Activity Based Planning (ABP)

The uses of Activity Based Costing (ABC) can be stated as 1) Understanding of Product, Customer and Channel Profitability 2) Understand the cost of processes and the drivers for those cost 3) Activity Based Planning (ABP). We have seen in the earlier posts a good amount of information on the first two parts of the uses. Today we will talk about the third part that is Activity Based Planning. Activity Based Planning can be divided into two parts a) Activity Based Resource Planning only b) Activity Based Financial Planning.

Activity Based Resource Planning helps to understand the requirement of resources based on the forecast done. In the Activity Based financial Planning, resource as well as costs and revenue are also included to understand the complete profitability for the future period. We will discuss the various steps in this process. The prerequisite for creating the ABP model is that the organization should have a running ABC model.

Once the strategic plan has been finalized for the organization (which may state what kind of products to be provided to which customer segments via which channels in the various geographies), it will help the sales function to convert it into the demand. This forecast will be used as the starting point for creating the ABP model. The cost objects as products, customer and channel combination will have the quantities from the sales forecast. These quantities will in turn back calculate the volume of various activities to be performed to fulfill the requirement of various customers. The relation between the products, customer and channels and the activities is used from the ABC model in the organization. In the same manner the resource requirement is calculated from the activity volume. This resource requirement generally talks about the volume of various skills required. For example, 1200 hours of Lathe, 3000 hrs of Sales executive etc. We have to compare this resource requirement with the available resources and see if it fulfills.

If the resource requirement does not match with the availability of the resources then we have perform some operational adjustments. These could be of multiple types.

A) Capacity adjustments – If the required resources are more than the available then we may hire more or we can also transfer skills from other functions where there is excess capacity and the cross-functional transfer is possible. If the available resources are more than the required then one has see if there is scarcity in other functions and if the resources can be transferred there. One has to also see the seasonality of the business, before taking any drastic steps with respect to the excess resources.

B) Consumption rate adjustments – This is nothing but the driver quantities as in ABC. In other simple terms how much time is taken for various activities or how many times an activities is performed to provide a service to a customer. With respect to time taken by activities, internal benchmarking is very useful. You can compare the timing in other plants, branches, location etc. One can also look at the ‘non-value adding’ activities and try to eliminate them. Sometimes few of the customers are making you perform certain activities or their recurrence which is not adding any value to you. In that case a discussion with the customer to make them understand the same is useful. It is also seen that a ‘menu based’ pricing is adopted. One has to understand that even if the customer is ready to pay for the activities, you may face the resource crunch; it is just that you get paid by the customer.

C) Demand adjustments – Once both the above mentioned adjustments are done then we can think of adjusting the demand. This could be increasing or decreasing. Increasing the demand means getting more market share or creating more market segments (by adding customers, regions or products). This has to be seen in conjunction with competition. Reduction of demand because of scarcity of the resources also has to be seen in multiple ways. It may be so that the demand in the market is temporary. If it is a sustaining requirement then investment in the machinery, people etc. can be seen.

As we have seen the adjustments are not always easy as talked here. One has to consider various possibilities and SWAT analysis should be performed. Also it is not so that the adjustment has to be done in this sequence only. Practically it would be various steps with a combination of adjustments.

Once the operational adjustments are competed, we start entering the financial information. The rates for the products or the total revenue, the costs of the resources etc. Once this information is entered we will get the predicted profitability of the organization. This is a combination of product and customer profitability. This value calculated is the result of the strategic initiatives out into action. One may find that the best of the strategy at any point nin time may not be giving you the best of the returns.

If the target for the profitability is not achieved then we can perform the financial adjustments like reducing the resource costs or increasing the price. Both of these could be very difficult to achieve. A practical combination of the same has to be performed.

This is an iterative process of adjustments. The various steps of adjustments or combination of the same can be saves as scenarios. The final accepted model is used as the planned model and the actual results are compared with the same.

In the usual financial budget we perform the comparison of the actual expenses against the plan one, GL account by account. With this comparison the manager is provided with information of favorable or unfavorable variance. With this information the manager can be happy or sad. She can never be wise. He never gets the information how well she has utilized the resources. The comparison of the ABP model with ABC model gives the variance of price, cost as well as resource utilization, activity variance etc. This helps the organization to revisit the strategic initiative to reach to the expected returns from the business.

Visualization of costs and profitability in Life Insurance Company with ABC

Today I am writing on this subject especially as a reaction to the new regulation that the Insurance Regulatory body in India has passed. It says that for the Unit Linked Insurance policies, the Insurance Company cannot charge of more than 9% of the premium as the expenses in the first year and may be 6% in the next and even less in the following years. Earlier this amount was up to 40% in the first year and so on. My experience had been that 90% of the premium income for the Life Insurance companies used to come from selling the Unit Linked Products. With this ruling, it will be difficult for the Life Insurance companies to provide for the commission to the agent and their own expenses. Naturally, they have to shift to alternate products and/or manage their costs. In both the cases they have to understand the cost of selling as well as servicing the various products. This is where, according to me, Activity Based Costing (ABC) will be a great help to the Life Insurance Companies.

While designing an ABC model for the objective, ‘to find out cost of various processes in the Life Insurance Company’, we can design the model which can deliver cost of a process for various products using various channels across regions within a Life Cycle Event of the customer. Let me explain you this statement. There are various processes in a Life Insurance Company like ‘Acquire Customer’, ‘Collect renewal premium’, ‘Pay claim amount’ etc. It has various products. We may go to the level of individual product but at least up to the product grouping according to their portfolio management. For example participatory products (where the insurer can get some bonus), non-participatory (typical Term Insurance) or Unit Linked (where one gets back sum assured or market value of the units invested, whichever is less) etc. The channels could be acquisition channels like agent, bank, corporate agent etc. or servicing channels like branch, internet, telephone etc. Regions are various geographical parts may be like South, North, East and West. The Customer lifecycle events are Acquisition, Service, Retain and Close. You will find more in detail in my earlier post at http://activitybasedmgmt.blogspot.com/2009/06/activity-based-management-results-in.html

Once we have created this type of ABC model, we can visualize the cost at least as per the following points:

• Quite a few times it is argued that in Insurance industry most of the expenses are for paying the claims as well allocating alternatively allocating to the various reserves for the future payments (claims or bonuses etc.). If it so, then why go for such a detailed calculation. Generally it is added as ‘Administrative overheads’ to the product cost.

My argument is that, even if it is a small Insurance company in India, it will be having Rs. 500 crore (approx. USD 100 mn) per annum as expenses other than the claims and commission. It observed across the globe that ABC can improve at least 3-5% of the overheads. This means it can save

• The first level of segregation is at the Customer lifecycle event. It can be seen that almost 45-50 % of the costs are for acquiring customers. When we say cost of acquisition, it is excluding commissions paid. In addition to this almost 30% of the costs are for managing the channels. This is a cost that is spent on various branches, people and infrastructure there. Approximately 10% of the cost is unutilized. This is across the organization and can be more or less for various departments.

