Activity-based costing: Innovative methods to decrease costs and increase profitability

Challenges facing insurers today
Insurance carriers face a myriad of challenges as they drive their businesses towards profitability. Volatile market conditions in the investment and real estate communities, typically bellwethers for insurance investments, are driving organizations to further examine their own costing structures and methods for identifying and understanding the costs that make up their business model. Combined with unprecedented customer churn, new entrants and consolidation in the market, and recent significant man-made and natural disasters, insurers need to adopt new methods to ensure that underwriting is profitable.
Impact of costs and expenses
Typically, insurance organizations are divided into two distinct areas.  One is corporate (or staff), with functions such as finance or actuarial. The second is field operations, with functions such as regional, district or branch profit, underwriting, and claims or service centers. Both need access to reality-based costing information.
Each profit center must identify and model premium, loss-and-expense driven relationships by line of business, region and branch, and plan and budget for both direct and indirect channels.
For corporate functions, the primary challenges involve process control and slow response times.  In field operations, the focus is on agent, policyholder, or claimant-facing activities which include the need to control resources efficiently, manage different revenue and cost areas within the business and meet a range of reporting requirements. Often hampered by a lack of financial analysis of true costs within their operations, field managers find it challenging to drive financial accountability.

• Claims and loss adjustment costs, including both direct claims or benefits cost and loss adjustment expenses, represent up to 75% of the incoming premium dollar.

• Business acquisition and underwriting costs, including commissions paid to agents and brokers, auto or property inspection expenses, credit and motor vehicle report fees, medical examination fees, and rating and underwriting expenses, represent 15-25% of the premium dollar, depending upon the type of business and insurer distribution model employed.

• General and administrative costs, including taxes and general expenses other than underwriting/acquisition and loss adjustment expenses such as rent and utilities, information technology and labor, represent 5-10% of the premium dollar.

