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The difference between first- and second-generation costing models....In first-generation costing models, indirect costs ("activities" in ABB) are accumulated in cost pools which are then allocated among the organization's external products. It's a simplistic, trickle-down "cascade" process. But in real life, some of those activities support other activities -- products and services sold to others within the organization. And these, in turn, may support both external and internal products. And so on.... For example, in IT, it would be tempting to assign the costs of infrastructure engineering to the infrastructure-based services (like email and applications hosting) sold to clients. But remember that some infrastructure engineers contribute to applications project teams. And some infrastructure services (like email, network services, shared storage) are consumed internally by IT groups such as the applications engineers. In real life, there's a complex web of customer-supplier relationships inside any organization. Allocating the costs of all activities directly to external products ignores these internal value chains. First-generation costing models introduce distortions in the cost which are not measured and are often significant. In the above example, if all infrastructure engineering is embedded in the costs of infrastructure services, and all of that is charged to clients, then infrastructure services will appear more expensive and applications engineering (which uses both the infrastructure engineers and some of those infrastructure services) will be underpriced. In practice, we've measured distortions as often greater than 30 percent, and in some product lines exceeding 100 percent! New second-generation costing models represent the rich web of internal "sales" to peers, applying costs down, up, and sideways to amortize indirect costs to just the right external products and services. In real-life business models, the spider web is very complex, involving many multi-party loops. A sells to B, and B sells to C, who sells to A and B, etc. Simple iteration of the calculations cannot resolve circularity when the full web of internal relationships is represented in the model. Second-generation costing models include tools to resolve this circularity without introducing material distortions. The result is significantly improved accuracy. In addition, second-generation costing models induce an entrepreneurial culture in groups whose customers are within the department as well as those who sell their products and services to external clients. There are no "second-class citizens." All sales -- internal and external -- are treated equally. Support functions learn a product and customer focus, just as do client-facing functions. By representing internal support services as sales of products and services to peers, second-generation costing models induce another level of frugality. They enable a rational, value-based process of deciding which internal support services are worth funding.
Full text of White Paper: Second-generation Cost Models
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