• The Cost of acquisition can be in various processes of acquisition like straight through process-STP (where for some products and sum assured combination if the proposer falls into certain category, the policy is issued directly) or non-STP with underwriting and with or without medical tests. For any process within the organization the costs are calculated for a ‘clean process’ and rework or any non-value added activity cost is separated. We can use the cost of completing the process cleanly as standard cost and use it in the product costing or internal benchmarking. The rework and non-value added activities can be eliminated to improve the margins. The amount of rework in the acquisition process is due to either lack of knowledge of the agent or the haste with which the proposal is logged into the system.

• If the cost of managing the ‘Direct Agent’ channel is divided by the # of policies sold in a period then it is four times the cost of the process of acquisition. For example if the cost of the process of acquisition is around Rs 1200 (USD 24) then the cost of managing channel per policy sold is Rs. 5000 (USD 100). This cost is even more for the various alternate channels like BankAssurance, Database sharing partners or other corporate agents where the cost goes up 15 times.

• Generally it is perceived that there are selling agents or partners and they are doing the selling part. But one would be surprised to see how much of time is spent by the line managers in actual selling the policies. One can almost say that agents are only for lead generating and rest of the work is done by the employees. There are very few agents those are selling policies on their own. Most of the agents are merely bringing the leads and the line manager from the Company has to fulfill the rest of the process. The other major activity is recruiting. The attrition of the agents as well as the staff is so high that almost everybody in the channel management is recruiting people one level below. Another major activity is managing on-going Incentive schemes. There are various schemes, themes; activities are floated every now and then. There is set of people at the region and HO those are constantly busy with recording data for the scheme, declaring the winners and calculating the incentives.

• The cost of issuing a policy ‘straight through process (STP)’, where the process is introduced for certain type of products, sum assured and profile of the proposer matches the requirement then the policy is issued automatically. The assumption behind this is that all this should happen using some software application and almost without human intervention. But if this is not the case then the cost of STP type of process is more than the issuance with underwriting.

• The rework cost is almost up to 10 - 15% for all processes across the organization. This include collecting the document multiple times, movement of the documents back and forth, re-scanning, re-underwriting, re-issuing, re-posting the policies etc. The major reason is the haste with which the proposal is logged in.

• The cost of conducting a medical test is obviously known, but the cost of managing the entire medical activities is not surfaced. The activities are like creating the medical network, addition and deletion of the doctors, managing the appointments, receiving the reports, analyzing the reports, receiving the invoices, checking invoices, payments to doctors etc. This cost of internal management of medical network can go up to 25% of the average cost of the medical tests. This is not generally visible.

• The utilization of the various functions is also an eye opener. The industry has cyclic nature across the year. Even in a month most of the sale happens in last few days. This is the ‘peak period’. Most of the times the staffing is done to match the work load during this ‘peak’ period and hence, we can see the non-utilization of the staff up to 20%.

• All this information is used to identify the non-value added activities as well as the opportunities to outsource the activities. The organizations can outsource the activities like managing the medical network, dispatch, customer service etc.



Various reports can be generated for the management decision purpose. These reports can be classified under 1) Cost reports 2) Profitability reports. Some of the examples are:


• Cost reports


o Customer Lifecycle costs - Total overheads of the organization for a period can be seen grouped as i) Cost to Acquire ii) Cost to Serve iii) Cost to retain iv) Cost to close v) Cost to sustain channel vi) Cost to sustain business vii) Cost available to use.


o Transaction costs – ABM model gives you information about cost of each transaction grouped under various lifecycle events. This is cost is provided as a’ Clean process’ and ‘Rework’. This information can be used to understand and improve the cost of the transactions. It can also be used to have internal benchmarking across products or across various regions.


o Department Costs – The cost of the departments are not the cost center accounting costs but costs added from the shared services like HR, Admin, IT etc. This report also shows the ‘cost per minute’ for the department. A department is seen as costly when the costs are higher for that department, but sometimes this is department is not costly on per minute cost, because of the available resource capacity is higher. This cost of department is shown as per their top 5 activity costs. This gives the information on the focus of the department. This report also tells about the utilization of the department.


• Profitability reports – The format of this can be like (Insurance premium + Investment income + other income – Reserves – Cost of customer services – cost of claims – Cost of capital)


o Profitability of Line of Business (LOB) by Customer Segment


o Profitability of Customer segment by region


o Profitability of Channels by Product group

Insurance companies can understand the costs and the drivers for those costs. With this knowledge they can now look for which alternate products they can look for, in the scenario of Unit Linked not being so profitable. As well they can improve upon the operational efficiency to add to their bottom line.

The analysis put here is related to the various eye-openers for the Insurance Company regarding the cost management. Once these costs are calculated the same information can be extrapolated to calculate the Customer Segment P&L for various periods. This will show the customer segments that are most profitable to the Insurance Company. Also we can perform an analysis that which acquisition channel is bringing most of those profitable customers and which are not. Then the knowledge transfer can happen to improve upon the selection of the customers.

Can you create a model with 520,729 activities in ABC?

This was the question asked by a consultant who had tried developing an Activity Based costing (ABC) model. First of all the answer to the question is 'YES'. Obviously I asked him, why do you need those many activities? Also what was the objective of the assignment? He told me that the client wanted the performance of each of the processes in the organization and hence we had defined so many activities. After doing this, they concluded that the cost of finding this information would not be acceptable. A big ‘YES’, I said. This is one of the examples of the expectations that people have created about the ABC concept. It’s been always told that ABC is more accurate than the traditional costing. This makes people think that ‘if it has to be accurate then it has to be in detail’.

With this notion various attempts have made by people to make the costing in detail. One of the ways as mentioned here, they create a huge number of activities. This will make any type of method to collect the cost expensive. Some created many cost centers, so that they can directly associate the expenses with the cost centers. Of course this is will help, but to get ‘Cost Center Accounting’ in detail. I have explained this in my earlier post ‘Deeper Cost accounting v/s Activity Based Costing’ http://activitybasedmgmt.blogspot.com/2009/07/deeper-cost-accounting-vs-activity.html.

Another line of thinking goes to entering the expenses to activities at the time of booking the expenses. I have seen some of the consultants working in the area of ABC using spreadsheets with this understanding. They always thought that the software solutions for ABC are nothing but doing this kind of transactions. Against this backdrop, when we try to make a statement that in ABC the accuracy needed can be up to 85% , these people feel that then there is not much difference between traditional and ABC. Let us see from the scratch i) what ABC is ii) how it differs from traditional costing iii) hence the details as otherwise expected are not required.

