Cause and Effect in Activity Based Costing

When we talk about costing, it is assumed that we are talking about the Product Cost. We have been trained to calculate the product costs. The reason could be that costing was primarily used in manufacturing industry and for calculating the ‘Inventory Cost’ to be used on the financial results. The same information was then started for pricing the products. Good old days when the price was typically calculated as Cost plus Profit.
Typical Product cost calculation is like

• Manufacturing cost
• Material Cost
• Direct Material costs
• Material overheads ( as % of material cost)
• Direct Labour Production overheads (as % of labour cost or machine hr or labour hr or cost of output)
• Special Direct costs
• Sales Cost (as % of Sales value or volume)
• Administration Cost (as % of Manufacturing cost or Cost of Sales)
  

What is wrong with this calculation?

In a typical product costing method we take all the expenses in the financial accounting to the products. This is call as ‘Fully Allocated Costs (FAC)’. Various regulatory bodies ask specifically the FAC for various products or services. Nothing is wrong in this calculation when you get this for the first time. When the Business Head starts getting this information on a regular interval and she does not see the relation between business changes and the product costs then she starts worrying about the product cost report that is received.

If we take a simple example that in an organization there are three products (A, B, C). Based on the FAC method the products A and C are profit making but the product B is making a marginal loss. The product manager defends for her product saying today it is making losses but it has got future potential and we should continue with the product. After a year the company introduces another product D. Now the FAC is calculated for all the products A, B, C and D. Surprisingly with the new calculations product B starts looking profitable.

Why? Because the same amount of overheads that were distributed over 3 products are now distributed over 4 products. Now the product manager for product B is confused. She says I have not done anything different for my product. Now the questions arises that which is product is correct? One that shows Loss or that shows ‘Profit”. This is where business managers start disbelieving the product costs.

What is the reason?

The basic reason for this is the absence of ‘Cause-and-Effect’ relationship in typical product costing. The assumption is that ‘all-the-costs-should-go-to-product’. This is different than the real business scenario. All the costs are not caused by product only. In any business the causes of the costs are Product, Customer, Built in Capacity and Business Sustenance. We should segregate the expenses in Product Costs, Customer Costs, cost of Capacity Available to Use and Cost to Sustain Business. Once we segregate in this way the same information can be used for various business decisions.

Product Costs - The product cost typically consists of cost to product the product. We can add the cost of any improvements, advertisements, product catalogues any other collaterals etc.

Customer Costs – The cost of selling the product, delivery, recovery expenses and campaigns run for specific customer segments, fulfilling various requests by the customer are all that related to the various customers and not related to the products that they buy. Once we understand and accept this then we can understand that the same product if sold to different customers can bring different amount of profit for the organization. This gives you a more correct (read as ‘real’) profitability than the typical customer profitability calculation.

Cost Available to Use – The management takes the investment decisions and invest in various resources like plant and machinery, people, branches, ATMs etc. This installed capacity causes cost to the organization, which may not be fully utilized by the products or customers. The unused capacity is typically called as ‘Idle capacity’. This term was mainly used for machinery. In the current context we can calculate the capacity of the human resources also and they do not like to be called as ‘Idle’. This is correct in some sense. They are not ‘Idle’ but they are ‘Available to use’.

We will take an extreme example to understand this concept. Let us assume that a bank has installed an ATM in a very remote place for the use of its customers. It spends a lot of money in running the ATM, but very rarely it is used by the customers, because of its location. One fine day a customer uses the ATM to withdraw money. That is the only transaction that happened in that month. If you take all the expenses of running the ATM for that month to the specific customer then this customer will be shown unprofitable almost for whole relationship period.

Cost to sustain business – These are the costs that are caused by various functions like Secretarial, Internal Audit, Accounting finalization etc. These functions are required to run the business, manage the statutory authorities. These costs do not belong to any product or customer. They should be taken to products or customers for any business decision. They can be taken to products only in the case where the statutory authorities ask for FAC. How to then take those costs to products? Well, one can take using any basis and we can debate on the most correct basis till the end, without any conclusion. This is because any basis is not a logical basis.

Activity Based Costing uses this ‘Cause-and-Effect’ relationship while calculating the costs for the organization. Using this method we can also calculate the capacity utilization of the functions like HR, IT, Administration etc. Finally once we segregate the costs like this then it quite simpler to take various business decisions on product pricing, customer pricing, utilization of the resources and improvement in the costs.

Do Accountants Lead or Mislead?

Gary Cokins, who is an Internationally recognized expert in "Corporate Performance Management" has written a 'Guest Blog'.

This chapter is an excerpt from Gary Cokins’ book:
Performance Management: Integrating Strategy Execution, Methodologies, Risk Management, and Analytics; ISBN 978-0-470-44998-1
Published by John Wiley & Sons with planned publication date of March, 2009.

