In “A Bank”, each corporate customer is assigned to an account officer from corporate banking
unit once they become a customer, actually each account officer is responsible of finding new
customers. The responsibilities of account officers include finding new customers, following the
customer base opening procedures, offering new products to customers, making sure all
business units are working accordingly to perform the activities for the transactions of their
customers, and reporting the performance of their customers. In the corporate banking unit
there are account officers and senior account officers based on their experience. Senior
account officers also have a responsibility to supervise the account officers.
Besides corporate banking unit, there are other units that support the customer transactions.
Not all units perform activities for all transaction types. Business units which perform activities
for corporate banking customer transactions are listed as below;
- Corporate Banking; finding new customers and maintaining the existing customers,
offering new products, following the transaction processes by the account officers and
senior account officers.
- Customer Service; is mid office of corporate banking unit, document proceeding, system
bookings, core banking system entries for the risk related transaction.
- Central Registry; signature verification, document verification, customer verification.
- Operations Compliance; customer and operation compliance check against political
exposure, terrorism and sanctions.
44
- Trade Finance Services; physical document coherence check for the trade related
transactions based on legal standards.
- Corporate Credits; is a risk mitigation unit to check the availability of customer limits for
the proposed transactions, corporate credits employees perform as credit officers of
customers and they make sure the transactions are processed within the boundaries of the
limits that the bank is willing to take the risk for each customer.
- Financial Institutions; maintains the relationships with the corresponding banks of the
seller or buyer of the trade related transactions of the customers.
- Managing Board; evaluation and approval of the high risk transactions.
- Money Transfer Unit; proceeding any kind of money transfer involved in the transactions.
- Treasury Back Office; operations of the treasury related activities such as currency
changes, proceeding derivative transaction.
- Treasury Front Office; pricing the treasury related activities such as currency changes,
proceeding derivative transaction.
- Access Control Unit; internet banking authorization, document check and verification.
These business units will be considered as activity centers and the labor hour spent from these
business units will be considered as the resource usage in the related activity.
The transaction types in corporate banking unit vary from cash loan utilization to fund
transfers, derivative transactions, internet banking administration and many others. The labor
from different business units that are involved in transactions has different costs, and they
spend different time to complete the deals.
The aim of the application section is to list the transactions that are done for the customers of
corporate banking, then analyze the activities that are performed for each transaction type,
after that, analyze the time spent in each activity in other words the resource usage in each
activity, and finally, multiply the labor time spent for each activity with the labor cost, and sum
the cost of all activities that are performed for each transaction and thus find the total cost of
each transaction.
45
i. Customer Transaction Analysis
As the first step of the application, the products and the transactions that are
performed for customers have been analyzed and clarified. By using the company’s data
warehouse capabilities all customer transactions have been listed with very detailed
information, such as customer, amount, deal date, deal rate and the information that
guides this study to analyze what kind of activities have been performed for each
transaction. For example for the same kind of loan issuance transaction, based on the
loan amount, different activities can be performed such as management approval. An
important point to mention is, for the same loan product of a customer, there can be
several transactions performed in different time periods such as loan utilization, loan
modification and loan early closure. These transactions will be kept as separate
transactions for the cost analysis because the cost of these transactions differ. After
allocating costs to each transaction, the total cost of one loan product of a customer can
be calculated based on the loan reference number, and also, total cost of one customer
can be calculated based on the customer number. This approach will provide granularity
for the future decisions related to the product and customer profitability.
In the below table, the product groups and the transaction types that are available for
corporate banking customers are shown.
46
Figure 10: Available Product Groups and Transaction Types for Corporate Banking Customers
The listed customer transactions have been stored in a database table with the
customer, the product group, transaction type and transaction related information. As
mentioned earlier there are some other parameters that define which activities to be
performed for the same transactions types, such as loan amount to define the approval
level. Therefore, these kind of information like the approval level information is stored
in the database table with the transaction information as well.