Once primary cost categories are identified and captured, the financial information must be translated into industry-specific operational key performance indicators (KPIs). Cost reduction and profitability across customers, products, channels, and markets typically play a predominant role in these KPIs.
Enter activity-based costing
As companies struggle to gain a more complete understanding of customer, product and channel profitability, they realize the importance of using activity-based costing (ABC) to correctly calculate costs. Activities can be defined at the macro level (such as direct premium payment) or at a more detailed level (such as payment at an agent’s office, recognizing that costs will vary by product and by delivery channel as well as geographically). One of the key challenges for insurance organizations is to understand how their infrastructure resources are consumed. This can only be reliably understood by using an ABC methodology to calculate how products, customers and channels consume activities and how activities consume resources and costs.
Activity-based costing defines and measures the cost and performance of objects, activities and resources. Cost objects consume activities, and activities consume resources. Resource costs are assigned to activities based on their use of those resources, and activity costs are reassigned to cost objects (outputs) based on the cost objects’ proportional use of those activities. ABC helps organizations to understand the activities and resources associated with cost objects. This allows for examination of a firm’s financial and operating data and enables the monitoring and analysis of performance metrics.
An example of ABC benefit
Net written premium is significantly impacted by the expenses incurred in processing and brokerage.
A large healthcare insurer in the Northeast worked with an assumed costing model for its claims process. Before ABC, it was assumed that the cost for processing a claim for one customer was the same as processing a claim for another, regardless of the methodology used for processing.
Using ABC, they started to examine critical points such as the number of claims received and the method by which they were processed. They reviewed the number of claims that were automatically processed and how many were received electronically versus paper claim submissions – critical drivers that impact the costs associated with each customer. Through the use of activity-based costing, they discovered that all claims processes do not result in the same cost structure and that some customer bands were costing significantly more than others.
Consequently, they arrived at a number of important discoveries regarding claims processing.  First, auto-adjudication (automatic processing of claims) proved to be an area of key cost differential. Accordingly, improving processes to increase the use of auto-adjudication and reduce human intervention resulted in significant savings.
They also focused on rework – those claims that had to be reprocessed as a result of being paid incorrectly. ABC provided a method to assign a value to claims handling and rework efforts. Once a dollar value was assigned to claims processing rework (and these values can run into the millions of dollars), employees and management began to pay attention. This type of analysis helped to focus improvement efforts.
This information had a significant ripple effect across the organization. As the company’s customer base expands, they can easily determine an appropriate allocation of costs for customers and products they are acquiring. It allows the insurer to understand levels of profitability associated with each customer band enabling them to negotiate contracts that drive more revenue or lower costs.
One of the key challenges for any large organization is to understand how their infrastructure resources are consumed. This can only be reliably understood by using an ABC methodology to calculate how products, customers and channels consume activities and how activities consume resources and other costs.
Activity-based costing methodologies
Activity-based costing involves the collection and collation of system and non-system data. This often involves interviewing staff and documenting activities and cycle times associated with those activities.
One of the main deterrents from implementing ABC has been the amount of time and cost involved in collecting and collating non-system data, often involving manual interventions that include interviewing multiple staff members and examining mountains of output from paper-based systems. This has led some to seek other methodologies for allocating resource costs to activities.
We can now turn to a review of the strengths and limitations of each of the methodologies used in ABC, including time-splits, time-capture and time-driven costing, and provide a working example of each.
The choice of methodology should be based upon characteristics of the specific activity being costed and the availability of reliable and robust data. In practice, this means implementations will rarely, if ever, be based on a single methodology. Organizations should ensure the software they select can easily support all three methodologies and includes the tools required to easily update their models.
Below is a simple insurance scenario that demonstrates how activities are costed using each of the methodologies reviewed:
Activities
This scenario is based on a department that carries out two activities: processing applications and handling claims.
Driver volumes
During the month studied, the department processes 5,000 applications and 1,000 claims.
Resources
There are four staff dedicated to the department, working seven hours for 20 working days per month, totaling 560 hours (33,600 minutes) of available capacity. In addition, a supervisor spends 60% of her time managing the department. The remainder of the supervisor’s time is spent managing another department.
Cost
The direct expense (salary, benefits etc.) incurred for staff running the department during the month is $16,800. The supervisor adds an additional $5,600. An estimated 60% of working hours are spent processing applications and 40% on claims.
In addition, there are costs of $4,200 allocated to the department each month for indirect costs such as facilities, IT and HR. Indirect costs are split between the two activities based upon the resources they consume. In our example, the “claims processing” activity involves making extensive use of outbound telephone calls. Therefore, this activity receives a larger cost allocation (70%), while the “process applications” activity receives less (30%). We’ll see that all of this information is required for costing, regardless of the methodology used.
Methodology 1: Time-splits
Time-splits are the simplest ABC methodology to understand. Managers are simply surveyed to find out what proportion of working time is spent on various activities. This proportion is used to allocate expenses to activities.
Calculated example of costing using time-splits
The manager responsible for the department needs to provide three numbers only: the proportion of time spent processing applications, the proportion spent on processing claims and a figure for any excess capacity.
For example, as the team processes each day’s applications until this activity is completed (generally early in the afternoon) and then processes claims until the end of the workday, the manager is sure that little or no excess capacity exists and that a fairly reliable split for the activities is 66% for processing applications and 33% for processing claims.
Calculation. The calculation has two stages: first we assign resource costs to activities, and then we assign activity costs to cost objects.
In Step 1, time-splits are used to assign resource costs to activities. In Step 2, volume drivers are used to calculate activity unit rates.
Step 1: Assigning resource costs to activities

ACTIVITIES

	Process Applications	Process Claims	Total
Time-split	66.7%	33.3%	100.0%
Assignment of direct cost	($16,800 x 66.7%)$11,200	($16,800 x 33.3%) $5,600	$16,800
Assignment of supervisor cost	($5,600 x 60% x 60%) $2,016	($5,600 x 60% x 40%) $1,344	$3,360
Assignment of indirect cost	($4,200 x 30%) $1,260	($4,200 x 70%) $2,940	$4,200
Total cost of activity	$14,476	$9,884	$24,360

Step 2: Calculating activity unit rates

     ACTIVITIES

	Process Applications	Process Claims	Total
Total cost of activity	$14,476	$9,884	$24,360
Volume driver	5,000	1,000
Calculation	($14,476 / 5,000)	($9,884 /1,000)
Assignment of indirect cost	($4,200 x 30%) $1,260	($4,200 x 70%) $2,940	$4,200
Activity unit rate assigned to cost object	$2.90	$9.88

