Time Driven Activity Based Costing (TDABC)
TDABC is a costing method that uses the time required to complete each step in a process to produce a product or deliver a service. The cost of a product or service is determined by multiplying the total time required to complete a series of process steps by the capacity cost rate, whereas the capacity cost rate (expressed as a cost per unit of time) is determined by the total cost of capacity supplied (such costs include personnel; benefits; management; occupancy; utilities; equipment costs; allocated indirect and overhead spending) divided by the practical capacity of resources (expressed using a unit of time) within a given time period. Similar to ACA, indirect and overhead costs are “allocated” (in many cases in an arbitrary manner ) such that they represent an overhead cost to the department that is performing the prescribed process—an overhead rate expressed in monetary or percentage terms. Since managerial and O&I costs are blended into the total cost of capacity supplied, the activities associated with these O&I costs cannot be determined so the value resulting from such costs cannot be established. Since many tasks that, at best, can be identified as “knowledge work” or variable in time consumption, such activities cannot be described in terms of specific process-step time and therefore, they cannot be adequately costed and may represent a significant portion of total spending. To refer to TDABC as activity based costing may be a misnomer as it does not follow the tenets associated with conventional ABC and more closely resembles Industrial Engineering process-based costing and ACA.
An example can best describe how a how TDABC is applied to the following Accounts Payable Process:
The estimated time for each process step is as follows:
The next step is to compute the Capacity Cost Rate, defined as:
With the quarterly departmental expenses computed to be:
Note: Of which 40% of the cost of capacity supplied represents allocated overhead expenses.
The following represents the volume-cost analysis for the Accounts Payable process:
From a cost perspective, the operation in Accounts Payables is running at 77.71% with the cost of excess capacity being $67,549. The difference in practical capacity (245,700 minutes) and the used capacity (191,418 minutes) is 64,282 minutes per quarter, equivalent to 2.62 Full-Time Equivalents (FTEs).
Limitations and shortcomings of conventional TDABC systems. The following represents the most significant issues related to Time Driven Activity Based Costing. Because of the complexity of TDABC, the number of significant limitations may actually exceed that of conventional ABC. Any advantages of TDABC over conventional ABC and conventional cost accounting are offset by its disadvantages:
- Lack of visibility of non-productive time. Since the cost associated with departmental non-productive time is integrated into the cost of capacity supplied and the resulting cost per minute, the total cost of such events are not computed individually so visibility to such costs are hidden. Additionally, since resource costs are blended and the blended resource rate is applied to each activity without identification of individual resources, TDABC cannot identify specific unused resources – necessary for performance improvement.
- Managerial time included in production time. The work of management is included in the computation of the total cost of capacity and thus losing visibility of the non-production time and cost of management, necessary if management activities are to be measured, analyzed, and improved.
- Limited to time being the only driver. Costs in TDABC are derived from the time required to perform various process steps. However, there are many tasks that, at best, can be designated as “knowledge work” that cannot be described by process time and such efforts may constitute a significant portion of total spending. Such efforts are often “allocated” to departments and/or LOBs using arbitrary methods similar to that used in conventional absorption cost accounting.
- Void of qualitative information. TDABC practitioners promote the advantage of eliminating surveying and interviewing employees. Yet, if production standards are not available, extensive interviewing in each department would be necessary to create standard times for each step in a process. Additionally, without interviews, qualitative information that would provide insights into operational roadblocks, concerns, and opportunities would not be identified – clearly required for performance improvement. Such input from stakeholders is necessary for employee engagement to evaluate the level of performance and whether process costs are reasonable.
- Lack of pre-determined activities. Costs are computed individually by department without the benefit of identifying cross-functional enterprise-wide activity costs. If individual pre-defined activities are not defined, yet a single averaged resource cost rate is computed, non-production costs that may have a negative impact on department performance will not identified. Also, without pre-defined cross-functional activities, organization-wide costs associated with activities cannot be produced nor cross-functional costs and duplication identified.
- Compounded errors in time standards. TDABC relies on estimations from employees and management regarding times required for each process step. Employees may feel they are under investigation, resulting in estimation errors. Validation of process-step times are not typically performed nor consideration of other factors that would influence the time estimates like level of training, volume, non-linearity, process bottlenecks, different characteristics across multiple LOBs, etc. Estimation errors may be compounded from process step to process step, producing significant over- and under-estimates of total process times resulting in significant costing errors. Cardinaels & Labro (Cardinaels, E. & Labro, E. (2009). “Time Estimates as Cost Drivers. Chartered Institute of Management Accountants.” The Helicon, 1 South Pl, London EC2M 2RB, UK, pg. 4.) referenced the research of Ittner (Ittner, C.D. (1999). “Activity-Based Costing Concepts for Quality Improvement.” European Management Journal, 1999, Volume 17, Issue 5, pp 492-500.) who, in turn, stated that experience suggests, that employees’ time estimates regarding their activities are often inaccurate. Also,“despite the widespread use of time estimates in costing and a general sentiment that time estimates may be prone to error, there has been little research into what causes this error.”