ii. Activity Analysis & Activity Cost Analysis
As a second step, the transaction – activity matrix has been prepared with the time
spent in each activity information in minutes. The time spent has been analyzed based
on the general observation and common sense, but later some analysis made on the
Product Groups Transaction Types
Cash Loan Cash Loan Opening
Cash Loan Cash Loan Revision
Cash Loan Cash Loan Modification
Cash Loan Cash Loan Closure
Cash Loan Cash Loan Early Closure
Cash Loan Cash Loan Partial Payment
Non-Cash Loan Non-Cash Loan Opening
Non-Cash Loan Non-Cash Loan Revision
Non-Cash Loan Non-Cash Loan Modification
Non-Cash Loan Export LC Advising
Fund Transfer In-bank Money Transfer
Fund Transfer In-bank Money Transfer Between Own Accounts
Fund Transfer Swift Transfer
Fund Transfer In-bank Money Transfer via Internet Banking
Fund Transfer In-bank Money Transfer Between Own Accounts via Internet Banking
Fund Transfer Swift Transfer via Internet Banking
Time Deposit Time Deposit Opening
Time Deposit Time Deposit Modification
Time Deposit Time Deposit Modification with Money Transfer
Collection Import Collection Opening
Collection Export Collection Opening
Derivatives FX Spot Entry
Derivatives FX Swap Entry
Derivatives FX Forward Entry
Derivatives FX Spot Entry via Internet Banking
Internet Banking Internet Banking Administration - Company Entry
Internet Banking Internet Banking Administration - User Entry
Internet Banking Internet Banking Administration - Company Modification
Internet Banking Internet Banking Administration - Operation Limit Modification
Internet Banking Internet Banking Administration - Company Account Restriction Modification
Internet Banking Internet Banking Administration - Data Modification
Internet Banking Internet Banking Administration - Company Document Modification
Limit Entry Limit Opening
Limit Entry Limit Renewal
47
results to see whether the allocated times were reasonable or not, and upon that
analysis some modifications have been made.
Figure 11: Transaction Type - Activity Matrix with the Resource Usage in min
For the pilot study, it has been agreed that the unit cost of each activity will be
considered unique regardless of the labors’ experiences and skills, because the
activities, most of the time, are performed by the same level of employees. As a future
Product Groups Transaction Types Approval Level Corporate
BankingCustomer
ServiceCentral Registry
Operations Compliance
Trade Finance Services
Corporate Credits
Financial Institutions
Managing Board
Money Transfer
Unit
Treasury Back Office
Treasury Front Office
Access Control
Unit
Cash Loan Cash Loan Opening
Corporate Banking 450 150 25 0 35 0 0 0 0 0 0 0
Corporate Credits 450 150 25 0 35 75 0 0 0 0 0 0
Managing Board 450 150 25 0 35 75 0 50 0 0 0 0
Internal Credit Committee 1 450 150 25 0 35 75 0 50 0 0 0 0
Internal Credit Committee 2 450 150 25 0 35 75 0 50 0 0 0 0
Cash Loan Cash Loan Revision
Corporate Banking 150 75 25 0 20 0 0 0 0 0 0 0
Corporate Credits 150 75 25 0 20 50 0 0 0 0 0 0
Managing Board 150 75 25 0 20 50 0 25 0 0 0 0
Internal Credit Committee 1 150 75 25 0 20 50 0 25 0 0 0 0
Internal Credit Committee 2 150 75 25 0 20 50 0 25 0 0 0 0
Cash Loan Cash Loan Modification 75 50 0 0 20 0 0 0 0 0 0 0
Cash Loan Cash Loan Closure 25 10 0 0 0 0 0 0 0 0 0 0
Cash Loan Cash Loan Early Closure 75 50 0 0 0 0 0 0 0 0 0 0
Cash Loan Cash Loan Partial Payment 75 50 0 0 0 0 0 0 0 0 0 0
Non-Cash Loan Non-Cash Loan Opening
Corporate Banking 450 225 25 50 275 0 50 0 0 0 0 0
Corporate Credits 450 225 25 50 275 75 50 0 0 0 0 0
Managing Board 450 225 25 50 275 75 50 50 0 0 0 0
Internal Credit Committee 1 450 225 25 50 275 75 50 50 0 0 0 0
Internal Credit Committee 2 450 225 25 50 275 75 50 50 0 0 0 0
Non-Cash Loan Non-Cash Loan Revision
Corporate Banking 200 100 25 25 175 0 25 0 0 0 0 0
Corporate Credits 200 100 25 25 175 50 25 0 0 0 0 0
Managing Board 200 100 25 25 175 50 25 25 0 0 0 0
Internal Credit Committee 1 200 100 25 25 175 50 25 25 0 0 0 0
Internal Credit Committee 2 200 100 25 25 175 50 25 25 0 0 0 0
Non-Cash Loan Non-Cash Loan Modification 125 75 0 50 150 0 0 0 0 0 0 0