Gary Cokins, SAS; gary.cokins@sas.com
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Over the past few years I have discussed a paradox with Doug Hicks, President of D.T. Hicks & Co., a performance-improvement consulting firm in Farmington Hills, MI. The paradox, which continues to puzzle me, is how chief financial officers (CFOs) and controllers can be aware that their managerial accounting data is flawed and misleading, yet not take action to do anything about it.

Now, I’m not referring to the financial accounting data used for external reporting; that information passes strict audits. I’m referring to the managerial accounting used internally for analysis and decisions. For this data, there is no governmental regulatory agency enforcing rules, so the CFO can apply any accounting practice he or she likes. For example, the CFO may choose to allocate substantial indirect expenses for product and standard service-line costs based on broadly averaged allocation factors, such as number of employees or sales dollars. The vast differences among products mean each product is unique in its consumption of expenses throughout various business processes and departments, with no relation to the arbitrary cost factor chosen by the CFO. By not tracing those indirect costs to outputs based on true cause-and-effect relationships–called drivers–some product costs become undervalued and others overvalued. It is a zero-sum error situation.

Perils of poor navigation equipment

I speculated to Doug that I think some CFOs and controllers are simply lazy. They do not want to do any extra work. Doug explained this counterintuitive phenomenon using a fable:

Imagine that several centuries ago there was a navigator who served on a wooden sailing ship that regularly sailed through dangerous waters. It was the navigator’s job to make sure the captain always knew where the ship had been, where it was, and how to safely and efficiently move the ship from one point to another. In the performance of his duties, the navigator relied on a set of sophisticated instruments. Without the effective functioning of these instruments, it would be impossible for him to chart the safest and most efficient course for the ship to follow.

One day the navigator realized that one of his most important instruments was calibrated incorrectly. As a result, he provided the captain inaccurate navigational information to use in making the decisions necessary to safely and efficiently direct the ship. No one but the navigator knew of this calibration problem, and the navigator decided not to inform the captain. He was afraid that the captain would blame him for not detecting the problem sooner and then require him to find a way to report the measurements more accurately. That would require a lot of work.

As a result, the navigator always made sure he slept near a lifeboat so that if the erroneous navigational information led to a disaster, he wouldn’t go down with the ship. Eventually, the ship hit a reef that the captain believed to be miles away. The ship was lost, the cargo was lost, and many sailors lost their lives. The navigator, always in close proximity to the lifeboats, survived the sinking and later became the navigator on another ship.

Perils of poor managerial accounting

Doug continued on with his story: Centuries later, there was a management accountant who worked for a company in which a great deal of money was invested. It was the job of this management accountant to provide information on how the company had performed, its current financial position, and the likely consequences of decisions being considered by the company’s president and managers. In the performance of his duties, the management accountant relied on a managerial cost accounting system that was believed to represent the economics of the company. Without the effective functioning of the costing practices reported from this system, it would be impossible for the accountant to provide the president with the accurate and relevant cost information he needed to make economically sound decisions.

One day the management accountant realized that the calculations and practices on which the cost system was based were incorrect. It did not reflect the economic realities of the company. The input data was correct, but the reported information was flawed. As a result, the current and forward-looking information he provided to support the president’s decision making was incorrect. No one but the management accountant knew this problem existed. He decided not to inform the president. He was afraid that the president would blame him for not detecting the problem sooner and then require him to go through the agonizing effort of developing and implementing a new, more accurate and relevant cost system. That would require a lot of work.

Meanwhile, the management accountant always made sure he kept his network with other professionals intact in case he had to find another position. Not surprisingly, the president’s poorly informed pricing, investment, and other decisions led the company into bankruptcy. The company went out of business, the owners lost their investment, creditors incurred financial losses, and many hard-working employees lost their jobs. However, the management accountant easily found a job at another company.

The accountant as a bad navigator

What is the moral of the story? The 2003 Survey of Best Accounting Practices, conducted by Ernst & Young and the Institute of Management Accountants, showed that 98% of the top financial executives surveyed believed that the cost information they supplied management to support their decisions was inaccurate. It further revealed that 80% of those financial executives did not plan on doing anything about it.

The widely accepted solution is to apply activity-based cost (ABC) principles–not just to product and standard service-line costs but to various types of distribution channels and types of customers. The goal is to apply direct costs to whatever consumes resources. For resources that are shared, these costs are to be traced using measurable drivers that reflect the consumption rate–not arbitrary cost allocations.

When one compares the properly calculated costs and profit margins using ABC principles to costing methods that violate the key accounting principle of cause and effect, the differences are surprising huge: The company makes and loses money in opposite areas from what the numbers show. This creates false beliefs throughout the organization.

Why do so many accountants behave so irresponsibly? The list of answers is long. Some believe the error is not that big. Some think that extra administrative effort required to collect and calculate the new information will not offset the benefits of better decision making. Some think costs don’t matter because the focus should be on sales growth. Whatever reasons are cited, accountants’ resistance to change is based less on ignorance and more on misconceptions about accurate costing.

