Activity Based Management

Activity Based Management (ABM) and Enterprise Performance Management (EPM)

2011-04-01T07:00:00.002+05:30

Now a day one can hear about the term Enterprise Performance Management (EPM) a lot of times in different ways. It also termed in different ways like CPM, EPM, PM etc. Sometimes it is also used interchangeably with the individual performance and organizational performance. There are various definitions also for EPM. I personally like the definition by Gary Cokins, which mentions that Performance Management is the process of managing the execution of an organization’s strategy. It integrates the business improvement methodologies with technology. So it is neither the methodologies only nor the technology in isolation.

As I have mentioned in my earlier posts, Activity Based Management (ABM) is the way to manage your business by managing the activities to provide improved value to the customer or organizational performance. After these definitions, we will try to see how these two things go together in different ways as concepts, execution and technology.

I personally believe that the EPM starts with the definition of the strategy. This is because if you do not know where you want to go, any way is a good way. Let us have a look at the following figure:

Defining the strategy for your organization, preparing business plan according to the strategy and then measuring the performance and analyzing the variances with reasons to modify the internal processes or strategy is a cyclic process. ABM fits into the ‘Measure and Analyze’ part of the cycle. Here the ABM model based on the business plan can provide the information on the resource requirement in the future as well measure the actual performance. Once you analyze the actual performance against the planned one, the same can be analyzed using various techniques like root cause analysis, continuous improvement etc. The analysis will tell whether one has to manage the processes to improve the customer value or organizational performance.

The performance management is also seen as the operational performance management or strategic performance management, as it is mentioned in the earlier part.

Operational performance management is looking at the processes to improve organizational performance and strategic performance management is looking at the processes to improve the value to the customer. The ABM model can be designed to manage the performance at both the levels. It can also be used for some tactical purposes as managing a customer segment or a product group etc.

Looking at all those things the tool vendors have combined their software solutions into one group as Enterprise Performance Management (EPM) suite. This suite generally includes the solutions for Strategy Management, Business Planning and Profitability & Cost Management. They project and try to sell these solutions as a suite. I have got the following figure from some document that I am not able remember, so please acknowledge the efforts of the person who has created it (if somebody knows it pl let me know, so that I can put the name in the acknowledgement).

In a very simple way, we will try to understand this diagram. It shows three differnet parts. Analytical toos as in the technological part that help us to alanyze the results. One may argue as to reporting is not exactly same as analytics. The second part is the analytical appliactions which are actually the software solutions based on the various business improvement methodologies. The third part is supporting tools ahich ehlp us to integrate the data and perform the administrative part for those solutions. All these solutions work on the same data mart or warehouse so as to provide one view of the data and these solutions use and provide data to the othersolutions through this data mart or warehouse.

If we see the Strategy Management methodology creates a strategy map, the Key Performance Indicators (KPIs) and corresponding action plans. Based on the strategic plan the budgeting and planning solution can create the business plan. It can also use the Profitability management solution (ABM) to create a driver based planning. ABM can also provide the actual values for various KPIs defined. The Activity analysis using the cost drivers and performance measures can provide information the performance of the organization vis-à-vis the planned one.

As we saw ABM fits into Enterprise Performance Management (EPM), conceptually as well as technologically and helps the organization to manage the performance at the strategic level as well as operational level (including the tactical one).

Should an organization use Activity Based Costing (ABC) when it is already making profits?

2011-03-01T07:00:00.002+05:30

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?

Strategic ABM (Activity Based Management) and Operational ABM

2011-02-01T07:00:00.001+05:30

We will start with definition of Activity Based Costing (ABC). According to the CAM-I (www.cam-i.org) the definition of ABC is ‘method of costing products through costing the activities’. In ABC we calculate the cost of activities firs and then the cost of products. This does not mean we can calculate cost of products only. It is based on the concept ‘cause-and-effect’. The cost objects (products, customers etc.) consume activities. This means we perform activities for products, customers etc. The activities consume resources i.e. the resources (people, facilities, expenses etc) are utilized to perform the activities. Based on this logic the cost are flown to the products, customer etc. Generally the costs are can be grouped into product related, customer related, unused capacity and the rest are ‘business sustaining costs’.

Activity Based Management (ABM) is a methodology to manage your business. It is like various management techniques that have emerged over a period of time like Management by Objectives (MBO), Management by Exceptions (MBE) etc. Let us see the definition of ABM: it is the method to manage your business with managing your activities to improve operational excellence (internal) or value provided to the customer (external). ABM is calculation of costs with the ABC method then analyze the data and take action on it to improve your business performance.

ABM can be used to understand and improve the performance at all the levels in the organization. It can be used to take decisions about the products, customers etc (Strategic use). It can also be used by a head of the department to manage her portfolio of products or customers (tactical use) or to improve certain processes (operation use). Based on these uses few people have segregated it as ‘Strategic ABM’ and ‘Operational ABM’.

Strategic ABM – ABM can be used for the purpose of taking strategic decisions like adding or retiring products, acquisition or retentions of customers etc. These decisions are based on the profitability information calculated using ABC method. This information is historical information of profitability. This historical information coupled with the future trends, competition etc can help the organization to take the decisions. In other words it is ‘doing the right things’.