Non-Cash Loan Export LC Advising 150 50 25 50 175 0 0 0 0 0 0 0
Fund Transfer Inbank Money Transfer 35 50 25 0 0 25 0 0 0 0 0 0
Fund TransferInbank Money Transfer Between Own Accounts 35 25 0 0 0 0 0 0 0 0 0 0
Fund Transfer Swift Transfer 60 50 25 25 0 25 0 0 0 0 0 0
Fund TransferInbank Money Transfer via Internet Banking 35 25 0 0 0 25 0 0 0 0 0 0
Fund TransferInbank Money Transfer Between Own Accounts via Internet Banking 0 0 0 0 0 0 0 0 0 0 0 0
Fund Transfer Swift Transfer via Internet Banking 35 25 0 25 0 25 0 0 20 0 0 0
Time Deposit Time Deposit Opening 75 25 10 0 0 0 0 0 0 0 0 0
Time Deposit Time Deposit Modification 35 25 0 0 0 0 0 0 0 0 0 0
Time DepositTime Deposit Modification with Money Transfer 35 25 0 0 0 0 0 0 0 0 0 0
Collection Import Collection Opening 100 100 0 50 175 0 0 0 0 0 0 0
Collection Export Collection Opening 100 100 0 50 175 0 0 0 0 0 0 0
Derivatives FX Spot Entry 60 25 25 0 0 0 0 0 0 10 10 0
Derivatives FX Swap Entry 125 25 25 0 0 0 0 0 0 10 10 0
Derivatives FX Forward Entry 125 25 25 0 0 0 0 0 0 10 10 0
Derivatives FX Spot Entry via Internet Banking 0 0 0 0 0 0 0 0 0 0 10 0
Internet BankingInternet Banking Administration - Company Entry 25 75 25 0 0 0 0 0 0 0 0 0
Internet BankingInternet Banking Administration - User Entry 25 50 25 0 0 0 0 0 0 0 0 50
Internet BankingInternet Banking Administration - Company Modification 25 25 25 0 0 0 0 0 0 0 0 75
Internet BankingInternet Banking Administration - Operation Limit Modification 25 25 25 0 0 0 0 0 0 0 0 75
Internet Banking
Internet Banking Administration - Company Account Restriction Modification 25 25 25 0 0 0 0 0 0 0 0 25
Internet BankingInternet Banking Administration - Data Modification 25 50 25 0 0 0 0 0 0 0 0 125
Internet BankingInternet Banking Administration - Company Document Modification 25 25 25 0 0 0 0 0 0 0 0 100
Limit Entry Limit Openning 12270 0 0 0 0 12270 0 0 0 0 0 0
Limit Entry Limit Renewal 1710 0 0 0 0 1710 0 0 0 0 0 0
Activity Centers/Cost Centers
48
study, the activities that are performed by different levels of labors will be divided into
separate groups if there are too many activities that are performed by different levels of
labors in the same department and if the cost of different levels of labors differ
drastically.
The unit costs of each activity, in other words labor salary per minute of each business
unit, hasn’t been given in this study in numbers but it has been calculated based on the
practical capacity and the average of labor salaries for each department. The total labor
cost for related business unit/activity center divided by the practical capacity of the
labors work in that business unit gives the unit cost of the activities.
For each transaction type, the required activities have been analyzed with the guidance
of the unit manager of Corporate Banking. As an example, for the cash loan product, for
the opening of a cash loan, in other words for the issuance of a cash loan, following
activities are performed;
A. Corporate Banking – 450 minutes
B. Customer Service – 150 minutes
C. Central Registry – 25 minutes
D. Trade Finance Services – 35 minutes
However, some of these cash loan opening transactions also require either the first
(Activity E) or both (Activity E and F) of the following activities to be performed. These
activities represent the different levels of approval.
E. Corporate Credits – 75 minutes
F. Managing Board – 50 minutes
There are several parameters that defines the approval level, such as the loan amount,
riskiness of the customer, maturity term, etc. But for this study, it is not necessary to
redefine and reuse all those parameters to understand the approval level, because the
core banking system automatically decides which approval level it should carry the
transaction. Therefore, by looking at the final decision of the system for the approval
49
level, whether these activities (E and F) were involved or not for a specific transaction
can be defined. In order to do that, ‘Approval Level’ information was gathered from the
data warehouse for each transaction, instead of calculating the riskiness and the
amount of the loan to understand the approval level.
