In the late eighties, the western organizations were facing competition from the Japanese organizations. These Japanese organizations (especially in electronics and automotive) had a distinct advantage of cost over the western organizations. This was due to the various management techniques used by Japanese (SPC, JIT, Continuous improvements etc.). At the same time some of the western organizations were looking at their decreasing margins, without knowing the real reasons behind it. During that time costing was used for completing the financial reporting by calculating the inventory costs. The same information was used to calculate the product cost. This was obviously leading to ‘not-so-correct’ product costs and decreasing margins.
This is when people built their first ABC models. These models provided them the information that helped them to understand that the basic reason for the wrong business decisions was the cross subsidizing product costs. Organizations then started ABC results for pricing and product mixes as well. With this came the flood of ABC implementations. Both the consultants and organizations went overboard. The models were designed with in detail (sometimes in too detail). The corresponding technological solutions could not cope with such detailed models and this led to the early reactions. ABC is very much time consuming. ABC takes too much time to build. ABC was also used for product costing only, then. So it has to face the criticism of not being customer focused or process oriented. Also the followers of ‘theory of constraint’, also criticized that ABC can only be used for long term decisions and not for short term decisions.
A lot of changes have happened to the modeling concepts, technology, uses of the concepts etc. The irony is that, people criticize the ABC concept even today, based on the state that ABC had 20 years back. It could be so because they do not know about the changes that have happened to the concept of ABC. Let me give a try to provide this information.
The concept of costing was relevant to manufacturing industry, because costing was always synonymous to ‘Product Costing”. With this understanding the modeling was such that each and every ‘penny’ spent was taken to the product. Over the years people have understood the ‘cause-and-effect’ relationship of costs and now the ABC models separates the costs that are caused by Products, Customers, Capacity and costs not related to any of these (business sustaining costs). Due to this segregation of costs organizations are able to calculate and understand the product as well as the Customer profitability also. As the costs are separated for the resources provided and resources used, organizations are able to calculate and understand the resource utilization of the various functions. Earlier capacity was always synonymous to machine capacity. When you know the capacity utilization you can use the concept to plan your resources. Hence, ABC can be used for resource planning.
In the early days of ABC modeling it was a single stage modeling. This means costs from resources taken to activities and from activities to the cost objects (products). The current ABC models can have multiple level assignments. You can assign resources to resources (Cost of HR function assigned to various other functions), activity to activity assignments (secondary activities supporting primary activities), reciprocating assignments (HR providing services to IT and IT providing services to HR in turn). By using various attributes one can view the cost of process at various stages. For example we can see the cost of procurement process at various stages as requisition, purchase order, QC, returns, payment etc. This analysis helps the organization to directly attack the areas that are inefficient. All this is possible because of the technological solution as well as changes that have happened in modeling.
The changes in technology have also happened in parallel. From the early days PC based solutions to the current enterprise wide application, is one way. Various functionalities like multi-stage assignments, reciprocating assignments, attribute etc. For me the most important is the ability to do the multi-dimensional modeling and viewing the results as OLAP views (for those who not so technical OALP are very similar to the ‘pivot tables’ in MS Excel). With the use of this feature we can not only see the product or customer profitability, but this can be seen as product wise – customer wise profitability (or vice-a-versa). This combination can possibly lead to understand profitability of a customer – for a product – sold in a region – thru’ a channel. Alternatively one can see profitability of a customer can be seen for a telecom company as a set of customers falling as private customer – acquired thru’ retail outlet – with a prepay plan – having very low technology aptitude – with a life stage as matured family – age group of 44 to 55.
As I said the costing as well ABC was initially used in manufacturing industry. It has had such an effect on people’s mind that people still think that ABC is useful for manufacturing industry only. In the early nineties came the CAM-I cross.
This diagram helped organizations to understand that ‘Activity’ was the most important part of the ABC model. Process in nothing but set of activities performed in sequence by one or more functions. Analysis of cost drives as the ‘cause of the cost’ helped organizations to use ABC results to improve their processes. Here was the answer to the people who criticized that ABC is useful only for product costing (and hence for the strategic use and not for operational improvements). This modeling concept led to the use of ABC in various service industries because the ‘products’ of those service industries were their ‘services’ and nothing but various processes. Initially the service industry used this concept to calculate the customer segment level profitability. In case of Retail it was used to calculate the category level or product group level profitability. The technological challenge was, it could not handle the millions of assignments. Today the commercial software solutions are available that can handle 100s of millions of assignments, which can be used to calculate profitability at subscription level in telecom, account level in banking or SKU level in retail. The time driven activity based costing equations have helped to model these millions of assignments very easily.
The latest technological evolution is the integration among the various software solutions. Because of this, the data required for the ABC model to update the model can be directly pulled from the ERP or any OLTP application running in the organization. For the ‘non-ERP’ data we can develop a small web-based solution, so that employees can enter the empirical data for the ABC model. The results of the ABC model can be integrated with various Customer Intelligence (CI) solutions like segmentation, retention, campaign management etc. ABC model can feed up-to 20% of the KPI data in a scorecard. This has increased the usability of the ABC information.
The use of ABC has also changed over the years. It started with calculating product costs, to customer, channel, Business unit profitability etc. This has been used to calculate the resource planning and activity based budgeting. After creating the activity based budgets, organizations can start reporting activity based variances. Route optimization in supply chain for various organizations like Retail or CPG, can be supported with more accurate costs of various activities at multiple places. This cost information coupled with optimization techniques can help them to find the optimal route for various vendor-item category-location combinations. ABC information can support any other process improvement program that is running in the organization, by providing accurate costs of various processes and help to prioritize the program. For this we can use the ‘2 x 2 diagrams’ methodology. We can use cost v/s potential to improve (the potential to improve will depend on how badly you are performing the process or activity). From here we can choose the quadrant that is ‘high cost and high potential to improve’. For the activities in this quadrant we add another attribute ‘potential to change’ (that is how easy it is in the organization to change the way in which we perform the activities). The first set of activities would be then ‘high cost – high potential to improve – high potential to change’. This seems to be the low hanging fruit.
It is no longer that the organization would start looking at business as a portfolio of customers. Then managing business is managing these portfolios of customers. To form the customer portfolios, customer profitability would be one of the most important information. Soon the board of directors would start demanding the customer profitability information and will challenge management to act on it. Who knows, shareholders would also start asking for this information. While mergers and acquisitions people will start running ABC project to understand the customer profitability, because in the acquisition, organizations are acquiring a portfolio of customers. The bid would also depend on the portion of the customers that match the profile but also portion of the customers that are profitable and matching profile.
During all this discussion, I wanted to explain that since the introduction of the concept of ABC till today and in future, it has gone through various cycles. Some people have used it, some have criticized it. It has taken its path of crests and troughs. Looking at the maturity of the use of the concept, technology available, consulting resources and competitive market situation, I feel the right time to start using ABC is TODAY. I will modify my title little bit and say “The best time implement ABC was 20 years back. The second best time is now….’