The ideal way of performing for an organization is to sell best of their products to best customers. For this the organization has to understand which their best products are and who their best customers are. ABC helps the organization to find their best products and customers as per the profitability. Once the organization has to find out the profitability, it can then group them into deciles (make 10 groups according to their profitability numbers). Each of deciles can be analyzed for products and customers as to what are the reasons for those to fall into that category. Then various action plans can be taken to move them from lowest of the deciles to the highest. As I said this is a historical data of profitability, one has to look for the potential future trends and couple them with current (and historic) data to take the strategic decisions.

ABM models for Strategic ABM are at a comparatively gross level. The activities are defined at almost a process level. Now a day we can calculate the profitability of the products even at SKU (stock keeping unit) level, in the hierarchy LOB-Product Group-Product-SKU. We can also calculate the profitability at account level in banks, subscription level in telecom. This can be grouped at the customer level, household level or other customer segments.

Operational ABM – In this case the use of ABC information is for improving the performance of various operations (processes) in the organization. The process is nothing bust various activities performed in a sequence by one or more functions in the organization. In this case various activities are tagged as ‘value add- non value add’ or ‘core, discretionary or sustaining’ and based on the analysis the activities are eliminated. Here I remember a methodology explained by Gary Cokins as:

a) See if the activity is required by the customer (internal or external). If the activity is not required then eliminate the activity

b) For the rest of the activities see if you reduce the recurrence of the activity. That means see if you can reduce how many times you have to perform the activity

c) Once this is done go one level down i.e. at the task level and repeat the steps mentioned above.

The activity costs can be analyzed by finding their ‘cost drivers’. Cost drivers are the causes of costs for the activity and typically ‘unit cost’ of the activity. For example;

When one wants to improve the cost of an activity, one has to work on those cost drivers. Once we analyze and take action plan to improve on those cost drivers we can measure the performance of the activity. Performance can be measured by at least three ways 1) productivity 2) cycle time 3) quality. This actually forms the horizontal view of the CAM- cross which is also called as ‘Process View’.

Sometimes the cost driver is used interchangeably with the resource driver and activity driver. The resource and activity drivers are nothing but the logic with which the costs are taken from resources to activities and from activities to cost objects.

ABM models for operational purpose are more detailed in the ‘Activity’ section. Here the level is taken to tasks. Most of the times these models can be created for each process separately. If you try to model everything in one then it may create implementation and maintenance issues for the model.

I have seen some of the consultants that do not use any software solution for modeling; it is very difficult for them to calculate the product, customer profitability in detail. They use the information of activity costs to improve the performance of the processes. So the ‘Strategic ABM’ and ‘Operational ABM’ are not altogether new concepts of ABM, but it is just what the concept is used for.

Shared Service Costs using Activity Based Costing (ABC)

2011-01-01T07:00:00.003+05:30

First of all, I wish you and your family a very happy and prosperous new year.

A shared service is an operational philosophy that involves centralizing administrative functions that were once performed in separate divisions or locations. Services that can be shared among the various business units of a company include finance, purchasing, HR and information technology. Shared Services is a service model designed to gain efficiencies in routine processing by leveraging common practices and enabling technology. In the earlier days the costs were not significant, but because of the IT services it has gone up. In some of the financial services companies or telecom companies the cost of IT function contributes more than 25% of the costs.

The primary objective of forming the share service departments is to leverage the economies of scale to improve the cost as well as the productivity of the departments. Some of the other drivers for moving to shared service model are a) Process standardization b) Process improvements c) headcount reduction d) Improve service levels e) Increase control f) in case of mergers it is used to capture the synergies. All these objectives look logical as well as moving towards the improved performance. But still the recipients of the services do not seem to be happy with the costs. This is generally because there is not transparency in the calculation of the cost of the services. There is also no relationship seen between the volume demand from the business units and the cost of the services.

The typical method of allocating these costs to the business units is headcount, capital employed, revenue, area occupied, # of users, # of workstations etc. These statistical keys may not always relate to the volume of the services received by the business unit. The planning of the shared services is also not in line with the business volume planning of the units. With this situation the utilization of the shared services is not in line with the business units’ volume requirements.

The chargeback system for the shared services should be

a) Equitable – It should be fair to all the recipients. There should not be any kind of cross-subsidization among the business units. This may generally happen when the basis of distribution of cost is ‘Revenue’ or ‘Headcount’. The business units should pay for the capacity of the resources they use. The underutilization of the shared service department should be charged to the business units. This overcapacity can result as there is no relation between the requirement for the business units and the resource planning by the shared service departments.

b) Repeatable and Accurate – The cost of the service should be the same irrespective of the time. It should cost the same across the year for the same volume requirements. Assuming the same input it should consume the same level of resources every time.

c) Understandable – Both the service provided and the business units should understand the methodology of charging the costs.

d) Predictable – The business units must be able to predict the costs of the services. They can plan for the higher volumes if required. In turn the service provider can plan the resources as per the requirement of the business units.