For cash loan opening transaction approval level can be one of the following levels. Next
to the approval level, the additional activities that are required are listed;
- Corporate Banking No additional activity required
- Corporate Credits Activity E
- Managing Board Activities E and F
- Internal Credit Committee 1 Activities E and F
- Internal Credit Committee 2 Activities E and F
Now, based on the approval level information, the activities that are performed for the
cash loan opening transactions are known. Thus the equation for the cost calculation
can be written as following;
Figure 12: Cost of cash loan opening transactions
Cost of Activity A. Corporate Banking * Time Spent in Activity A. Corporate Banking+
Cost of Activity B. Customer Service * Time Spent in Activity B. Customer Service+
Cost of Activity C. Central Registry * Time Spent in Activity C. Central Registry+
Cost of Activity D. Trade Finance Services * Time Spent in Activity D. Trade Finance Services+
If Approval Level is Cost of Activity E. Corporate Credits *Corporate Banking +
Cost of Activity F. Managing Board *
If Approval Level is Cost of Activity E. Corporate Credits * Time Spent in Activity E. Corporate CreditsCorporate Credits +
Cost of Activity F. Managing Board *
If Approval Level is Cost of Activity E. Corporate Credits * Time Spent in Activity E. Corporate CreditsManaging Board +
Cost of Activity F. Managing Board * Time Spent in Activity F. Managing Board
If Approval Level is Cost of Activity E. Corporate Credits * Time Spent in Activity E. Corporate CreditsICC 1 +
Cost of Activity F. Managing Board * Time Spent in Activity F. Managing Board
If Approval Level is Cost of Activity E. Corporate Credits * Time Spent in Activity E. Corporate CreditsICC 2 +
Cost of Activity F. Managing Board * Time Spent in Activity F. Managing Board
0
0
0
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For each transaction that is done for Corporate Banking unit’s customers, this
calculation will be done automatically and this will give us how much each transaction
create an operational labor cost.
This calculation system have been established in the data warehouse with the following
structures;
- Data warehouse table for the customer transaction list with the information of the
customer number, deal number, and some specific parameters that define the
transactions’ nature such as approval level. Shown as “Customer Transactions” in
Figure 13.
- Data warehouse table for the matrix of the mapping of the transaction types and the
activities, which also includes the parameters like approval level to be able to map
which activities are performed for which transaction types, and the resource usage
information for each activity in minutes. Shown as “Transaction Type - Activity
Matrix” in Figure 13.
- Data warehouse table for the activity centers with the unit costs of the activities.
Shown as “Activity Costs” in Figure 13.
Figure 13: Data Warehouse Tables for the Cost Analysis
Customer Transactions Transaction Type - Activity Matrix Activity CostsTransaction Id Product Groups DepartmentProduct Group Transaction Types Unit Cost (per minute)
Transaction Type Approval LevelApproval Level Corporate Banking (in minutes)
Transaction Date Customer Services (in minutes)Customer Number Central Registry (in minutes)Customer Name Operations Compliance (in minutes)
Transaction Amount Trade Finance Services (in minutes)Channel Corporate Credits (in minutes)
Account Officer Financial Institutions (in minutes)Managing Board (in minutes)
Money Transfer Unit (in minutes)Treasury Back Office (in minutes)Treasury Front Office (in minutes)Access Control Unit (in minutes)
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- Data Warehouse table, that applies the equation given in figure-10 for each
transaction and finds the transaction cost. Shown as “Customer Transaction
Operational Labor Cost” in Figure 14.
Figure 14: Data Warehouse Tables for the Result
- Reporting structures that show the detailed cost information of the transactions,
and the reporting structures that show the aggregated cost information in the
customer level, and business unit level.
The business unit level reporting does not give the complete picture of all business
units, because the same or similar activities are also performed for the customers of
other business units which are not in the scope of this study. After adding all customer
transactions to this structure, the complete business unit level and company level cost
information can be delivered.