Doug Hicks observed to me: “Today commercial ABC software and their associated analytics have dramatically reduced their efforts to report good managerial accounting information, and the benefits are widely heralded.” Furthermore, the preferred ABC implementation method is rapid prototyping with iteratively scaled modeling, which has destroyed myths about ABC being too complicated. By leveraging only a few key employees and lots of estimates, usable ABC results as repeatable reporting system are produced in weeks, not years. A survey by www.bettermanagement.com reported the No. 1 challenge in implementing ABC is designing and building the model, which is what the rapid prototyping method solves through doing–make your mistakes early and often.

Reasonably accurate cost and profit information is one of the pillars of performance management’s portfolio of integrated methodologies. Accountants unwilling to adopt logical costing methods, and managers who tolerate the perpetuation of flawed reporting, should change their ways. Stay on the ship or get off the ship before real damage is done.

Profitability Solutions and Business Intelligence

The analysts are talking about the future of the Business Intelligence (BI) in the form of a) Predictive analysis b) Profitability analysis c) Benchmarking. The same is happening in the BI vendors market. The BI vendors are preparing to capture this market opportunity by consolidating their positions either by acquiring the ABM tool vendors (e.g. ABC Tech by SAS in 2002 or ALG by BO in 2006) or by having some tie up with the ABM vendors (e.g. Teradata, Cognos are having tie-ups with companies like Acorn or Hyperion etc.) The topmost measure in any Performance Management initiative of any organization is “Maximize Shareholders’ Value”, which can be achieved by increasing the profitability by acquiring and retaining profitable customer segments and improving internal productivity. The Enterprise BI is incomplete without the Customer Intelligence (CI).

Customer Intelligence

Unless one understands the Customer Profitability (read as Account level Profitability in Banking or Subscription level profitability in Telco), one cannot acquire profitable customers or retain them profitably or convert unprofitable customers into profitable ones. In short CI is incomplete without the understanding of Customer Profitability. This current profitability information then can used to calculate future potential or Customer Lifetime Value (CLV).

Organizations provide Products or Services to their customers. The profitability of a customer is dependent on the products or services she buys. At the same time it also depends on how demanding the customer is on the way in which those products or services provided to her. For maximizing profitability best customers should buy best product or services of the organization. For this one should also understand her Product or Service items’ profitability.

Operational Intelligence

For improving the organizational productivity one has to understand the internal business processes and the cost drivers for those processes. To improve the performance of the process one has to work upon the performance measures for the process. Performance Measures are generally of three types; a) Productivity b) Quality c) Time. By understanding cost drivers and managing them properly enhances the performance of the process financially.

To remove hindrances in achieving the Key Performance Indicators (KPIs) one has to understand ‘Where’ it is failing (e.g. Regions, Products, Customers, Channels etc.) and ‘Why’ it failing (e.g. Root cause analysis). The ‘Where’ part can be handled by the drill-down on the performance of the measure and ABM can help in finding the ‘Why’ part. It also gives the costs attached to the process. With the help of this information organizations now can plan the improvement initiatives in the organization.

When there are number of initiatives in the organization that can be planned, it has to prioritize them. This can be done with the help of 2x2 graphs. This is nothing but simple scatter graphs superimposed with a cross on that converting it into four quadrants. (e. g. Process chart with ‘Importance to Strategy’ v/s ‘Potential to change’ will give processes that are having high importance to strategy with high potential to change should be chosen first for improvement initiative)

To summarize Profitability Management using Activity Based Management (ABM) can help organization improve the overall performance of the organization. This information can be used by other solutions in the Enterprise BI like Customer Intelligence, Operational Intelligence and Financial Intelligence.

Doing right things and Doing things right

ABM can help in both ways

a) Are we doing the right things (Strategic) – This is related to the customer and product profitability. It is always best for any organization to sell their best products to their best customers. One should always analyze this and improve upon. For this one should know who are area their best customers and which are their best products. Second step is to find out whether they are doing this. Next is if not then find out why the customers or products that are not profitable are behaving so. Once we understand thins then move towards the action plan and get the feedback. In all this process ABM helps in every step.

b) Are we doing the things right (Operational) – This is related to the value that we are adding or destroying through our business processes (and/or activities). ABC helps to identify the non-value adding activities in the organization. It also helps to understand the underlying drivers for the same. One can work on these drivers to improve the organizational cost structure and productivity. ABM also helps in prioritizing various action plans in the organization simply by providing the information about the cost of the processes (or activities). Typically the processes (or activities) with high cost can be pushed forward for improvement, but within those processes (or activities) we can further prioritize depending upon their importance towards improving customer value, potential to change within organization, the competitive advantage that it can add etc.

In today’s radical scenario organizations have to look at both these things as to whether they are doing the right things as well as the thing right. For understanding the level of accurate information and feedback on the same, one must look at the use of Activity Based Management in their organization.