“Activity Based Costing is a methodology to calculate the cost of activities (what we do) and cost of cost objects (products/services, customers, channels etc.).” This is the definition as per CAM-I glossary. In ABC there is a ‘cause-and-effect’ relationship. Product, customers etc.(Cost Objects) make the organization perform activities and activities are performed by people, machines and they require some facilities (all these are Resources). Hence it is called as hence called as Cost Objects consume activities and activities consume resources. If we flow the cost with this logic then there is an obvious cause-and-effect relationship in that. This is the most important difference between the traditional and ABC.

If we take example of various cost centers in an organization and see how the logic of the cost flow (drivers) is there in ABC, we will understand the difference.

Sales overheads – Typically these expanses are taken to the products on the basis of cost of sales or revenue etc. As I have mentioned this quite a few time, in traditional costing every penny spent is taken to the product. It is not the case. They are related to the product, customer, channel, capacity, doing business etc.

The sales expenses are not cause by the products, but they are caused by the customers and/or the channels that you use. So these expenses should go there. This helps to understand the ‘cost-to serve’ the various customers through different channels. This alters the profitability of the customers even if they are brining same revenue. In a humorous way we explain that the sales overheads are not in a linear proportion with the revenue. Actually it is in inverse proportion to the revenue.

Shared Services expenses – These the expenses of the cost centers like Administration, HR, IT etc. If those cost centers are shared by various business units (BU) then it is even more important to use ABC. Typically these expenses are shared based on the ‘headcount’. More the number of employees in the BU/cost center more the share of costs. Within a BU these costs are taken to the products based on may cost of production and shown as ‘Admin Overheads’ in the product costs.

The definition of the services provided by the functions like Admin, HR, IT etc. is the first step to flow their costs to various cost centers. Recruit people, Measure performance etc. for HR, Book tickets, Arrange seminar etc. for Admin, Manage application, Create user etc. for IT are some of the examples. Using ABC the cost of each of this services is calculated and then based on the volume of the services utilized the costs are taken to the cost centers within various BUs. This solves the major issue of the sharing the cost of these cost centers among the Bus. Most of the software solutions can take care of the ‘reciprocal’ way of flow of expenses as typically HR can provide services to IT and receive services from IT as well.

Once the costs are taken to the various cost centers they lose their existence and become the part of the expenses of the cost centers. From there they go as manufacturing expenses or sales expenses etc.

Procurement expenses – Let us understand the completeness of procurement expenses. This process starts from planning the material up to the payment to the vendor. In this various activities are performed by different cost centers as material planning by Planning, vendor management and purchasing by Procurement, quality checking by QA, storing by Stores, payment by Accounts Payable (AP) department. In traditional costing typically the expenses of Planning, Procurement, QA and Stores go to the products as manufacturing overheads, expenses of AP as admin overheads.

First of all ABC segregate the expenses from various cost centers in to ‘Procurement expenses’ based on the various activities performed by those cost centers. From here these expenses are taken to the various materials and vendor that are supplying the materials. With this information the organization can understand the cost procuring same material from various vendors. This gives information about the ‘cost to serve the vendors’. This depends on the lot size, distance, payment schedules, quality etc. This is very important information as it gives the ‘real’ landed cost of a material to the organization.

The requirement of the details and level of those and reason for the same are already explained in the post ‘Incremental progress is better than delayed, or unattained, perfection’ at http://activitybasedmgmt.blogspot.com/2009/08/incremental-progress-is-better-than.html.

These examples will give an idea about how the ABC differs from the traditional costing and accuracy of ABC does not lie in the details but most important concept of ABC and that is ‘cause-and-effect’. The cause-and-effect’ relationship let us know that the costs are not always caused by products. Hence, not all the costs go to the product. If we try to take all the costs to the product and calculate the product cost, it does reflect the changes in business scenario in the cost of the products. This leads to erroneous decisions making with respect to products, customers, channels etc. ABC can not only reveal these details but it also makes us understand the obvious drivers for the same. This information as ‘where’ it is going wrong and possibly ‘why’ it is going wrong help us to take better business decisions.

An ABC Initiative is only as effective as the software that supports it

For any change initiative or performance improvement initiative that is taken in an organization, it is always important that the goal of the initiative has to be finalized first. This is true for Activity Based Costing (ABC) initiative also. While finalizing this goal or objective, the organization should consider the requirement and target outcome of each functional group of the organization. Any conflicts that arise should be resolved against the common objective of the organization. During this part, there has to be management’s buy-in for the initiative as well as the objectives.

Whatever is the method used for this, the primary objective of the organizations for implementing ABC is to provide the various functions in the organizations better and more relevant information to help them take business decisions. For this it is not necessary to have good participation but it is also important that the software that is going to be used is supporting the overall and individual objectives as well as the expected outcome. Fortunately today’s software solutions have come a long way and are able to support this requirement. We will see here the requirements from a software solution to complete the ABC initiative successfully.

Features of the software solution

ABM modeling

Multidimensional Modeling - Dimensions are nothing but different aspects (attributes) of an object. For example a person can be differentiated as sex, color, height, hair, eyes etc. These are various dimensions with which we can analyze people. Similarly in an ABC assignment we need to know the costs or profitability of Products, Customers, Channels etc. We can further segment the customers by Age, Geography, Use of products etc. The expenses in the Resource group can be grouped by Region, Department and GL group. These are various examples of dimensions in an ABC model. The software solutions today are equipped with dimensional modeling. This type of modeling helps us to analyze results better. For example, we can view product profitability by customer, Channel profitability by product or product profitability by customer segment.

Multiple periods and scenarios – The ABM model should contain data for various periods. These periods could be various months or quarters etc. The ABM software can create hierarchy for the period. For example, Year-Quarter-Month. This hierarchy can be used in the OLAP reporting, where the results from various periods can be compared and variance can be reported. This hierarchy also helps to roll the data up from month to quarter to year and we can see the year-to-date data also.

Scenario is used to manage the variation in the data within a period. Scenarios could ‘Actual’ and ‘Budgeted’. Once the data is entered we can compare the like ‘Q1 2010 – Actual’ data with ‘Q1 2010 – Budgeted’ data and also find the variance. Here it is not only the variance in the expenses that are generally covered in the expense budget, but we can compare the Activity usage variance or resource usage variance, apart from the expense variance. Scenarios can also be used to create various ‘what-if’ scenarios for the future.