Customer Transaction Operational Labor CostTransaction IdProduct Group
Transaction TypeApproval Level
Transaction DateCustomer NumberCustomer Name
Transaction AmountChannel
Account OfficerTime Spent in Corporate Banking (in minutes)
Cost of Corporate BankingTime Spent in Customer Services (in minutes)
Cost of Customer ServicesTime Spent in Central Registry (in minutes)
Cost of Central RegistryTime Spent in Operations Compliance (in minutes)
Cost of Operations ComplianceTime Spent in Trade Finance Services (in minutes)
Cost of Trade Finance ServicesTime Spent in Corporate Credits (in minutes)
Cost of Corporate CreditsTime Spent in Financial Institutions (in minutes)
Cost of Financial InstitutionsTime Spent in Managing Board (in minutes)
Cost of Managing BoardTime Spent in Money Transfer Unit (in minutes)
Cost of Money Transfer UnitTime Spent in Treasury Back Office (in minutes)
Cost of Treasury Back OfficeTime Spent in Treasury Front Office (in minutes)
Cost of Treasury Front OfficeTime Spent in Access Control Unit (in minutes)
Cost of Access Control Unit
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E. Results / Managerial Impacts
In this section, the results of the time-driven ABC application on the operational labor cost of
the cost centers under Cost of Operations group will be discussed in terms of transaction and
customer profitability affects, the capacity analysis, and the comparison of the cost allocation
from cost centers between the existing cost allocation system and time-driven ABC.
Transaction and Customer Profitability Affects
First of all, after the application and creating the database table including all customer
transactions of corporate banking unit with the transaction related information and also the
operational labor cost information, it becomes easier to track transactions for account officers
to observe how much their transactions contribute to an increase in operational labor cost, and
it enables them to make more effective and optimized pricing for the future transactions. It also
enables account officers to evaluate their customers’ profitability with the cost information that
reflects the cost of complexity of the transactions. For example, some customers generate
bigger revenues and they might be considered as the prioritized customers, nonetheless, some
of these customers might require too much complex transactions to perform that generates
higher operational labor cost and it is not reflected in the direct costs but became visible after
allocating the operational labor cost with this study.
The reporting structure has been prepared to provide the ratio of the overhead cost of
operational labor over the gross profit in the transaction level and the customer level, which
provides a picture of how much the gross margins cover the operational labor cost for each
transaction, as shown in Figure 15 and Figure 16
Figure 15: Transaction Level Profitability Analysis
Transaction Id
Customer Number
Customer Name
Fee and Commission
Expenses
Fee and Commission
Income
Funding Interest Expense
Funding Interest Income
Interest Expense
Interest Income
GROSS PROFIT
Total Time Spent by
Operational Labor
Total Cost of
Operational Labor
Operational Labor - Gross Profit Ratio
Transaction Level Profitability Analysis
53
Figure 16: Customer Level Profitability Analysis
The analysis results show that some customers already became unprofitable after deducting
the operational labor cost from the gross profit and this level does not include other overhead
costs yet, the aggregated results are given as below;
- 3% of the total corporate banking customers’ profitability turn to a loss from profit
after deducting the operational labor cost. And the average operational labor cost
over gross margin ratio for these customers is 170%, which means “A Bank” uses on
average 1.7 times more resource then the gross margins of the transactions of the
3% of the corporate banking customers.
- 97% of the total corporate banking customers remain profitable after deducting the
operational labor cost with the average operational labor cost over gross margin
ratio of 8.7%.
- 2.5% of the customers that stay profitable after deducting the operational labor
cost, have the operational labor cost over gross margin ratio above 50%, 97.5% of
these customers’ ratio remains below 50%.
- Average operational labor cost over gross margin ratio for all corporate banking
customers is 13.5%.
This customer level aggregated analysis is useful for customer analysis, however, in “A Bank”
the relationships with the corporate customers are usually established in their customers’
group level, which means “A Bank” retains several entities of the same group as separate
customers without losing the relationship between the same group customers. For example,
different entities of a group have separate customer bases in core banking system of “A Bank”,
and they ask for different products, one of them might require more revenue generating
products and the other one might require less. The reason these customers might do this is
their risk mitigation activities, they might want to have diversified portfolio of credit activities
Customer Name
TOTAL GROSS PROFIT
Total Time Spent by
Operational Labor
Total Cost of Operational
Labor
Operational Labor - Gross Profit Ratio
Customer Level Profitability Analysis
54
to disperse their risk. By having a group level relationship, “A Bank” supports their customers to
reach their goals and reduce their risks, and also create a win-win relationship.
Therefore, besides the customer level analysis, it is also very important to look at the same
analysis on the group level. The group aggregated results are given as below;
- 1.2% of the total corporate banking customer groups’ profitability turn to a loss from
profit after deducting the operational labor cost. And the average operational labor
cost over gross margin ratio for these groups is 115%, which means “A Bank” uses
on average 1.15 times more resource then the gross margins of the transactions of
the 1.2% of the corporate banking groups.