Activity Based Costing (ABC) can be the answer to reduce the conflicts between the service provider and the business units and also fulfill the requirements for the good cost allocation method. In ABC the model for shared service cost calculation can consider various shared service departments like IT, HR, Procurement, Facilities management and define their services (as activities) and business units as the Cost Objects. Sometimes the services provided can be defined as the ‘Services’ in the Cost Object and Business units as the ‘Customers’. In that case the activities are the various steps for completing the services. Some of the consultants create a separate model for the shared service cost calculation only. The final model starts with the resource costs as per the cost center accounting plus costs from the shared service model.

Let us consider the various services that can be defined for the departments.

a) Accounts payable – Vendor payment, employee reimbursements

b) Accounts receivable – Billing, accounting for receipts, ageing reports

c) HR – Recruitment, training, grievance management, performance measurement, payroll

d) IT – Application management, infrastructure management, help desk – applications, help desk – hardware

e) Corporate services – Travel management, facilities management, internal functions management

In the first step the demand for various services is collected from the various business units. Based on this demand and the various activities required and the time taken by various activities the total resource requirement is calculated. In this way the resources of the shared service departments can match with the business plan of the business units and they can plan for the resources for themselves. This in turn saves the business units being charged for the unutilized capacity of the shared service departments.

Once this demand is converted into the resource requirement and the same is planned for, the second step is calculating the cost of those services. For the all the costs for the shared service department is accumulated as a cost center. Care should be taken that these shared service department as providing services to the other are also receiving services. For example as IT department is providing services to HR, it is also services from HR department. This ‘reciprocal’ assignment of cost should be modeled properly. Once all those costs are collected, they flow through the ABC model and calculate the unit costs for each of the service. Then based upon the volume of services availed by the business units the cost is allocated to them. In this way even if there is any excessive capacity in the shared service department, it is not transferred as cost to the business units.

In this way the business units can see the unit cost of the shared services and they can either question the shared service departments for the same or if allowed they can avail the services from the third party. Sometimes the ‘Employee self service’ program is also taken by the business units. In this program the employees perform the services for themselves. This reduces the cost of the organization and the satisfaction levels can be matched. The performance of the shared service departments can be improved by creating the ‘Service level agreements (SLAs)’ and/or defining the performance indicators for the services. At least three types of performance indicators can be defined.

1) Productivity type – Cost per service

2) Cycle time type – Time taken to perform the service

3) Quality type - % of times the service is provided with required quality

Activity Based Costing (ABC) models for shared service departments help the organization to achieve their goals for the initiative as well as provides transparency in allocating costs and utilization of resources of the shared service departments. The planning of the shared service departments can happen in line with that of the business units.

Activity Based Planning (ABP)

2010-12-01T07:00:00.001+05:30

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

2010-11-01T07:00:00.011+05:30

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?

2010-10-01T07:00:00.004+05:30

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

2010-09-01T07:32:00.001+05:30

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

2010-08-01T07:00:00.002+05:30

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

2010-07-01T07:00:00.001+05:30

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

2010-06-02T12:33:00.002+05:30

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

2010-04-01T10:00:00.003+05:30

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.

The ROI of an Activity Based Costing (ABC) project

2010-03-02T10:54:00.002+05:30

This is the most common question that is asked to all the vendors that propose any concept, solution to any organization. I, as a management consultant have answered this question a lot of times. Surprisingly, when I am at the client’s place and see various internal projects (managed totally by the employees of the organization) launched, almost none of them are proved (or may be asked) on their positive ROI. They are run as a necessity and the outcome is ‘expected’ to be good but does not guarantee anything. Especially the marketing campaigns and sales improvement related projects.

Today I am going to talk about the return on investment (ROI) of an ABC project. As you know from my earlier post that ABC has already completed 20 years of its existence. Over those 20 years various experts have explained the ROI of ABC project in different ways. I will try to put most of them as well as my own view.

ABC methodology came into existence, as the US markets were facing tough competition from the Japanese market on the costs. The earliest use of the concept was to take costs to the products with a more logical way. The method that was used to take overheads to the product, before ABC was based on ‘Labor hours’. After this it has been used for various purposes like Product profitability, Customer profitability, Process improvements, Cost reduction, Resource planning, Activity based budgeting, customer segmentation, marketing campaigns, customer life-cycle value (CLV) etc.

Now we will look at the components to calculate ROI, i.e. Cost and benefit. On the cost side it is easier to compute as you know the costs for the components like software solution (from spreadsheets to enterprise wide integrated solution. Now you can get ‘pay per use’ type of option also), hardware cost to host this application (not an investment in case of ‘pay per use’ option) and the consultancy costs for initial modeling and training of the team. The ongoing costs are those for the software licenses and hardware maintenance. The internal costs, are related to the time spent by various personnel in collecting, uploading the data; creating and circulating reports. This is comparatively simpler to calculate.

Now comes the difficult part that is calculating the ‘value’ of the benefits in monetary terms. I remember the days when various ERPs were introduced in that market and the ROI was calculated on the benefit that ERPs can improve your business processes hence; the organization can improve the inventories and less number of people would be require to run the business. In case of ABC, the experts have various views on the calculation of benefit. Some say that the use of the ABC information is for taking better business decisions. Hence, it is very difficult to calculate the benefit of ABC. Some say, as it is used for talking better business decisions, the benefit due to the business decision taken can be attributed to ABC. In other words the benefit can also be calculated as the ‘Loss avoided’, if we had not got the information given by ABC project.