Cost flow – In ABC model the cost flows from resources to activities and then to cost objects. The ABC model creates the linkage between the ‘Source’ and the ‘Destination’. This linking is called as Assignment. The assignment can be done between two entities within same module (Resource, Activity, Cost Object) or between two different modules. The model can also perform ‘Reciprocating Assignments’. For example the assignment where HR provides services to IT and IT also provides services to HR. The other important component of the cost flow is the ‘Driver’. Driver defines the logic with which the cost should be as well as the amount of the cost to be flown to each destination point.

In this example ‘Salary & Wages’ is the source and the ‘Activity’ is the destination. ‘# of Hours’ is the driver name. 90, 20, 40 is the driver quantity for each activity. The driver name helps us to create the logic to collect the driver data. But the actual cost flows based on the driver quantity. The driver can be a simple one to enter the numbers or it can have the facility to create mathematical expression to calculate the driver quantity.

Attributes – Attributes help us to group the costs within Resource, Activity or Cost Object. Some examples of attribute are ‘Fixed_Variable’, ‘Value Add_Non Value Add’. With the Fixed_Variable attribute, we can get cost of products or activities grouped into fixed cost and variable cost. Similarly with Value add_Non Value Add, we can get cost of serving customers and within that the quanta of non Value add activities. The use of attributes helps us to analyze the data that leads us to root-cause analysis.

Data Integration with source systems

This is one of the most important features of the ABC software solution. The ABC software solutions provide the facility to enter the data interactively, but it would be a time consuming activity for a real life model. The ABC software provides the facility to bring the data from various sources like GL, CRM or any other software solutions. There is some data like # of hours, which not every organization collects electronically. This type of data is collected using small web based solution. All this information is collected in a set of structured tables and called as ‘Staging tables’. From these tables the data can be pulled into the ABC software. There are various ETL (extract-Transfer-Load) tools that are available in the market and can be used for this purpose.

Reporting

The ABC model should be created to provide the appropriate information for taking the business decisions. This is achieved using various reporting techniques. ABC Software has various reporting techniques. First of all, it provides the facility of analyzing data interactively using the GUI (Graphical User Interface). Here we can see how the costs are flowing. The other way of analyzing is using the report templates. The most important is the OLAP analysis. In this the software creates a ‘cube’ using the dimensions that are created in the model and we can create various views depending upon the analysis we want to perform. The views are very similar to the ‘Pivot tables’ that the spread sheet software does. We can select multiple dimensions like Product v/s Customer, Customer v/s Activities etc. I have explained here with two dimensions only for simplicity, but we can as many dimensions as we wish. For example we can analyze the data for Product v/s Customer v/s Channel. The most important requirement before OLAP analysis is that we should have a question in our mind; otherwise we see only numbers in the pivot table that may not make any sense to us.

Data export to other solutions

In the earlier stages the ABC software solutions were desktop solutions. They were used by a single person. After that they became ‘enterprise-wide’, where multiple users create and analyze the model simultaneously. This is now moving onto the SaaS style application. Whatever is the type but it has to have the facility to export the data as the output from the ABC model is useful for various other solutions like CRM. The BI solution is based on a large warehouse where data from various sources some and then transferred to other solutions. Again the staging table can store the calculated data from the ABC model and we can use any ETL tool to export it from the staging tables.

At last the most important part is the actual decisions to be taken and implemented within the organization. ABC is like a thermometer, it can tell us the temperature. We have to analyze the data and take proper action. The change management is very important to implement the action plans.

Profitability solution for Bank

When we talk about the profitability solutions for the banks it is calculated by using information from various sources. Typical profitability calculation starts with the Net Interest Income. This is the difference between the Net Interest income and the charge for the funds. Also Interest expenses and the credit for the funds for the deposit products are used for calculations. This information is available from the Fund Transfer Pricing (FTP) solution. The difference between these gives the Net Interest Margin (NIM). This is one part of the revenue. The other part could be from the various fee based products or commission from the third party products. This makes the total revenue from the customer.

From this margin the bank can adjust the margin by probability of the losses. This is calculated from the credit risk calculations. The adjusted figure gives the risk adjusted margin for a customer. From this margin the expenses are deducted. These expenses can be calculated using activity Based Costing (ABC) solution. This will give net contribution from the customer. Deduct Tax and then cost of funds and one can get the Net Vale add by the customer. So what we have seen is the calculation of profitability includes a) Revenue accounting b) Internal funds accounting c) Risk Adjustments d) Capital Allocation e) Expense Accounting.

The issue for the banks is that, they have good handle on the revenue accounting but little that they know about the accuracy of expense accounting to the product and customer level. Today we are going to see more on how this expense accounting be done using ABC. So it is more about how to calculate the profitability rather than the why bank should calculate the profitability. Even within that we would be looking at the 'expense accounting' part using ABC technique.

Find below the schematic diagram of the Profitability model using ABC technique.

Resource Section

Activity based costing has three major sections viz. Resource, Activity and Cost Object. For the profitability model for Banks, the resource section contains the expenses grouped for various departments (Functions or Cost Centers) in the Bank. Generally these expenses are taken for a period (say a quarter). The departments are grouped as at corporate office (sometimes Zonal office also), Branches, Alternate channels like ATM, Call Center, Direct selling agent (DSA), Internet etc. and finally the shared service departments like IT, HR etc. The services that are provided by the ‘shared service department’ are defined and their costs are calculated. Then, based on the volume of the services provided by the department, its costs go to the various other departments. Most of the commercial software solutions available today can handle the ‘reciprocal assignments’ i.e. IT providing services to HR and vice-a-versa. The departments can be also grouped by the region. Another way of grouping the branches and ATMs is by their ‘costs’. This means grouping of the branches or ATMs that are having similar costs. Simple way of doing this is by grouping them as Urban, Semi-Urban and Rural. The scope can be expanded, if required, in future by doing at each branch or ATM.

Activity Section

The activities are defined as per the transactions that are performed by the customer for various products using different channels. For example ‘origination of commercial loan’. For this the activities could be receiving the application, interviewing the applicant, understanding the credit history, evaluating the applicant, taking decision, disbursing the loan amount. Like this once you have defined all the transactions, each transaction is then broken down into activities and then against each activity, put the name of the department, time taken by the activity. For the activities that are performed in a batch mode, one has to consider the batch size also. The activities are generally grouped as per departments.

Cost Object Section

As usual this is the most important section of the model and defined first. In cost object we see the result that is expected out of the model. Typically this section can be divided into two parts. The first section calculates the cost of various transactions, performed by the customer for various products using different channels (distribution channel). For example, withdrawal of cash using ATM for a savings account. Here we can see that the withdrawal for a checking account and savings account using an ATM may not differ, but still we calculate the cost for the same separately, as it is required in the next section of the cost object.