The research of (Cardinaels & Labro) 2009 suggests that employees tend to significantly overestimate their Rtime (e.g., in minutes) that they spend on activities when asked to estimate their efforts using time units. They found in their research that 77% of the participants over-estimated their time by 37% on average.
Such estimation errors increase resulting cost computations to the point that decisions based on these estimates may be unusable. Exit questionnaires administered by Cardinaels & Labro (2008) indicated that there is much greater confidence in the accuracy of their estimates than in their absolute time (minutes) estimates.
- Complexity of time equations. TDABC is only beneficial when the number of individual products or services are limited to only one or two LOBs. Multiple LOBs, with each having unique time standards, would add insurmountable complexity to the development of cost equations as evidenced by the simple example described previously.
Ratnatunga (Ratnatunga, J.: Tse, M. & Balachandran, K.R. . “Cost Management in Sri Lanka: A Case Study on Volume, Activity and Time as Cost Drivers. The International Journal of Accounting. 47, pg. 281.) stated…
“we conclude the following: the TDABC model has similar implementation complexities to ABC if modelling conditions are strictly adhered to … and in its simplest form, the model generates the same decision information errors of traditional costing.”
- Use of averages. TDABC relies heavily on averages which distort outcomes:
- The capacity cost rate (e.g., the cost per time period), representing an cost per minute of employee effort, could contain significant variations from that average that would contribute to over- and under-costing as with conventional and ABC costing methods.
- Production standards are estimated averages of the time required to perform an activity and like other averages, the standards may not reflect the variations in the time based on LOB, complexity, linearity, and other factors that would significantly influence production times.
- Average time estimates are treated as variable, driven by the quantity of production where the total time is proportional to the quantity. Economies of scale, batch sizes, and other factors that would affect output are normally not considered in actual practice.
- Misapplied corporate, independent, and support costs. Many departments in the organization do not directly “touch” a product or service but support the infrastructure of the business. If these costs are not included in the total departmental cost, such spending will be missed in the computation of the cost rate. Many organizations will assign such costs utilizing arbitrary methods similar to that used in conventional cost accounting (e.g., by revenue, machine hours, etc.). When assigned as an overhead cost, they will not typically represent the cost of the process and/or capacity cost rate related to the production of the transactions. These allocations of support costs rarely represent the demands on the support functions from individual operating departments. Although it is recommended that TDABC should be applied in these support departments as well. However, the driver for much of their work is not time as many of the support activities and/or events are variable in nature. It is often recommended that such costs are to be accumulated – corporate sustaining expenses - then allocated to the departments using more rational methods. Given that the work in the support functions most likely will not directly pertain to the processes performed in a department, such costs would have to be allocated to multiple departments that support multiple LOBs which would be an impossible task. The errors that could be created would be considerable in some industries – high-tech firms often incur such costs that are more than 50% of total spending.
- Treats costs as linear. TDABC treats costs as linear with no consideration for capacity or identification of fixed and variable costs – simply resource costs divided by volume. Cost-Volume-Profitability analysis is hampered by the lack of understanding of the cost behavior over changes in volumes.
- Inadequacy of unused and/or excess capacity information. Although TDABC computes the cost of excess or unused capacity, the resultant cost is challenging, at best, as a tool that can be used to improve resource utilization and performance. Since the capacity cost rate is a result of blended costs, both direct and indirect, it is difficult to determine the sources of the excess capacity. Does the excess capacity cost stem from direct, front-line or touch labor; management and/or supervision; inaccurate processing step rates; indirect and overhead costs allocated to the department; or a combination of these factors? The only valid cost of excess capacity is that related to direct, front-line, or touch labor that is directly involved in processing transactions which is oftentimes impossible to determine. Given that the determination of overall LOB profitability must include all costs, including excess capacity costs, such costs would have to be allocated across LOBs reminiscent of the methods used in conventional absorption costing for which TDABC was designed toreplace.
- Difficulty in application across functional areas. Process costs may be distorted if processes are performed across multiple departments. TDABC is best applied when the entire process is performed in one department or work center with an average resource cost rate.
The nature of cross-functional work, especially without pre-defined activities that would facilitate the accumulation of costs as the process moves from department to department, makes it very difficult, if not impossible, to define total product cost and profitability using TDABC.
- Lack of specific resource identification. Necessary for informed management decisions regarding performance improvement, resource identification under TDABC is hidden within the blended capacity cost rate. The activities and costs associated with non-production effort within a department are disguised which inhibits the determination as to whether the right activities for the right LOBs are performed by the right personnel. Under TDABC, resource identification contained within unused capacity cannot be identified. If considerable unused capacity is determined, this leaves management little opportunity to identify the resource components involved.
In summary, Time Driven Activity Based Costing (TDABC), as a variant of an ABC solution, may be a misnomer as it may not adhere to the fundamental principles of Activity Based Costing such as organization-wide activities necessary to capture costs throughout the enterprise rather than simply by department. TDABC appears to be more akin to the application of Industrial Engineering production rates used for costing processes based on time standards sometimes associated with Short-Interval-Scheduling (SIS) and referred to as Reasonable Expectancies (REs) – the expected time to process a unit of production. Costing an LOB requires the summation of both cost and time equations associated with every process performed by every department that contributes to each LOB.
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