Strengths of time-splits
Ease of implementation
Costing using time-splits is very straightforward and only requires data found in the general ledger and data collected from each responsibility center. As such, it is frequently used for pilot studies, where early results guide the methodologies used for model refinements.
Implementing ABC based on time-splits involves working with each responsibility center to develop a dictionary of the activities they carry out and allowing them to routinely report the amount of time spent on each activity. This allows managers to directly participate in the project and review results with the knowledge that they contributed to them. Consequently, there is likely to be greater commitment to the success of the project.
Weaknesses of time-splits
Data collection and collation
Resurveying contributors every time a model is refreshed can be laborious. However, the advent of web-based ABC applications that allow data to be entered directly into the database and the deployment of work management tools that expedite routine data collection has eliminated many of these issues.
Failure to identify excess capacity
When asked to submit time-splits, few managers will willingly reveal large amounts of excess capacity and idle time. This means that substantial excess capacity is rarely revealed when time-splits are used.
Supposed lack of accuracy
Because of its simple empirical approach, time-splits are viewed as being less accurate than other methodologies. However, in those responsibility centers where there is reliable data on how staff spend their time (e.g., customer contact centers), managers acknowledge the value of this information. This will produce results that are no less reliable than those generated using other methodologies.
Methodology 2: Time-capture
Time-capture is a particularly useful method for ascertaining how staff split their time between projects and customers. The value becomes evident when applied to functions such as research and development, IT, or in professional service organizations, where activities are rarely repetitive. As a rule of thumb, wherever the time-capture method is already being used in an organization, it should be considered the appropriate method for ABC costing before any other is considered.
Calculated example of costing using time-capture
The amount of time staff  spend on each activity might be captured from the systems they are using, from a specific time-capture application or from time sheets submitted by staff. In the example below, the figures indicate that 336 hours were spent processing applications, 168 hours processing claims and 56 hours unaccounted for, which the manager records as excess capacity.
Calculation
In this example, the actual hours are used to assign resource costs to activities in Step 1. But in Step 2, volume drivers are used to calculate activity unit rates, just as in the first example.
Step 1: Assigning resource costs to activities

ACTIVITIES

	Process applications	Process claims	Excess capacity	Total
Time spent (hrs)	336	168	56	560
Assignment of direct cost	($16,800 x 336/560) $10,080	($16,800 x 168/ 560) $5,040	($16,800 x 56/560) $1,680	$16,800
Assignment of supervisor cost	($5,600 x 60% x 60%) $2,016	($5,600 x 60% x 40%) $1,344		$3,360
Assignment of indirect cost	($4,200 x 30%)$1,260	($4,200 x 70%)$2,940		$4,200
Total cost of activity	$13,356	$9,324	$1,680	$24,360

 
Step 2: Calculating activity unit rates

ACTIVITIES

	Process applications	Process claims	Excess capacity	Total
Total cost of activity	$13,356	$9,324	$1,680	$24,360
Volume driver	5,000	1,000
Calculation	($13,356/ 5,000)	($9,324/ 1,000)
Activity unit rate assigned to cost object	$2.67	$9.32

Strengths of time-capture
Where blocks of time are dedicated to specific projects or customers, and where activities aren’t repetitive and time-capture is already in use, time-capture is the preferred methodology for allocating resource costs to activities.
Weaknesses of time-capture
Exposing excess capacity
Unless time-capture is completely automated and not dependent upon an individual triggering a recording of time spent working, it is unlikely to accurately expose excess capacity (although it is more likely to do so than the time-splits methodology).
Staff resistance
If a time-capture system is already in use for billing or cross charging, using the data for ABC costing is unlikely to generate dissent among staff. However, introducing a time-capture system where none previously existed requires strong change management skills.
Methodology 3: Time-driven ABC
Time-driven costing involves allocating costs based on the practical capacity of the resources supplied by measuring (or estimating) the amount of time taken to perform an activity. The volume of transactions is fundamental to the calculation of time-driven costing:

• Transactional cost drivers are counts of the number of times an activity is performed. Examples include the number of purchase orders processed, the number of inbound telephone calls answered and the number of delivery drops made. By definition, a transactional driver is used whenever a repeatable activity is completed in a similar amount of time.

• Duration drivers are measurements (or estimates) of the time required to perform a task or activity. Examples of duration drivers include the time taken to answer a telephone call or process an application. In certain responsibility centers, duration drivers may be reliably accessed (e.g., in most customer contact centers, the amount of time to handle a call is automatically recorded). Using logistics operations as another example, duration drivers may be captured from hand wands at the time of collection and delivery.