Customer lifecycle event - All these transactions are grouped according to different events in the lifecycle of the customer. They are Acquisition, Provision, Serve, Retain and Close. All the transactions related to the acquiring of a customer are grouped here in Acquisition. The ‘up selling’ of a product is grouped here as if it is a new sale. In Provision all the transactions that the customer can perform as a part of having the product are grouped. For example for a saving account, the customer can deposit cash/check, withdraw cash, receive account summary, check balance etc. The serve sections could be similar to the provision but here the transactions are requested by the customer specifically. For example, the customer can receive a monthly statement of records, but she may ask for a statement for a particular period in between. This request may or may not be charged. In the retain section, all the transactions that are performed (mostly by the bank) are grouped. This may contain the efforts for cross-selling, campaigns, communications etc. The cost of some free gifts can also be added here. In the close section, the transactions related to the natural closing or forced closing is added. In addition to this there are two other groups here viz. Cost to sustain business and Cost available to use. Cost to sustain business are the costs that are neither related to the product nor to the customer, but are required to run the business. For example the costs of the departments like Company secretarial, Account finalization etc. These are separated in the model as the model is used for internal business decision making. In case of any statutory reporting this can be allocated to the products. The last is the ‘cost available to use’. By using the bottom-up modeling technique we can calculate and separate cost available to use (aka idle cost) in the organization and that to department by department. You can read more about the ‘bottom up’ modeling in my earlier post at http://activitybasedmgmt.blogspot.com/2010/06/push-and-pull-in-abc.html

Channel - The second way of grouping the transaction is by Channel. The primary channel for banks is a branch. The model can be designed for grouping branches as per their costs (may be within a region). As described in the Resource section, the branches can be grouped as Urban, Semi-Urban and Rural. The model can be taken to individual branch level also. This helps the bank to find the branch or location level profitability. Most of the times customers of one branch (where she has opened the account), avail the facilities of the other branches. In this case the inter-branch charging can be used to calculate the branch level profitability. The cost of process can also be compared among various locations and optimized.

Apart from the primary channel as branch, there are other channels (distribution channels) like ATM, Call Center, Internet etc. The cost of transaction performed using these alternate channels are typically less than that performed at the branches. Banks are using various programs to transfer users from the branches to these channels. The cost savings can be calculated here. But one also has to look at the ‘resource capacity’ released at the branch. The bank has to take care of this capacity otherwise there would not be any positive impact on the bottom line of the bank. Now-a-days one of the segment of the customer is as per the ‘attitude towards technology’. This can be seen by the use of these newer channels by the user. The bank can get a report on utilization of various channels by various customers and can use this information for further investments in technology, locations etc.

The information on the cost of the processes and the utilization of the channels has helped the banks to use the ‘menu based pricing’ methodology for various types of the customers. Now a day the banks charge the customers for using the branches or ATMs. This typically depends on the type of the account that you are holding with the bank.

Product – The transactions are also grouped by product. The product group can start at the group level as Deposit, Credit, Revolving Credit, Fee Based, Third Party etc. Within these groups then a hierarchy can be created as per the requirement. The same can also be used to calculate the Line-of-Business (LOB) profitability by grouping the products. The product manager can get reports like product profitability by region, customer segment etc. She can use this information for creating new products, proposing to the appropriate customers/prospects, fee structure, risk factors etc. Typically when we talk about customer profitability, the product profitability is actually built in the model.

Transactions - These are the processes that a customer can perform. For example, deposit cash, withdraw cash, receive debit card, receive statement, open account, check balance etc. There are some transactions performed by the bank on their own. This is typically in the ‘Retain’ event. Communications, offers sent to customers or closure of a dormant account etc. The level should be decided as a proper transaction performed by the customer.

The ‘unit cost’ calculated for the transaction is end of first level calculation in the profitability calculation. Once the cost of each transaction is known to the bank then these costs can be taken to the customer very easily.

Customer Profitability – The customer profitability for banks now means the profitability at the account level. One customer can have multiple accounts with a bank. For example, a savings account, a car loan account, a housing loan account, a locker etc. The profitability can be calculated for each of these accounts. Let me make clear at this point that, when we say customer profitability, it is the Customer P&L for the period. Then it can be rolled up for a customer. So a customer may not be profitable for a particular product but may give more profit from the other. Bank can use this information (if it has got integration of information done) to cross sell, up-sell or provide some discounts. The customer level information can also be rolled up to a ‘household’. This helps the bank to propose various products to the members of the family at their life-stage. This also helps not to propose same product to different members of the family. For example, proposing same housing loan to the same family may be a waste of resources. Customer profitability report can be provided by each product. This information can be analyzed and utilized by the bank for various purposes. You can find more details in the post http://activitybasedmgmt.blogspot.com/2009/12/customer-analytics-with-profitability.html

The profitability solution can be also created at the customer segment level as initial phase and then taken to the customer level. The segments can vary for each bank but some of them are shown in the figure as life stage, products held, attitude towards technology etc. Generally the segment level information is used for campaigns, introducing new products, up sell, cross sell etc.

Activity Based Costing can measure the profitability of thousands of retail banking customers by examining their behavior in detail. It actually concentrates on the various activities that are performed for the transactions that the customer perform and then it distributed the cost of those transactions based on the use of those transactions by the customers. This provides the accurate information for calculation of the customer profitability.

“Push and Pull” in ABC

Those who are familiar with the manufacturing system must have heard or used this “Push and Pull’ technique. In this technique the downstream manufacturing process does not produce the part unless it is required by the upstream process. This is true for the final product also. It has got another name also “Top down and bottom up” approach. This is very popular with the planning and budgeting process. In the Top down approach the budget amount from the parent is distributed among the children with some logic. In Bottom up approach the budget amounts from various children departments are accumulated for the parent one.

In costing also people used to take every dollar from the accounting system and passed it to the final products. The accounting principles also required it to be done in that way. Later on people started using the capacity of the manufacturing equipments in the calculation of product costs. Though the machines were available for all 24 hours, their capacity was considered upon how long they are generally used, and called as ‘Normal Capacity’. The unused capacity is called ‘idle capacity’ and corresponding costs as ‘idle costs’.

Activity Based Costing (ABC) also started with the loading 100% of the costs from the resources to the cost objects through the activities. When the use of ABC was started for the services industries like banking, insurance, telecom etc. it must have started looking absurd to take all the costs of a branch of a bank to the services that it provides and then decide its profitability. This must led to the different way of putting the ABC model. I think that is when people thought of the ABC model which calculates the costs of the services based upon the volume of transactions.

