The innovation that Robert S. Kaplan and David P. Norton achieved in the Balanced Scorecard (BSC) methodology was the creative synthesis of three well-established traditions in business thought: managerial accounting, activity-based costing, and strategy. In my first post of this series, I addressed the influence of managerial accounting. In this post, I’ll highlight the importance of activity-based costing in the development of BSC.
Activity-based costing (ABC) gained popularity in the 1980s as a more accurate means of allocating costs to products and customers. Traditionally, firms allocated all overhead costs based on a single variable such as direct labor hours or machine hours. (So if a firm used 10,000 direct labor hours to produce a product, that product was charged 10,000 times the overhead rate, which itself is calculated by dividing all overhead costs by the expected number of direct labor hours for the period.)
The traditional approach worked reasonably well when firms produced less of a variety of products and when direct labor and materials made up the majority of costs. But with the increased overhead costs of automation and the increased diversity of products (each of which consumes resources in different ways), the traditional approach failed to allocate costs appropriately, over-costing some products and under-costing others, leading to strategic mistakes in marketing, pricing, and product development.
ABC separates overhead costs into multiple activity-based cost pools—such as design, mold-setting, packaging, order handling—and allocates costs from these pools to cost objects—such as products and customers—based on activity measures that have a cause-and-effect relationship to the consumption of costs in the activity cost pool.
For example, a complex product might require more frequent and costly design changes than a simple product. Allocating these overhead design costs based on direct manufacturing labor hours would result in an under allocation of design costs to the complex product. In contrast, an ABC system might allocate these design costs based on an activity measure such as the number of components in the product or the number of design changes, measures that more accurately reflect the actual consumption of the resource.
ABC introduced several innovations that BSC built upon:
- ABC calls for the accounting team to work closely with operations, marketing, sales, design, and other stakeholders to gain an intimate understanding of how the business operates in order to model cost drivers.
- ABC looks beyond manufacturing costs (the only costs allocated to products in traditional costing systems) to marketing, sales, and product development.
- ABC calls for the analysis of cause-and-effect relationships between costs and the activities that sustain products, customers, and the organization.
- ABC advocates expect that the information collected will enable executives to make strategic decisions about products and customers.
Kaplan was an early advocate of ABC and wrote articles on the topic in the 1980s. In The Balanced Scorecard (1996), Kaplan and co-author Norton refer to ABC several times as a key to cost control, process efficiency, and the measurement of customer profitability.
Interestingly, while BSC built on the innovations of ABC—especially the call for accounting to work with the business to understand cause-and-effect relationships between variables—BSC complements rather than replaces ABC. Indeed, Kaplan still contributes to the development of ABC. In Time-Driven Activity Based Costing (2007), Kaplan and co-author Steven Anderson wrote that “ABC provides a model of cost while the Balanced Scorecard describes a model of value creation.”
By value creation, Kaplan refers to the role of BSC in the execution of strategy for competitive advantage, a reference to the work of Michael Porter, which I’ll address in the next post of this series.