It is a common notion that an organization should seriously look at the costs when it is in a serious trouble. This trouble could be that they are making losses or a competitor has come with a similar product with lower price or a possibility of losing an order because of pricing. Cost is also seen as something that has to be reduced in any case. Generally because of this an organization is serious about understanding costs only when it seems to be making losses.
I have also mentioned in my earlier postings that when somebody talks about costing it is about the Product Costing. The management accountants have been trained professionally to take each and every unit of expense to the product. This is not true with any kind of business. There are some costs that caused by the products/services, some are caused by customers, some are caused by running the business and not related to any product or customer are some caused by the installed capacity. One should be able to segregate costs in the according these causes and relate them to the profit/loss the organization is making.
Activity Based Costing (ABC) has a word ‘Costing’ in it, so the same question arises for its use in the organization. ABC is based on the concept of ‘cause-and-effect’; hence it separates the costs that related product, customer, business and unutilized capacity. Even within the product and customer related costs, they are apportioned based on the consumption. With this calculation the organization can understand the costs related to the products, customers, channels etc. and take proper decisions based on the information.
To explain this, let us see the following diagram. This diagram shows the relationship between cost of products with traditional costing and ABC.
The horizontal dotted line in the diagram represents the cost of products according to the traditional way of costing and the ‘S’ curves represents the cost of products using ABC. It is generally seen that few products are grossly ‘overcosted’ and more than that products are grossly ‘undercosted’. The products that are overcosted have more cost up to 50% and the products that are undercosted have costs less up to 500%. The primary reason for this incorrect cost calculation is that generally the overheads are taken based on the volume produced. The complexity of product is not considered. It is seen that the change in the overheads of the organization is related to the additional complexity of the business. This complexity could be added due to more products, more customers, more channels etc. It can also be introduced due to the complexity of the product features. This is complexity is generalized in the traditional costing and the same is converted into a logic for apportioning the overheads in ABC. It is generally seen after the ABC modeling that the organization is almost shocked after looking at the results. This is due to the fact that the products those were ‘dear ones’ earlier start looking loss making and vice-a-versa.
We will see another diagram, which is called with different names like profit cliff, whale diagram, profit umbrella etc. This diagram depicts the products or customers on the horizontal axis and the cumulative profit percentage on the vertical axis. This diagram can be plotted for products as well as customers. The following diagram is taken from one of the book written by Gary Cokins, who is an internationally known expert on Performance Management.
In this diagram the horizontal axis represents the products and the vertical axis represents the cumulative profit in USD millions. The current profit shown in the financial records is $ 2 mn. If we start analyzing the diagram, we can see that the same $ 2 mn is achieved by first 13% of the products. So from the products that are making most of the profits top 13% give you the current profit of $ 2mn. The story does not end there. The top 65% of the product by profitability provide the organization a profit of $ 8 mn (400% of current 4 2mn). Then there are some products are neither profit making nor loss making. And almost 15% of the products which are actually making loss, bring the profits from $ 8 mn back $ 2 mn.
So on the face of it the organization is making a profit of $ 2 mn. It may be also happy with that profit, but then it is not realizing that the potential of the organization is $ 8 mn and not mere $ 2 mn. With the use of ABC and then plotting this graph the organization can realize its potential. It can also understand the loss in profit it is making. More important that this, it will also understand which products are bringing the profit and which are taking away. A similar diagram for customer profitability shows which customers are profitable and which are taking away the profits.
This is where the ABC that is the costing part ends and Activity Based Management (ABM) starts. In ABM the organization looks at the costs analyzes them and takes proper action on the same. For the organization uses various techniques like root cause analysis, benchmarking, cost driver analysis etc. to understand the reason behind the profits or losses. So we not only understand ‘who/which’ are making profit and loss but also ‘why’ they are. Based on this information the organization can take series of actions so that it can optimize the profits by selling its best products to the best customers. It can also take actions to promote the loss making products/customers to profit making.
With these actions the organization can reach as near to its potential profit as it can. But the first and foremost understanding the organization must have is its profit potential. This potential is brought forward by using the ABC methodology. So even if know you are making profits and you are happy with the number, think again is that the real profit potential of your organization?