- 98.8% of the total corporate banking groups remain profitable after deducting the
operational labor cost with the average operational labor cost over gross margin
ratio of 4.6%.
- None of the groups that stay profitable after deducting the operational labor cost,
have the operational labor cost over gross margin ratio above 50%.
- Average operational labor cost over gross margin ratio for all corporate banking
groups is 5.9%.
The group level aggregated analysis shows that some of the high costs incurred by the
customers are compensated by the other customers of the same groups, because the overhead
cost ratios are lower in the group level.
The reporting structures for different user groups in “A Bank” has been prepared and they have
been evaluated by the corporate banking manager. But with this study, only the corporate
banking unit’s customer transactions were subject to the allocation, in order to publish these
results company-wide, the next phases of allocating the cost to other business units’ customers
have to be completed. The reports for different user groups include;
- Account officer level reporting which includes the related account officer’s
customers and transactions with the operational labor cost coverage ratio.
55
- Department manager level reporting including all account officers’ customers and
transactions with the operational labor cost coverage ratio and department level
profitability changes after deducting the operational labor cost.
- Executive management level reporting including, the profitability changes in the
group level and department level, and also the allocated cost from other cost
centers/business units to see how much each business unit work for other business
units.
Capacity Utilization Analysis
Secondly, this study enables the capacity analysis in corporate banking department, and it will
enable the capacity analysis company wide, when the cost allocation is applied to all customers
of the bank.
In corporate banking unit, there are several teams formed, based on the customer’s business
areas, called desks, such as “Structured Trade Finance Desk”, “Corporate Lending Desk” and
“Corporate Customer Service Desk”. Each account officer works under one desk and can be
assigned to customers regarding their desks and customer’s business area. In the cost allocation
level this breakdown hasn’t been taken into account, because when a customer requires a
transaction, the activities performed and the time spent in each activity is the same regardless
of the desk. The purpose of this differentiation is to train account officers accordingly to give
the best service to their customers. The capacity utilization analysis has been made upon the
desks to see if there is any inefficiency. It can be done in the account officer level as well.
In order to do that, first of all, the account officer of the customer information has been used
and the transactions have been divided into three groups based on the desks of the account
officers. Then the practical capacity in man-day of each desk has been calculated with the
“account officer number” times “total working day” times 95%. The reason that the analysis
made upon man-day instead of labor hour is this study is made over the year to date data and it
is agreed that man-day will make more sense for the executive management, if it is needed, it
can be also done in the labor hour level. Secondly, for each transaction the time spent in the
56
‘corporate banking’ activity center/cost center has been gathered as “system work” for the
customers of each desk and converted to man-day. This gives the work that has been done by
the corporate banking labor for each activity. But actually, this is the work that can be tracked
through the core banking system, however account officers also spend some time on finding
new customers, maintenance and retention of existing customers, reporting, etc. These
activities cannot be tracked through the core banking system. Therefore, the estimated time for
these works that are not in the system have been fed to the capacity utilization analysis
manually. Finally, the total work divided by the practical capacity gives the capacity utilization
on the desk level.
Figure 17: Capacity Utilization of Corporate Banking
Figure-13 shows the capacity utilization calculation and results for the Corporate Banking unit.
Corporate Lending Desk works close to fully utilized, while Structured Trade Finance and
Corporate Customer Service Desks work under-utilized. However, the practical capacity
calculation that is done over 95% might need to be revised based on the industry standards.
With this analysis, account officers can see how much of their time is spent for which customer,
and in total how effective they have been working in total. Because the time spent in each
activity has been defined based on the estimations and every account officer will have different
pace, with this information they will be able to compare their performance with the average
estimated performance.