The first way modeling where the 100% of costs are ‘pushed’ to the cost objects through the activities is called the ‘Push model ‘or the ‘top-down approach’ model of ABC. The other way of ABC modeling where the costs are pulled by the cost objects based upon their volume from the resources through the activities is called the ‘Pull model’ or the ‘bottom-up approach’ model. The major difference in these two models is in the push type 100% of the cost flows to the cost object. In pull model cost flown may be less or more than the cost entered in the resource module. This depends on the capacity utilization. In case of the machine we generally used the remaining capacity as ‘idle capacity’, but the in case human resources people do not like them to be called as idle. This sometimes gives a feeling that they have work but are not doing it. So we defined a term as ‘capacity available to use’. For example a branch has a ‘teller’. She will perform the cash deposit or withdrawal activities. If she does not have the sufficient number of transactions because of the footfall in the branch, then we say the rest of time she is available for other activities of the branch. She is not said to be ‘idle’.


This type of modeling has helped in calculation of product and customer profitability in the services industries very well. It has also helped in taking the costs of the internal services departments like HR, IT etc. It has been used by various consultants for a long time now and the current wave named as ‘time driven activity based costing (TDABC)’ is actually a more sophisticated version of the bottom-up or pull type of ABC modeling. This is a modeling technique and most of the commercial software solutions are capable of building such type of models. Now we will take some example and try to understand the difference.

I have learnt this concept from Greg Nolan of GJ&Nolan Co. and I will try to explain this in a similar way. Let’s take a bank is using a push approach to calculate the product profitability.

Push ABC example

The figures in the first column are from the financial accounts. The total revenue, total expenses are available and from that we can calculate the overall profitability of the bank. The revenue can be reasonably taken to the products, but the expenses are not easy to take to the products. We assume that the expenses here are taken on the basis of the # of accounts for various products. !00% of the expenses are taken to all the three products. So if you add the expenses of all the three products it matches with the total expense. With this calculation it shows that product 1 and product 2 are not doing good and product 3 is making profit.

If you ask any business manager if there anything wrong in this, invariably the answer would be ‘NO’. In absence of any cost information this would be accepted and used. The issue starts when you start getting information on a regular basis and start comparing with the earlier period(s). The changes in the figure then may not match with the changes on the business that are happening. To understand this clearly we will add a new product to this scenario and see the calculation.





With the addition of the product 4, brings its own revenue as well as expenses. Because of this the total revenue and the expenses are changed. The new amount of expenses is distributed based on the number of accounts various products. And now, the profitability of the products changes. The product 2, which was unprofitable till last period looks profitable now.

This is when the business managers start disbelieving the numbers. Quite reasonable too. Because there was no business change that happened in that period and still the product started looking profitable. The question comes, what is the correct information? The current information that the product is profitable or the earlier information that the product was unprofitable. Nobody can give the correct answer with this data.

Pull ABC Example

We will take the similar example of the products and try to understand the Pull ABC model.

What is the difference here? The expenses are not distributed based on the # of accounts, but the unit costs are calculated for each product and it is multiplied by the # of accounts. In this case the total expenses do not match with the sum of expenses of the products. This is because the balance is the capacity available for expansion.

Now we add a product here also and see the calculation.

When you add the product and the income and expenses of the same the profitability of the products 1,2 and 3 is unchanged. And which should be, isn’t it? The expenses are taken from the capacity available and the available capacity is reduced.

For the services industries most of the operating expenses are incurred in putting up the resources to service the customers and process the transaction they perform. The profit in that case is the difference between the amount paid by the customer and the amount of resource they consume, as well as the amount of resources positioned but not consumed.

We will take another example of a withdrawal from an ATM. There is an ATM in remote corner of the city, which is hardly used by any customer, but put up by the bank. One fine day a customer goes to that ATM and withdraws some money. In case of the Push model, the whole of the quarter’s expenses for the ATM would be charged to customer and the poor customer would not be shown profitable for the entire life with the bank.

In case of Pull model, the cost of one transaction would be calculated based on the capacity of the ATM to handle and time taken by the transaction. Based on this calculation the customer would be charged to the customer.

The Pull modeling technique can also be used for resource planning. Based on the volume of the different products to be sold in future, we can calculate the requirement of various resources like machines, skill set etc. by adding budgeted expenses to this model we can calculate the planned profitability of the organization. Using this planning model we can compare the actual expenses, profitability, utilization etc. and understand the reasons for the variance.

For the “Haves” and “Have-Nots” of Cost and Profitability Solution

For a long time we have been talking about the benefits of having Cost and Profitability solution. We have been doing this during the presentations to the prospects, workshops, seminars, webinars etc. The Activity Based Costing/Management concept had been there for more than 20 years now. Still there is a majority of organizations across the globe that ‘have not’ embraced it. Some of the organizations have had it and later stopped using it. The concept itself had its ups-and-downs during those 20 years. On this background we see that most of the times people talk on this subject for those who are ‘Have-Nots’ of the concept. Today I am going to write primarily for those organizations which have already implemented Cost and Profitability solution. It’s just that I cannot resist myself writing about the benefits of this solution for those who do not have it, before I proceed for the ‘Haves’.

Benefits of Activity Based Management (ABM) for “Have-Nots”

a) Information for effective decision-making – ABM provides more accurate information about the profitability of the products, customers, channels etc. This helps the organization to understand the ‘cross subsidization’ among the products/services. It also tells about the profitability of the customers and more importantly the possible causes. This helps the organization to put the resources for the right set of customers to maximize the profitability.

b) Information to continuously improve processes and reduce costs – ABM provides the important information about the cost of various processes. Process is nothing but a set of activities performed in a sequence by one or more functions. With ABM we can understand the cost of those processes, benchmark them against internal or external targets and improve upon them.

c) A relationship between organizational cost and organizational value – ABM provides objective information about the cost of the various activities or processes. We can add other subjective or qualitative attributes like ‘value add’ to these processes. This added value can be seen for customer, organization etc. By comparing the cost of the process or product or customer against the value that is added by it, we can focus and create appropriate action plan.

d) A focus on significant costs – There are various programs running in any organization for the improvement of productivity, reduction of waste, managing processes etc. The unique ability of the ABM initiative is it helps to focus on ‘significant costs’. Otherwise people take various improvement programs, which may or may add significant cost improvement. ABM helps to prioritize the improvement program by combining the objective of the initiative like importance to strategic value, importance to customer value, potential to change etc. together with the cost of the process. By creating a 2x2 diagram organization can choose the processes with high customer value and high cost processes first for improvement.

e) Methods to measure performance with accountability – Performance of a process or activity can be measured at least by three ways. 1) Productivity 2) Cycle time 3) Quality. For example let us take an activity ‘Assemble a product’.

1) Productivity – Cost per assembly, # of assemblies per person
2) Cycle time – time to assemble a product
3) Quality - # of product assemble correctly in first attempt

With this kind of measure we can monitor the performance of various activities. Now the activities are performed by one or more persons. With this we can manage the performance of the activities and people together with the accountability of the same.

