Activity Based Management in a company where 90% cost is Raw Material only

Whenever I go for pre-sales presentation to organizations, there are various questions that they ask. When it is a service organization like a bank or insurance company, they say Activity Based Management is useful for manufacturing companies. The manufacturing people say, most of our costs are material costs (anything between 65% to 90%), then do we need Activity Based Management efforts for the rest of the expenses? Recently I was asked following questions;

“I am working in one of the better known aluminium extrusion company in India. We primarily buy virgin aluminium ingots from primary aluminium manufacturers. Afterwards we melt the aluminium, alloy it with different alloying elements and extrude it into thousands of different forms.

Our costing method is very primitive. One of the reasons is that, almost 90% of the total cost is accounted by Raw Material. Then there are various other variable costs which can be directly associated with a particular cost center. The % of fixed cost rarely exceeds 5%. Though not satisfied with my present costing methods, I want your opinion that to control only 5% cost, whether so much efforts is necessary to change our costing system to ABC. Kindly correct me if I am wrong. “

I will try to answer this question from various angles.

Answer # 1)

First of all we will see typically which type of organizations that need Activity Based Management. It is needed by all those organizations that;

a) Are striving for improvement.
b) Need accurate costs.
c) Are interested in bottom line results
d) Desire improved decision-making.
e) Wish to be competitive in the new millennium.

Now you would say that means ‘everybody’. You are correct. The reason being who does not want to achieve one of more of the points mentioned above. So the primary answer for, who needs ABM is, ‘everybody’.

Answer # 2)

Let us go into more details and try to understand more about the organization. For that we need to know;

a) How many different products do you make?
b) How many customers do you have?
c) How many different types of customer do you have?
d) How many different plants do you have?
e) How many channels do you use to sell your products?

In the old days organizations used to have few products and were selling to a limited geographical area. In the today’s world customer is asking various options in the products. They also want the product to be available at the nearest point. The complexity of the business is increased when it has multiple products, multiple types of customers, serving different geographical locations, using various different channels to sell and serve. As the complexity of doing business increases it requires more resources to manage the complexity. This increases the overheads in the organization. Activity Based Management helps the organization to calculate the ‘cost of this complexity’. Actually it helps to reduce the complexity of the business by understanding which are the ‘non value adding’ products, customers, channels etc.

Answer # 3)

Let us look at the benefits of Activity Based Management

a) Information for effective decision-making
b) Information to continuously improve processes and reduce costs
c) A focus on significant costs
d) A relationship between organizational cost and organizational value
e) Methods to measure performance with accountability

Activity Based Management tool provides you the costs for products, customers, process etc. Once you calculate those costs with various dimensions you can use the OLAP (Online Analytical Processing) tools to ‘slice-and-dice’ the data. For example we can analyze customer profitability v/s customer revenue, Current profitability v/s future profitability, importance of a process (activity) v/s performance of the process (activity). We can use various subjective attributes together with objective cost data to take various business decisions or improvement action plans.

Answer # 4)

Let us now take the example of this particular organization and use the financial data that is publically available.

When I saw the company's website, it tells that they have sales of Rs. 8000 mn in 2006-07. It also shows they have 15% of profit which is Rs. 1200 mn. It leaves a cost of Rs. 6800 mn. 90% of this cost is material cost i.e. Rs. 6120 mn.

So the other costs are Rs. 680 mn. We will primarily assume that we cannot use the material cost and we have to work only on the non-material costs. If you use Activity Based Management to manage those costs, typically one can save 3-5% of these costs. With about 3% of savings you are making almost Rs. 21 mn. To achieve this profit, one will have to increase the revenue by Rs.143 mn.

There are examples where organizations have reduced the number of items they handle as raw material or non-raw materials by using the Activity Based Management concepts. Activity Based Management does not only calculate the costs, it unearths the drivers of the cost. When we analyze this and take actions on the non-value adding work, we go on improving our processes and reduce costs.