Working days#
Corporate Lending Desk Structured Trade Finance Desk Corporate Customer Service DeskEmployee number # # #
Practical capacity (man-day) Employee number * Working days * 0.95 Employee number * Working days * 0.95 Employee number * Working days * 0.95
System work (man-day) Time Spent in Corporate Banking Activity
Center Time Spent in Corporate Banking Activity
Center Time Spent in Corporate Banking Activity
Center Other daily works which are not in the system (man-day) Total other works Total other works Total other works
New customer acquisition Half an hour per account officer per day *
Employee number * Working days Half an hour per account officer per day *
Employee number * Working days -
Existing customers maintenance/retention One hour per account officer per day *
Employee number * Working days One hour per account officer per day *
Employee number * Working days -
Reporting and other issue Half an hour per account officer per day *
Employee number * Working days Half an hour per account officer per day *
Employee number * Working days -
Account opening- -
Fifteen minutes per account officer per day * Employee number * Working days
KYC renewal maintenance- -
Half an hour per account officer per day * Employee number * Working days
IT work order/projects- -
Forthy five minutes per account officer per day * Employee number * Working days
New customer aquisition & Existing customer maint- -
Half an hour per account officer per day * Employee number * Working days
Total Work (man-day) System Work + Other Work System Work + Other Work System Work + Other WorkCapacity Utilization 103% 91% 81%
Corporate Banking Activity Center
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On the other hand, this analysis provides a very useful information for the department
managers and executive management for the employee related decisions.
With the existing costing system, the total cost of the capacity is being allocated to the profit
centers, therefore it is not visible to see whether the system works fully utilized or if there is
any under or over utilization or not. This is also one of the challenges of the conventional ABC,
since all costs are being allocated based on the cost drivers and rates, any capacity utilization
inefficiency is not visible. The time-driven ABC enables the allocation of costs based on the
estimated usage time, therefore unused capacity or over-used capacity can be assessed.
As Kaplan and Anderson (2003) suggested, the practical capacity has been used in this study to
make sure the total operational labor cost is subject to the cost allocation. If the ideal capacity
is used for the analysis, the 5% of the capacity, which is the accepted time as the break time for
the labor, will not be subject to the cost allocation, because there will not be work done during
the 5% of the capacity. However, that 5% of the capacity is included in the labor cost of “A
Bank”, therefore the expected working time should be calculated based on the practical
capacity.
Comparison between the Existing Cost Allocation System and Time-Driven ABC
Finally, comparison of the cost allocation from cost centers to corporate banking unit between
the existing cost allocation system and time-driven ABC can be done with the results of this
study. In this section, Corporate Credits, Customer Service and Trade Finance cost
centers/business units’ cost allocation rate with Corporate Banking unit will be discussed
regarding the difference between the existing cost allocation system and time-driven ABC.
Figure-14 shows how much resource has been used for corporate banking unit’s customers in
corporate credits, customer service and trade finance activity centers. The “other works” that
customer service perform are the activities that they perform for corporate banking unit,
therefore they have been added to this analysis manually as well. In the corporate credits and
trade finance activity centers there is no other work done for the corporate banking unit.
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Figure 18: Resource Usage in Customer Service, Corporate Credits and Trade Finance Activities for Corporate Banking Unit's Customers
As shown in the figure, customer services spent 89% of the total resources for corporate
banking unit’s customers. In the existing system, the allocation rate of total overhead costs of
customer services cost center for corporate banking unit is 91%, the rest of their resources are
used for reporting to executive management. Therefore, the existing system and the time-
driven ABC results are coherent.
The study shows that corporate credit spent 25% of the total resources for corporate banking
unit’s customers. In the existing system, the allocation rate of total overhead costs of corporate
credit cost center for corporate banking unit is 36%. This means with the existing system, the
operational labor cost of corporate credits cost center is over allocated to corporate banking
unit.
The study shows that trade finance services spent 40% of the total resources for corporate
banking unit’s customers. In the existing system, the allocation rate of total overhead costs of
trade finance services cost center for corporate banking unit is 49%. This means with the
existing system, the operational labor cost of trade finance services cost center is over allocated
to corporate banking unit.
Working days#
Customer Service Activity Center
Corporate Credits Activity Center
Trade Finance Services Activity Center
Employee number # # #
Practical capacity (man-day)
Employee number * Working days * 0.95
Employee number * Working days * 0.95
Employee number * Working days * 0.95
System work (man-day) Time Spent in Customer Service
Activity Center Time Spent in Corporate Credits
Activity Center Time Spent in Trade Finance
Services Activity Center Other daily works which are not in the system (man-day) Total other works Total other works Total other works
New customer acquisition- - -
Existing customers maintenance/retention- - -
Reporting and other issue- - -
Account opening Fifteen minutes per account officer
per day * Employee number * - -
KYC renewal maintenance Half an hour per account officer per day * Employee number * Working
- -
IT work order/projects
Forthy five minutes per account officer per day * Employee number *
Working days - -
New customer aquisition & Existing customer maint Half an hour per account officer per day * Employee number * Working
- -
Total Work (man-day) System Work + Other Work System Work + Other Work System Work + Other WorkCapacity Utilization 89% 25% 40%
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F. Challenges of the Applied Methodology
In this section, the challenges and difficulties of the applied methodology will be discussed. First
of all, time-driven ABC application on the operational labor cost created the granularity for the
transaction based and customer based profitability observation for the decision making.