Now we talk about the benefits to the “Haves” of Cost and profitability solution. This is not talked about so often, but it is equally important as the use of the data that is calculated is also important for the organization. This helps them in taking business decisions. In the earlier days of ABM, the projects used to be for solving certain business issue. After the model was created and analyzed, people seldom updated the ABM model. The current situation is different, as the results of the cost and Profitability solution can be and is used in other business solutions like Planning and Budgeting, Scorecarding, Customer Intelligence etc. Also the improvement programs in the organization are looked upon as a ongoing exercise rather than one time project. For this actually American Productivity & Quality Center (APQC) had done an exercise and I will be elaborating on the findings.

Best practices for profitability calculations

a) At best-practice organizations, customer profitability is owned by marketing, with finance as a key stakeholder – Though the responsibility of calculating the profitability lies across the organization. The use of the information of profitability and related improvement lies with the marketing department. The Finance department is the custodian of the information.

b) Best practice organization create a organization wide view of the customer – With the help of initial understanding of the customer profitability, organizations use the same information for overall customer intelligence. This leads the organizations to create the ‘one view’ of the customer across the organizations. For example for Retail Banking the profitability of the customer is calculated across the products held like savings account, cash-credit account, fixed deposit account, housing loan account, car loan account, Demat account etc. With this single view the overall profitability can be seen and cross-subsidization in various service fees can be seen.

c) Best-practice partners have clearly defined customer segments and sub-segments – Organizations generally start the segmentation of the customers with the help of demographic information like age, education, life-stage, geography etc. Profitability information helps the organization to segment the customers according to the profitability. The organizations at least segment the customers with profitability deciles (creating 10 groups of customers). Once this is done analyze the behavior of the customer in each of the deciles to understand why the customer is in that category. This helps the organization to create the segmentation by behavior (psychographic). The profitability of the customer largely depends on the behavior and this information helps the organization to improve the profitability by managing the behavior of the customer.

d) Best-practice organizations capture revenues and costs at the transaction level for each specific customer account – This is possible only with the Cost and profitability solutions. With this information at their hands organizations can compare the cost of transactions across the products, channels, regions. The use of channels for various transactions can be seen and the customers can be properly channelized to use the low cost channels.

e) Best-practice organizations take a holistic view of customer profitability and include lifetime value and customer valuation metrics in the calculation – As we discussed earlier the customer profitability information is used for segmentation, marketing campaigns, retention etc. With the available information of past profitability together with the analytical values of propensity to buy and churn, the organization can calculate the ‘customer lifetime value (CLTV)’ and use this information to retain the customers with highest CLTV. Also analyze the behavior of those customers to align other customers.

f) Best-practice organizations include the majority, but not all, of their costs in the customer profitability calculation. Best-practice organizations use appropriate methods for cost assignment – With the help of ‘time driven activity based costing’, we take the cost that are relevant to the various processes. The installed capacity cost if not utilized completely is not taken to the product or customer. This is shown in the ABM model as ‘Cost Available to Use’. Also the cost of various departments that are not related to the customer or product are separated and shown as ‘Cost to sustain business’. This helps the marketing department to use relevant information for taking business decisions.

g) Best-practice partners all work closely with IT. Enabling technologies for calculating customer profitability include data warehousing, CRM systems, data mining, external databases, and predictive analytics – The work with the IT starts with the building of the ABM model. Here most of the data available in the transactional systems is brought into the ABM model with the help of the ETL tools. The no-system-data is also brought with the help of the web-based solutions. Once the results are calculated in the ABM model, it integrated with the other solutions using the warehousing solutions. The historical data is used for predicting the future behavior and the related profitability of the customer.

h) Best-practice organizations emphasize intelligence (e.g., decision support), not routine reporting, in customer profitability information dissemination - The organizations do not create large number of reports for everybody. In fact the information is provided to those who are decision makers and also as and when required. In this the OLAP tools help the organizations to create the ad-hoc reports and the slice-and-dice required across various dimensions of the report. The dissemination also happens now with the dashboards and intranet facilities.

i) Best-practice organizations secure buy-in from the users and upper-level support for customer profitability initiatives – This is the most important factor in the initiative. The buy-in helps the authenticity of the input data as well as the results. This helps the decisions makes to use the output freely for the improvement initiatives and business decisions.

j) Best-practice organizations hold employees accountable for customer profitability – Most of the times the compensation or incentives the sales force is on the basis of the revenue that is booked (may or may not be realized). Typically the sale people sell those products that are comparatively easy to sell and bring more incentive. This may not always tie-up with the overall strategy or profitability targets of the organization. By understanding the profitability of the customers and holding the employees accountable for the profitability, organizations can align the sales force to the overall performance and strategic initiatives of the organization.

k) Best-practice organizations use customer profitability and segmentation to appropriately align sales and marketing resources – With the Cost and profitability solution, organization understands the current profitability of the customers and more importantly the reasons for their current profitability. With this information and the future targets, organizations can plan and employ the resources to maximize the profitability. The Marketing campaigns can be also targeted for ‘right’ customers. This helps in optimizing costs for the campaigns as well as the success rate of the campaigns increases.

l) Best-practice organizations have specific programs/sales efforts geared to their more valuable customers – The cost and profitability solution provides the accurate and detailed customer profitability information. Based on this the organizations can focus on acquisition, retention, cross sell, up sell programs.

m) Best-practice organizations successfully convert unprofitable customers to profitable customers - The organizations can also put their efforts to move the customers from lower profitability to higher profitability zone either by providing alternate products, removing activities that are not required, menu-based pricing etc.

Finally it has been observed and accepted by various organizations that the insufficient profitability insight is hurting the performance of the organization. The most accurate and detailed profitability information is provided by the Cost and profitability solutions. The results of the same can be used for better strategy formulation & execution, better marketing efforts and better matching of the resources to potential.

Maturity of Cost Management in Organizations

While I was thinking on writing on this subject, I could see the possible reactions from the various stakeholders (is this a really big word with respect to costing?). Costing is generally looked upon as ‘we know it all’ in manufacturing to ‘we have never done it’ in service industry. Sometimes people say, in today’s world the price is decided by the market, so there is no need of costing. In India, there is a statutory need for some of the industries to provide cost data on a regular basis to the bodies. I have the experience that if I use the words Activity Based Management instead of Activity Based Costing, people are more ready to listen to. But there are few organizations in India which have undertaken the study of their maturity of cost management. This is what, it prompted to me to think on this topic.

