The first generation of cost models were termed "activity-based costing" (ABC). Costs are assigned to activities, which are then apportioned to the products/services an organization provides.

FullCost implements activity-based budget (ABB), but it goes well beyond ABB in method and in results.

Calculating true cost requires that you link activities and costs across all the groups within your organization. This presents some interesting puzzles. Consider this example:

There are many situations where one group serves others within the organization. For example, infrastructure engineers serve infrastructure operators by providing upgrades and enhancements, repairs, second-level support, performance tuning, etc.

When Group A serves Group B, costs in A should be spread over the products/services of B.

In real life, there's a complex spider-web of customer-supplier relationships inside any organization. This creates complex circularity in the calculations. Simple iteration of the calculations isn't feasible when the full web of internal relationships is represented in the model.

First-generation costing models avoid this problem by allocating the costs of all activities directly to external products. Indirect costs ("activities" in activity-based costing) are accumulated in cost pools which are then allocated directly to the organization's external products. It's a simplistic, trickle-down "cascade" process.

This introduces distortions.

For example, in IT, first-generation models might 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 by IT groups such as the applications engineers.

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 often measured distortions greater than 30 percent, and in some product lines exceeding 100 percent!

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....

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.

Costs of internal products/services are transfered to the internal customer, and spread over that group's products/services. At this step, costs flow through the web of internal support relationships until they ultimately end up on the external products/services.

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.

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