Let us take an example here. An organization is looking at increasing a market share. This is aimed at acquiring more number of customers in a particular segment. The reason behind acquiring such type of customer was they were giving more and more revenue to the organization. The logic presented was more number of customers will more revenue and definitely more profit to the organization. A marketing campaign was run and the organization got more customers with increased revenue. To cater to the increased requirement of the products/services the organization has invested in infrastructure and facilities. But the financial statements statement showed that the profitability was unchanged (sometimes it is even worse as the profitability decreases).

If ABC had been implemented in this organization to calculate the customer profitability and product/service profitability (sometimes region wise also), then the organization could have known that which products/services to be offered to which customer segments and which regions, based on the profitability information of the existing customers coupled with their demographic and psychographic information. This would have made the marketing campaign more effective towards the ultimate aim of increasing market share with profitability. In this example the benefit of ABC project can be calculated as the increase in the revenue and profits of the organization. Alternatively it can be also calculated as the loss of expenses on the campaign that did not increase the profitability of the organization.

I am sure it can be also applied to the other uses of ABC projects, but would not be always so simple to calculate the benefit which could be more implicit than this. The experience of implementing ABC over 20 years has shown that at a gross level the benefit can be stated as reduction of installed overheads by 3-5 % or improvement of the profitability by 200% percent.
When we talk about the reduction of overhead costs, people in various types of industries tell that our overheads are very less. For example in manufacturing, they say 65-90 % of our costs are material costs. So why take so much of efforts and try to rock the boat (by change management) for 10% of the overheads? To answer this, we take an example of an organization with INR 5 billion (approx USD 100 million) of revenue. We will assume that the profitability is 10% i.e. INR 0.5 bn. This leaves us with a cost of INR 4.5 bn. The material cost is 90% of this, i.e. INR 4 bn approx. So we are talking about 3-5 % of INR 500 mn (approx USD 10mn), which comes to INR 15 mn (approx USD 300,000). In Indian context this would give less than a year’s ‘pay back’ period for this organization. If we couple the improvement of the profitability it would look like the payback period is in few weeks. This is explained in more detail in my earlier blog http://activitybasedmgmt.blogspot.com/2009/03/activity-based-management-in-company.html

Actually a blog post by Dr Peter Turney, founder of Cost Technology Inc., has given me a stimulus to write on this subject in detail. It will also help all the readers, especially those who are thinking of implementing ABC (even more for those who have postponed or cancelled the ABC implementation). In this article of Dr Turney, has mentioned three reasons for implementing ABC, viz. a compelling business need, recognition that ABC is superior to whatever you currently have or don’t have, and a positive return on the required investment. I also present the ABC case as to answer three challenges,

Making strategic decisions based on a true understanding of which business segments are profitable

Determining the business processes that drive cost and how to control them

Predicting future resource needs, and costs in dynamic organizations, and the impact they will have on future financial performance

In 'Sanskrit' (an old Indian language), we used to have small riddles. In this, there used to be three questions in first three lines and the fourth line used to be the answer of those three questions. The amazing part was the answer used to be in 'single word'. This single word had three different meanings, which used to be the answers to the three questions. I want extend the same idea here. I would say whatever the reason for implementing is; the results give you an 'INSIGHT'. You use this insight to find answers to different questions.

We will now focus on the 'ROI' part, for a long time experts have mentioned that the ROI comes from either improving costs or profitability. The percentage would vary from organization to organization. It is dependent on how good and how bad you are. Actually it would 'how bad' and 'how good' you are, if we want to look at it sequentially.

Let us take the ‘How bad’ part of this. This is nothing but haw bad are the internal processes today. How much is the ‘non value added’ part in these processes. This non value added part can come because of doing activities that are not at all required or doing activities again and again or to do them because the information or material is not of proper quality or any other reason. This tells us the ‘Potential to improve’ in an organization. The same logic can be applied to the profitability information also. The 2x2 diagram with customer profit plotted against customer revenue will tell how good is our understanding about the customer profitability and how well we know the requirements of our customers to add or manage or retain our best customers.

Now comes the most difficult part. The 'how good' part. This is nothing but the ability of the organization to implement the action plans to achieve the benefits. This actually talks about the ‘potential to change’ in the organization. So the ABC project may have identified various opportunities to improve (may be worth 5% of the overheads), but the actual benefit achieved will depend on the willingness of the people at various levels in the organization. To help the organization to reap maximum benefit, I suggest plotting a 2x2 diagram of potential improve v/s potential to change.

The quadrant that talks about the highest potential to improve and also highest potential to change is the priority area. I also call this as the ‘low hanging fruit’. Once you start implementing these actions and show the results of the same. These people or actions can be shown as the ‘islands of excellence’. This actually can propagate the chain of actions in your organization to achieve maximum of the ‘potential to improve’.

Finally the ROI of the ABC project can be calculated, though difficult. It can be as high as 300-400%. It can be seen as a payback period of less than a year. It actually is different for each organization as the potential to improve and potential to change does differ from organization to organization.