When we talk about costing, there are various techniques that are available in this area. Some them could be Product or customer profitability (activity based costing), strategic cost management, target costing, lifecycle costing etc. Each of this technique has its own way maturing in its use. The levels could be just measuring, managing and optimizing etc. At each of this level the use of the technique could be ‘one off’ or a process used by a few people or it is spread across the organization. So when we are trying to gauge the maturity of the cost management within an organization we can do it, at least across three different dimensions; a) # of techniques used b) level of maturity of the use c) how far it is in operation. Some organizations may be using one or two of them but doing to the most, at the same time it is still in the hands of few people in the organization. Like this the level of maturity would be different in different organizations and across different dimensions. A formal study on this would be very useful to create a ‘best practices’ workbook for the use.

Techniques used – There are various techniques that are available for cost management. Starting from the standard costing, absorption costing to calculate the product costs and variances to activity based costing, target costing, lifecycle costing, strategic cost management etc.

In manufacturing industry the bare minimum use of costing is there for inventory valuation. For this generally the absorption costing method is used, where the expenses booked in the period are charged to the products as manufacturing or admin or sales overheads. The method to charge the overheads to the products is bead on volume drivers. In service industry this is not required statutorily so you wouldn’t find there. Most of the times, the same information is used to understand the product profitability and take the business decisions. And we have seen time and again that this leads to incorrect decisions making.

Some organizations use activity based costing to calculate the product, customer profitability. Here the cost of the cost objects is calculated by calculating the cost of the activities first. The cause and effect relationship is used. The cost objects consume the activities and activities consume resources. Based on this relationship the cost flows to cost objects. This is a better way to arrive at product and customer profitability.

In target costing, the organization looks for introducing a product. Before doing this a market survey is conducted to understand the features that are desired by the target customer segment and the price that they are ready to pay for the same. A study of competitor’s product features and the corresponding price is also done. Based on this information the features of the new products are defined. A target price is decided with an expected profit. So the cost is the resultant factor. Target Price – Target Profit = Target Cost. Once this is done, a cross-functional team is formed to work on the design of the product, material, processing, marketing etc. Vendors are involved in this process. With the help of this team the organization tries to achieve the target cost.

In Lifecycle costing, the organization looks at the costs of the product throughout the life of the product. From the design, R&D, introduction, enhancements to the phasing out of the product. This helps the organization to plan the costs as well the price at various stages of the lifecycle of the product. You can plan the overall profitability of the product and manage the costs accordingly. The similar concept is now being introduced for customers also and called as Customer Lifecycle Value (CLV).

Strategic cost management relates the management of the costs based upon the strategic direction of the organization. I repeat, it is the management of the costs according to the strategy of the organization. Quite often I have seen people confusing strategic cost management as the cost of the strategy. In other words, that will be cost to the organization if they have to take certain strategic decision. This is like a cost benefit ratio. Typically if use the Porter’s concept of competitive strategy, there are two ways, a) Cost leadership b) Differentiation.

In case of ‘cost leadership’, the organization has to manage the costs in such a way that costs are at a minimum level without compromising the value to the customer. For this one can use cost driver analysis, waste elimination etc. Activity based costing can help the organization to understand the non-value adding consumption of resources.

In case of differentiation, the organization looks at capturing the market, beating competition and making money by making differentiation in product features, customer services etc. For this the Lifecycles costing concept can be useful, as it will help the organization to make money on overall life of the product and pricing can be defined at various levels of the life-stage of the product. Activity Based Costing can help here to understand the future resource requirement and costs of the same.

Another way of defining strategy is by ‘target customer segment’ management. In this the organization defines its target customer segment and tries to capture, retain and benefit from the customer segment. In this case the target costing can help the organization to manage the product costs.

Maturity level of the technique – The maturity level can be defined at least as a) measurement b) management c) optimization. One can define more in between each of these levels. The level measurement is where the organization is collecting the data. For example in product costing, the organization is just calculating the cost of the product for inventory valuation purpose. No other use of the information is made. Here the typical argument made is ‘the price is defined by the market and we cannot do anything about it’. Here goes into the trap they neither manage the price nor the costs (which at least is in their hands). Some organizations do calculate the costs and start managing those costs. For example they have budgets at expense level; they have standard costs for products. They compare the actual expense and product costs with the standard periodically find the variance, the reasons for the variance and take action plan to improve upon the ‘unfavorable’ variance. It helps to think of cost-optimization in terms of a weight-loss program -- you may temporarily lose weight on a crash diet, but in order to maintain an ideal weight, you must adopt a healthy lifestyle and diet over the long term. Similarly, only executives who take the time to examine the cost structure throughout their business and embed cost discipline within their organization's culture will see gains that can be sustained over the long term. To do this, organizations need to look at costs across whole processes, not just within functions. Ultimately, this means rethinking the entire business model around lower costs, possibly taking out whole layers of the organization or supply chain, examining customer interfaces, and considering outsourcing, shared services, and off shoring. The focus should be on creating a leaner, more efficient organization, with cost reduction as the consequence, not necessarily the target. The other way of looking at maturity level is the ‘SMILE’ pattern. S – see M – measure I – improve L – Learn E – Evolve.

Operationalization – The third dimension that we mentioned earlier was the opertionalization of the use of the technique. In here we first have to look at how frequently the techniques are used. Sometimes the techniques are used once in lifetime, may be due to the influenced by someone at the top and then it ends there. The word ‘used’ here means used in taking business decisions including defining and managing strategy. Quite a few times we see that there are various variance reports are generated but nobody looks at them seriously. In some cases the information generated is very useful, but it given the status of ‘confidential’ and kept in the hands of few people. What I mean by real operationalization is the technique is used regularly for creating information, used for taking business decisions and provided to the people who are going to take those decisions.

In the current scenario, the operationalization can also be looked from the angle of ‘use of technology’ for the cost management techniques. Spreadsheets are the minimum that people use and they know it is not the best of the ways always. There are various stand alone software solutions are available in the market and use of those does help the organization to make most of the techniques. Going further, the results of cost management techniques can be integrated with other cost techniques or overall performance management methodologies.

The maturity of the organizations can then be plotted as shown below.

The horizontal axis talks about the # of techniques that the organization is using. The Vertical axis talks about the overall maturity of various techniques. The diameter of the circle shows the level of overall operationalization in the organization. When I am saying ‘overall’, it is the combined effect for all the techniques that are used. With this we will try to understand the position of various organizations from the graph.

The organization ‘A’ is using may be only one technique and at a very low level i.e. measurement and it is still not operationalized. Organization ‘B’ is using many techniques but their overall maturity of use is low but they have achieved some progress in operationalization. Organization ‘C’ is using couple of techniques only but achieved best of the overall maturity and operationalization. Organization ‘D’ is using few techniques with middle level of maturity and operationalization. Organization ‘E’ is using most of the techniques at a very high maturity level but not operationalized it.

Once such a study is conducted it will definite help to understand the cost maturity of the organization, industry, geography and help the organizations to see which type of technique at what level of maturity and oeprationalization would help them.

Finally, wish you a happy fools’ day.