An early exponent of ABC, Dr Robert Kaplan, promotes time-driven costing as being “… simpler for estimating and maintaining an ABC model, and also more accurate.” While time-driven costing undoubtedly has a place in ABC and is the preferred methodology in certain situations, it has its limitations.
Calculated example of costing using time-driven ABC
Time-driven duration drivers for our two activity examples are system-generated. The processing system provides the average duration for application processing (4 minutes), while call accounting functions of the telephone system provide the average duration of time to handle a claim (10 minutes).
Calculation
In this example, the department’s resources consisted of four staff members working 7 hours per day for 20 days. Including holidays and sick days reduces the available time by 10% to accurately reflect the true resource availability.
Step 1: Calculating the unit cost of available time

	Total
Direct cost	$16,800
Time available(mins)	((4 x 20 x 7 x 60) x 90%) 30,240
Cost per minute	($16,800 / 30,240) $0.555

Step 2: Calculating activity unit rates

ACTIVITIES

	Process applications	Process claims	Total
Volume driver	5,000	1,000
Cycle time (mins)	4’00	10’00
Total time used (mins)	(4 x 5,000) 20,000	(10 x 1,000) 10,000	30,000
Cost of time used	(20,000 x $0.555) $11,100	(10,000 x $0.555) $5,550	$16,650
Assignment of supervisor’s costs†	($5,600 x 60% x 60%) $2,016	($5,600 x 60% x 40%) $1,344	$3,360
Assignment of indirect cost†	($4,200 x 30%) $1,260	($4,200 x 70%) $2,940	$4,200
Total activity cost	($11,100 + $2016 + $1260) $14,376	($5,500 + $1,344 + $2,940) $9,834	$24,210
Activity unit rate	($14,376 / 5000) $2.88	($9,834 / 1000) $9.83
Excess capacity (mins)			(30,240 – 30,000) = 240
Cost of excess capacity			(240 x $0.555) $133

† It should be noted that while time-driven ABC is effective, it should not be used in isolation. In this example, supervisory and indirect costs are not suited to time-driven costing, therefore, costs are based on the resources consumed by each activity.
Completing the calculation reveals that $133 of resource cost, equivalent to 240 minutes (4 hours) of the available resource time, is attributable to excess capacity.
Strengths of time-driven ABC
Surfacing excess capacity
When people estimate how much time they spend on a given list of activities, they invariably supply percentages that add up to 100%, as very few individuals will say that any of their time is unused or idle. As such, cost driver rates calculated from this process may incorrectly assume that resources are working at full capacity. Time-driven ABC effectively overcomes this problem and reveals differences between the total amount of time needed to carry out activities in a responsibility center and the actual amount of time available given its current resources. (Note that this can lead to time-driven ABC becoming closely associated with time and motion studies, which are viewed unfavorably by many workforces.)
Weaknesses of time-driven ABC
Availability of reliable and robust duration drivers
Unless the data are readily available, robust and reliable, time-driven ABC can generate as many problems as it purports to solve.
If the data come from reliable systems such as automated call handling systems, and are regularly updated, they will be accurate. However, if they are out of date or based on estimates, they could result in substantial errors; the difference between an estimate of four minutes and four minutes ten seconds to handle an inbound telesales call may not seem like much, but when one considers volumes of 100,000 calls or more it becomes quite substantial. Therefore, a time-driven methodology requires as much data collection as any other methodology if it is to be robust and reliable.
In any organization there will be responsibility centers, such as marketing, legal, research and areas of IT, where activities are far from homogeneous and repetitive and duration drivers are simply not available. In these instances, a different methodology must be used.
Understanding variances in duration drivers
Duration drivers can be used at the aggregated or individual level. Where duration drivers are available for each individual transaction, a time-driven methodology can be used to calculate a unique cost for each instance. For example, if the system logs that it takes an agent 8 minutes to handle an inbound telephone call, it would pick up twice as much cost as a more typical call that takes only 4 minutes to handle.
The cost is valid if this is a more complex call for a different type of service: the type that would be identified as a separate activity under any other ABC methodology. However, if the call took 8 minutes simply because it was taken by an inexperienced agent, then the charge is invalid and will provide erroneous results.
The above discussion is not intended to provide a definitive answer on the use of time-driven costing. Rather, it’s provided to illustrate that even in those situations where hard data such as duration and cycle times are available, their use in calculating costs and profitability need to be carefully considered if inappropriate allocations are to be avoided.
Data collection
It is frequently suggested that time-driven costing eliminates the need for surveys and data collection; this is not the case. Each time a model is refreshed and recalculated, duration drivers must be updated; even the most repetitive processes change. Contact center agents are frequently provided with new scripts in attempts to up-sell and cross-sell other products and services, and all such changes impact the length of a call. These changes need to be acknowledged by either extracting the data from a transactional system or asking process owners to provide updates. This is easily achieved with web-based ABC applications and work management tools that expedite data collection.
Importantly, if reliable systems are not in place to capture cycle times, there may be a dependency upon surveys, and survey subjects are likely to alter their normal working patterns so as to appear to be more productive than they may actually be.
One also needs to consider what happens if the computation of driver volumes and activity cycle times suggests that a department is working above its theoretical capacity, as this would surely cast doubt on the reliability of any ABC model and lead managers to question the validity of the reports.
Volume of data
Costing individual transactions using a timed-based methodology quickly generates enormous amounts of data, which require large databases and powerful analysis and reporting tools to derive meaningful reports.
Before going to this level of granularity (e.g., using a time-driven methodology to calculate the cost of every transaction for every customer), it is worthwhile understanding exactly how managers in the organization intend to use the information to inform their decision making. Other than for key accounts, the focus of most strategic and operational decisions is at the customer segment level, and so it may be more useful – and considerably less burdensome – to provide analysis at this higher level.
The hybrid model
While each of the methodologies discussed previously has its own particular strengths, none is perfect for every activity in every responsibility center. In practice, models will be hybrids, with different methodologies being used for different responsibility centers. Even then, it is unlikely that reliable data are available for every activity; in certain instances it may be necessary to resort to approximations using weightings.
Nevertheless, whichever methodology is chosen, it is essential to refresh non-system driver data each time a model is calculated. Web-based ABC applications make this remarkably easy and there is no reason why ABC data should not be produced every month as part of the traditional reporting package.
It is unlikely that a single methodology will be appropriate for all activities in a model, so it is essential organizations choose an ABC application capable of supporting all the methodologies, together with the flexibility to incorporate any special requirements for unique situations.  Excess capacity should be identified and costed, but it’s also important that future periods where capacity may be exceeded are identified early enough to be able to take action.
Moving forward with activity based costing
Activity-based costing offers a number of significant improvement opportunities within insurance organizations. Here are some best practices to consider when looking to undertake an activity-based costing initiative.