The best time to plant a tree was 20 years ago. The second best time is now.....

2010-02-13T07:47:00.001+05:30

I passed my management accountancy exam in 1992. This was the same time when Activity Based Costing, was at its peak (may be first peak). Although I was not aware that such a concept exists then. I heard about this concept for the first time, when I was asked during one of the employment interviews in 1993, “What do you know about Activity Based Costing?” I was zapped, as I had never heard about such a thing in my life. Life took me back to Activity Based Costing again in 2000, when I started reading about anything and everything about it on Internet. Since then I have been hooked on to this concept till date. The only reason why I telling all this is, when I look back, I see Activity Based Costing and my alliance with Costing have crossed 20 years of mark. In those twenty years I have changed a lot, as well as the concept of Activity Based Costing. Let me put the life of the Activity Based Costing for last 20 years as I know it. Correct me, wherever I am wrong, by posting your comments.

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….’

Profit plus Cost is Revenue

2010-01-11T17:18:00.003+05:30

We have seen the business planning happening majorly as ‘Sales Planning’. In other words we can say that it is the ‘Revenue’ planning. Based on the planned revenue and returns expected the ‘Cost Budget’ is targeted. With the equation ‘Revenue – Profit = Cost’. The pressures are majorly on the costs. With this pressure the management as well as the line managers try to cut costs which is nothing but cutting expenses (read as ‘resources’). Activity Based Management (ABM) helps to understand the ‘non-value added’ activities and those can be scrapped with reducing the expenses and resources can be freed to perform the customer facing activities. This would in turn help to maintain the ‘Customer Value’.

Instead of starting with revenue if we can start with the profit expected by the management, then understand the market situation to bring that profit. With this study we can understand our product offering, their pricing, our customer segments, their requirements, competition etc. With this understanding we would be able to build our business strategy comprising of ‘what to sell’, ‘whom to sell’ and ‘how to sell’. This will help the organization to understand their current business processes and the plan the future one. This planning would define the activities to be performed and the resources requirement for the same. This information can be converted into cost budgets. What we know now is profits plus the costs, and the sum of this should be the revenue that needs to be brought in. Based on this information we can break down the revenue into various products, customers, channels, prices, geographies etc. Based on this a detail sales plan can be defined and monitored further.

In recent past various organizations are using ‘Balanced Scorecard’ as their performance planning and managing methodology. In this methodology organizations define their ‘strategy map’. Based on this map and the strategic objectives various KPIs are defined. Among those are the cost related and profit related KPIs. While defining this strategy map and the KPIs, if we can use the ABM models where in we can create various ‘what-if’ scenarios based on various options that the organization may have to achieve their ultimate goal, then the organization can choose the strategic path that is matching with their ROI targets. This is based on the assumption that the strategy map (by itself) does not give the numbers that can be achieved. But the ABM scenarios can help the organization to understand the impact of various actions on the profitability. Before choosing a path the organization can understand the effects of their future action converted into bottom line.

I have posted this with few assumptions and I would be interested in getting the feedback from readers on at least following questions (more than that is always welcome);

1) Is this concept already used by the organization?

2) If yes,
a. What type of industry is using?
b. In which geography this organization is?
c. How useful is this?
d. What are the challenges faced?

3) If no,
a. Does this sound practical?
b. In which type of industry this would be helpful?
c. What are the lacunae?
d. What type of alternatives can be used?

4) Any other comments (for or against), as this will make us the concept understand better.

You can post here or send me an email at rajenpatil12@gmail.com

Workshop on Profitability and Cost Management

2009-12-29T09:46:00.001+05:30

Indian industry, notwithstanding its growth projection, continues to face an uphill battle to identify the ‘real’ opportunities for growth amidst reduced consumer confidence and a customer population that is prone to churn and attrition. Many Indian enterprises, having invested heavily in good times are now finding it very difficult to sustain the cost structures with reduced margins. While the economic crisis will have serious impact on the growth and profitability of the companies, the crisis offers an excellent opportunity for companies to transform themselves towards long term profitable growth and increased stakeholder value. Not surprisingly several leading firms in India have started comprehensive transformation programs. The question though is – what should be the goal of such transformation programs? Should they focus on growth or profitability? Wouldn’t cutting costs offer immediate return of profits? Should more customers be acquired? Do more customer means more revenue and importantly more profits? While these are very common questions that the executives driving these transformation programs address, the reality behind these transformation programs is that often companies undertake these programs on “Gut feel” rather than basing them on “complete and consistent facts”.

To improve financial performance is a high priority in most organizations today. But to find accurate information on costs and profits for decision-making can be difficult. The problem is that traditional accounting systems were developed mainly for external reporting purposes. As a result, these systems often provide inaccurate and misleading information about costs and profitability. What you need is a system that will enable you to accurately measure costs and profitability for products, services, customers, and processes. It should also reveal the root causes of a certain cost or profitability level, enabling you to make the right decisions and take action to improve financial performance. What you need is Activity-Based Costing and Management. An unmatched concept that enables you to make better strategic and operational decisions to increase profitability, manage costs, and improve operational efficiency.