However, every new implementation in the organizations might create resistance. In order to
sustain this cost allocation methodology, the business units support should be ensured,
because the reliability of the calculations depend on their estimations on the resource usage.
The proposed methodology brings the visibility on the resource usage in a very detailed level, it
also brings visibility on the capacity utilization in the account officer level. This means, the
account officers’ performance can be tracked through every transaction they perform. When
the study is expanded to the company level to include all customers, every employees’
performance can be tracked on the transaction level. This might take away the autonomy to
some extent. Currently, they are expected to manage their time and reach their targets, but
with the proposed methodology, they will be expected to perform according to the estimated
times for each activity. However, in real life some transactions or some customers might not fit
in the estimations.
Another challenge is the maintenance of the proposed methodology. As shown in figure-11,
there are many different transaction types and each of them requires different activities, and
the resource usage in each activity differs between transaction types. If the transaction types
and the estimated resource usage in the activities for each transaction change instantly, it
might create maintenance issues. The importance scale of this issue depends on bank’s decision
about the usage frequency of the proposed cost allocation process. If “A Bank” decides to use
the process yearly or semiannually, the maintenance of the “Transaction Type - Activity Matrix”
will be less complex than it will be if they decide to use the process daily.
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G. Future Studies
As the future studies, the application should be extended to the company wide to be able to
see the overall picture of the cost impacts on the transactions and customers. In order to do
that, all profit centers’ customer transactions should be analyzed and the activity analysis and
the activity cost analysis should be done as it has been done for corporate banking customer
transactions in this study.
Furthermore, this study only includes the allocation of operational labor cost, the application
can be extended to include the allocation of all overhead costs. At least, for the allocation for
other overhead costs, instead of using the cost allocation ratios that are given in the existing
system, the results of this study can be used, which means the calculated time spent by each
business unit for each profit center can be used to allocate all other overhead costs as well,
because it relies on real usage level of the resources.
The study can be extended to different directions, such as time-driven ABC application on
assigning the overhead costs to cost centers at the beginning, or automation of some of the
processes that are explained in this study, or creating an automated tracking infrastructure to
assess the real resource usage for each transaction. It is an open area for the new innovations
or new applications for the existing framework. However, for the sake of the simplicity and
sustainability, it is more convenient to extend the application step by step by observing the
effects and implications over the time.
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IV. CONCLUSION
Time-driven ABC provided ease and convenience for the application in terms of the simplicity of
the terminology and the number of cost drivers to focus. It also shorten the time spent on the
activity analysis and the activity cost analysis, because it only requires estimated average time
spent on each activity and can be provided by the unit managers, as it was described by Kaplan
and Anderson (2003, p.7) as, “The time-driven ABC procedure uses an estimate of the time
required each time the activity is performed. This unit time estimate replaces the process of
interviewing people to learn what percentage of their time is spent on all the activities in an
activity dictionary”. In this study, the corporate banking unit manager has provided all the
estimated time spent for each activity including other business unit activities with the
consultation of other business unit managers.
As it was mentioned in the same paper (Kaplan and Anderson, 2003), it gives a validation ability
by calculating the total time spent with comparison to the total head count. In the conventional
ABC, since the all the overhead cost is allocated based on the ratios regardless of the real
consumption of the resources, it is hard to validate, whether total overhead cost was indeed
used by the products and customers or not.
This study also showed that besides the cost allocation analysis, results of TDABC can be also
used for the capacity utilization analysis as it was claimed by Ozyurek and Dinc (2014, p.106) as
the advantages of TDABC, “Provides visibility to process efficiencies and capacity utilization”.
This pilot study, first of all, provides a picture of the activities and the capacity usage of
Corporate Banking unit in “A Bank”, which can be used for improvement decisions, on the other
hand, the study also provides an ability to allocate operational labor cost to each transaction
based on the nature and distinctive features of each transaction, which can be used for
profitability analysis. It is important to see the effects and implications of TDABC after
completing the application to all customers of “A Bank”, then the management can decide on
the usage area of the results of the applied methodology.
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