• Pick a key area in your organization that would likely benefit from a better understanding of costs and devote a meaningful amount of time in that area implementing activity-based costing principles. Once you’ve been successful in that area, use your success as a sales tool and a model to expand into other areas within the organization.

• If you are new to activity-based costing, it’s worth the investment to bring in a consultant to help during the setup and establishment of ABC methods. Look for consultants with experience in activity-based costing as they can help move you through the process more effectively and help accelerate “time-to-results.”

• Senior management buy-in is critical to ensure that you have the needed support to be effective.

• Target areas include areas that staff know could use a good dose of improvement. When you are able to assign a real dollar amount to the cost of inefficiency, it tends to grab the attention of management.

• To be reliable, profitability measurement must be based on an ABC methodology.

• Analysis of only one dimension of profitability (e.g., customer profitability) will not provide adequate insight for decision-making.

• Companies need to ensure that their ABC initiative fits seamlessly into their existing data schema. Frequently, this means costing individual transactions and individual customers.

• Always use a costing methodology appropriate for a specific activity within a specific department.

• Companies should ensure that the methodology used in their chosen ABC application uses a single-step, multi-dimensional allocation of activity costs to cost objects.

The real value from activity-based costing projects is the ability to manage costs and report actionable information. Such information creates a huge level of awareness within an organization regarding cost drivers. Conscientious managers and staff are hungry for this type of information; it gets them engaged in mapping processes to derive an understanding of the activities related to that process and their associated costs. This helps manage budgets with far greater reliability. The result is a more collaborative approach to the business – and its bottom line.

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Richard Barrett is Director of Operations in Business Objects’ Center of Excellence. He started his career in pharmaceuticals, received an MBA in 1981 and became a Fellow of the UK Chartered Institute of Marketing in 1990. He has worked in consultancy, national and international positions in consumer marketing, insurance, and business-to-business marketing. He first became involved in planning and budgeting as Planning Manager for DHL Worldwide Express in Europe in the late ’80s and has continued his interest in the topic ever since. In 2000, he joined ALG Software, a leading provider of software for activity-based costing, which became part of Business Objects in 2006. He regularly speaks at performance management events and presents courses on customer profitability and driver-based budgeting for the Chartered Institute of Management Accountants (UK).