With ABC/M you can:
– Identify the most and least profitable products, services, customers, or sales Channels
– Accurately determine true costs for products and services

We are pleased to invite nominations from your organization for our One Day's Workshop on "Profitability & Cost Management". The details of the same are as under:

Date of The Workshop - Friday, 22nd January, 2010

Time - From 9:00 a.m. to 5.30 p.m.

Venue of the Workshop:
B.V. Rao Hall , 1st Floor
Deccan Gymkhana Recreation Building
Deccan Gymkhana Club
Opp Hotel Ait / Near Chitale Sweet Mart
Pune - 411 030

Faculty:
Mr. Rajendra Patil is B.E. - Polymer Engineering from Pune Univ. & a Cost Accountant (AICWA). He is a technocrat with 17 years of proven experience in Business Analysis, Providing Consultancy in Strategic Cost Management, Profitability Analytics, Organisational Performance Management and Business Process Management. He was working with SAS Institute R&D India Pvt. Ltd., Pune, a US based Enterprise, as a Specialist – Performance Management Solutions for Indian Customers. In 2008 he ventured into consulting and started APPS Consulting.The major objective of APPS is to provide consulting services to organizations in Banking, Insurance,Retail, Communication, Manufacturing, IT and KPO sector. The unique proposition of APPS is to prove and earn. Mr. Patil has undergone Training on Activity Based Costing & Profitability Management as well as on Expert Modeling and OLAP analysis at SAS, U.S.A. He has handled various projects related to (ABC/M) various Business Organisations from Manufacturing, Telecom, Retail and Banking Sector. His clients are Kirloskar Group, Suzlon Energy,Thermax,JK Files and Tools,Merck India,Syngenta India,Waterville TG, ING Vysya Life Insurance, SAS R&D India, Systems America Inc.,Mercedes Benz India,Finolex Cables.

Who Should Attend the Workshop:
• CEOs, Senior as well as Middle Level professionals from Finance, Marketing, Costing, Operations, Sourcing who are keen to take their functional expertise to the next level.
• Note: This is not just a workshop but this can lead to Consultancy on ABM Projects. Systimatic Implementation of ABM will add to your bottom line in Lacs!!
• Workshop Charges / Fees - (Includes Course Material, Break-fast, Tea-Coffee & Lunch & Certificate)

Rs.4800/- for 1 participant.
Rs 4500/- per participant for 2 participants from the same organization.
Rs.4200 /- per participant for 3 or more participants from the same organization.

Payment to be made by cheque in the name of "Human Capital Consultants".

With Best Regards,

Ajay Walimbe
Director
Human Capital Consultants
A/16, Pradnyangad Apartment
Opp. Haripriya Hall
Navsha Maruti Mandir Lane
Off Tanaji Malusare Marg
Pune - 411 030
Tel: 020-66203576
Mobile: +91-9881060190
We Turn People into Asset!

ajaywalimbe@vsnl.net

Customer Analytics with Profitability Solution

2009-12-21T13:43:00.016+05:30

In the last post ‘Revenue is means and not end’, we saw that it is important to understand the customer profitability for taking business decisions around customer acquisition and retention strategy. I had made a point that once we know the profitability of various customers; we can understand who is creating profit and who is creating a loss. When we get this information we should not directly jump to the conclusion that we have to ‘chuck’ all those loss making customers. Initially we may concentrate on the other customers and define the strategy to acquire and make deliberate attempts to retain the profit making customers. We may not take any action on ‘loss making’ customers, if we wish to, as there could be various reasons to do so.

We have seen the ‘whale curve’ diagram, which tells us the information about potential to reach a profitability level that our organization has. The same information can utilized to understand the behavior of the customers and how to use the same to maximize the profits for our organization. I am going to talk about one of the techniques, which I call as a ‘2x 2 diagrams’. It has many other names also. This is nothing but a scatter diagram using two characteristics of customers. Imaginary thresholds are created to distribute the scatter diagram into four quadrants. I found it useful for the reason that once we start using these diagrams, we can understand the reasons for the behavior of the customers and hence, we can have our strategy to tackle those customers for our better performance. I have used possible actions in those diagrams and would like to mention that these could be some actions that you can take but are not limited to those only.

1) Customer deciles

Before going to the 2 x 2 diagram I am going to talk about another way in which the whale curve can be projected. Here we have created deciles of the customers based on their profitability. Once we have created such groups, we can understand who is falling in which group. This is a kind of segmentation based on the profitability. Once this segmentation is done then we can start analyzing the behavior of those customers that are making high profits as well as that are making high losses. The reasons could be buying profitable products, less cost to serve, good payment terms, less special requests, using better channels etc. Using these various reasons we can further segment the deciles in behavior patterns. This kind of detail analysis is useful to relate the behavior of a customer to the profitability that is brought in.

2) 2 x 2 - Customer Revenue and Profit

This is based on the information available on the revenue and profit that is brought in by the customers. We start with the top-right corner (HH). Here the customer buying is high and the profits are also high. This means the customers are not only bringing revenue they are possibly buying the most profitable products or less cost to serve. This type of customers should be retained at any cost. As well analyze their other demographic characteristics and try to acquire similar type of customers in future. The L-H quadrant is where the revenue is low but profits are high. Obviously we should sell more and more with cross sell, up sell efforts, so that we get maximum of the ‘wallet share’ from the customers. The H-L quadrant shows high revenue but not such a great profit. This could be possibly because of the product mix, cost to serve, payment terms etc. We can offer them alternate products that can serve customer’s requirements and are more profitable, we can offer ‘menu based pricing’ for few of the services. We may also remove some the services that are not adding value to the customer. The lat quadrant L-L, is low revenue and low profitability. We should try to move them horizontally to increase the revenue or vertically to increase profits.

3) 2 x 2 – Cost to serve and revenue

From the earlier analysis if we find that the basic reason for difference in profitability is the behavior of the customer and particularly the ‘cost to serve (CTS)’, then we can analyze this behavior and can understand the reasons, which could be the buying patterns, special requests, channels used, changes in schedules, changes in requirements after ordering, knowledge about the product etc. Let us look at the quadrants. The L-L quadrant is where the CTS is low but the revenue is also low. We should try to sell more by cross sell, up sell strategy and keeping the services levels same. The H-L quadrant shows high CTS and low revenue. So the customer is too demanding. Here we can discuss the real requirements of the services that are needed by the customer. First of all remove all the services that are not needed by the customer. We can make our customer understand the more number of orders, frequent changes in the orders and products, special packing needs are adding costs and could be reconsidered. Then from the required one decide which can be offered by default and the other can be pushed to ‘pay per use’. The L-H quadrant is the best quadrant here and we should try to sell more and more to the customers in this quadrant with the similar level of service.

4) 2 x 2 – Loyalty and Profitability

The 2 x 2 diagram of loyalty and customer profitability can be used to allocate and program the marketing campaigns. Here the H-H quadrant shows that the customers are with you for a sufficient amount of time and they are profitable too. You can use these customers as your brand ambassadors. Understand their requirements and keep them happy. The H-L quadrant is happy with your service o products, but they may not be buying with a full potential from you. So you may spend more on cross selling or up selling to them. They may not be buying the most profitable products from you, so you can try to sell alternate products to them. The L-H quadrant is there the customers are profitable but they are not with you for a long time. This could be the customers are new or they like your products but may not like the service. Understand the requirement of those customers and improve the service or try to retain the new customers that are adding to your portfolio. The L-L quadrant may not be looked into initially, unless there is large number of customers lying there or a major portion of revenue is coming from those customers. If this is true then it really a cause of concern for the organization and should be given priority.

In some industries like telecom, the value of ‘probability to churn’ is used instead of loyalty. This is the probability that the customer is likely to terminate using your services. There we can use the similar graph with an attribute ‘churn’ instead of loyalty.

Till now we have seen various attributes for analysis which are objective and historic. But we can also use the attributes which are analytical and predictive. Probability to churn is one of such attributes. We can use similar attribute that is related to profitability and is called as ‘Future profitability’. The profitability we were talking of was the ‘current profitability’. Not all the decisions can be taken based on the current profitability or the historic profitability of the customer. We also have to see the future profitability potential in the customer. The future profitability is actually made up of two parts viz. a) predictive profitability b) potential profitability. Predictive profitability is if you extrapolate the profitability because of the products or the services that the customers are using in future. Potential profitability is the profitability that is brought in because of the customers propensity to buy other products and if they do buy, the profitability band they would fall in.

5) 2 x 2 – Current and future profitability

Here we are putting the current profit v/s the future profit (combination of predictive and potential profit). Profitability solutions provide the information about the current profitability for the customers. If the organization has calculated such ‘current’ profitability for a long period they would have history about the profit. Using this information and other variables statistical models can be created to calculate the future potential of profit. This is important to understand as the customers that are unprofitable today may have potential to be profitable in future and vice-a-versa. The text book example for this is the young doctor who has started his practice recently may not look profitable today but she can have potential to bring profits in future. Also a doctor who is potentially retiring in few years may look profitable today and had provided good results in past may not be a good future potential.

If we look at the L-L quadrant where the current and future profit looks low, you may not want act on them immediately (unless this is a large portion of customers). The L-H quadrant where the current profit is low but there is good potential in future. Here you would like sell more to them by understanding there requirements. For example for the young doctor in the earlier example it may start with the credit products for the clinic and may have potential to buy house and bigger or luxurious cars etc. H-L quadrant is where the current profit is high but does not look great in future. You can maintain the current relationship with them and the marketing spend may not allocated much to them. The best is the H-H quadrant where the current and the future profit look good. The strategy could be to retain these customers at any cost and acquire customers with similar profile.

6) 2 x 2 – Predictive and potential profitability

We can also go deeper in future profitability and see the analysis of predictive profitability against the potential profitability. If we look at L-L quadrant then we can see that if both predictive and potential profitability is going to be low then the overall future profitability is going to be low and we may not wish take immediate action (as always if this is not true for the major section of customer). In the L-H section we can see that the customer would be profitable in future with the same type of products but the behavior shows that the propensity to but other product is good. This may bring future profits for the organization and you may choose them for cross selling other products. H-L section is opposite to this and shows that these customers are unlike to buy other products but they can be profitable with the current products they are having. So the organization may look at up selling. For the H-H section where they would be profitable with current products have great potential for buying new products and could be profitable with those new also. The best segment of customers to have and you can try and spend more on selling them.

We have looked at various types of analysis that we can perform using the profitability information. These attributes could be objective as revenue, loyalty etc. or could be predictive (and hence subjective) like propensity to churn, future profitability. The future historic, current and future profitability information can be used to calculate Customer Lifecycle Value (CLV) and it can also be used for analysis. For this you need correct calculation of Customer profitability and the best way to get is using Activity Based Management Concept.

Finally wish you happy holidays. Hope you have done well in 2009 and best wishes for 2010.

Revenue is means and not end

2009-11-16T10:22:00.004+05:30

The three major challenges that Activity based Management (ABM) concept helps to get insight into are

• Understanding profitability of products and customers
• Understanding the process costs and the drivers of those costs
• Understanding the resource utilization and planning resources for the future

Let us take the first challenge of understanding the Customer profitability. I have mentioned in my earlier posts also that whenever we use the word ‘costing’ it is always assumed that we are talking about ‘product costing’. This assumption has always led us to take all the costs to the product (whichever methodology of costing you use). The obvious effect of this thinking is that we always calculate and talk about the profitability of products. And we almost ignore the fact that a product sold to different customers can bring different profits (even if the selling price is the same).

As a follower of ABM concept when I try to explain the prospects that the customer profitability is not the revenue less the ‘total product cost’, most of the time they fail to understand (at least initially). Customer profitability is ‘revenue less cost to produce the product less cost to serve’.

As the product cost is assumed the same for all the customers, those customers who buy in more quantity and hence bring more revenue are supposed to be the more profitable customers. In this way revenue has become the most important ‘Performance Indicator (PI)” for any sales person in most of the organizations. The performance incentive or commission is also based on the revenue not only for the sales employees but the partners for sales also.

On this background I would like to present the information that the ABM project can display with respect to customer profitability.

a)

This is graph which plots the customers on the x-axis and the cumulative profitability on the y-axis. The typical scenario shows that, the top 12-15 % of the customers provide you the 100% of the profits you are getting today. Theoretically if you cater only these customers you will the same profit that you are getting today. The next observation is the first 35-40% of the customers take the profits to 350% of the profit. The middle 40% of the customers are almost ‘no profit – no loss’ and the last 20% of the customers who are practically loss making bring the 350% of the profits back to the 100% i.e. your current profits.

This graphical presentation helps the organization to understand their own profit potential and also who are their top 20% of the customers as well as who are bottom 20% of the customers.

b) 2x2 diagram for customer profitability

Once the organization has understood the ‘who-is-where’ from the whale curve, it is natural for the organization is to think of taking actions. The graph shown above is one of the useful graphs for the same. In this graph, the information about the customers is plotted revenue v/s the profit. This type of analysis not only segregates the customers, but gives a possible action plan. To retain the customers in the ‘high revenue-high profit’ quadrant at any cost and moving in some other quadrant the customers from ‘low revenue-low profit’ area.

The typical reaction from the people is that if we cannot do anything about the last 20% of the customers or the customers in the ‘low revenue-low profit’ quadrant, what the use of the information is. You do not have to guess that these are people from the Finance function.

This is information is not only for understanding who the worst are and the action is to be taken only for them. The other 80% of the customers in the first graph and the customers in the other 3 quadrants in the second graph are also important.

It is important to understand who your profitable or unprofitable customers are but also important to know why they are profitable or unprofitable. This helps the organization to focus on the type of customers to be acquired in future or retained. If you want move the customers from unprofitable to profitable zone what is that you have to do. Even in case of the unprofitable customers it is not always taking them away. You can try to move them to move horizontally to ‘high revenue’ zone or vertically to ‘high profitability’ zone by taking various actions. If all the actions do not lead to the better performance it could be still good for your organizations to lose those customers as this will improve your profitability and possibly reduce the profitability of your competitors.

This view is not only taken by the Finance person but by the Sales person as well and the main reason is that there is revenue coming from those customers. The Finance person can afford to say that if she cannot do anything with the unprofitable customers, there is not use of the information, but the CEO cannot say this. The purpose of a commercial enterprise is to earn a return on investment, not to generate sales. Any sales person that refuses to try to make his account a more profitable customer for the company should be made to walk the plank.

Incremental progress is better than delayed, or unattained, perfection

2009-08-10T08:47:00.001+05:30

This is an old saying that keeps on coming back to my mind every now and then. This is because there are discussions going on Activity Based Costing (ABC) lately. These discussions are happening in person, workshops, networking sites on the Internet. The talks are about the results that it provides and the requirement of data for creating and maintaining the ABC models. It is now well known to the people that having an ABC system would provide a better understanding of the costs and hence the profitability of the products or customers. But at the same time they are worried about the efforts that they have to put to collect the data.

It is true that, this requires some efforts to create the model in your organization, but it is not to the extent that is cannot be managed. Some of the statements are like “Do we have now perform the time study using a stop watch for all the departments?” “Do we have to enter activities for which the expense has happened, like we enter the cost center?” “Do we have to change the chart of accounts?” Actually they are reluctant to do all these things for getting more accurate costs. But to their surprise, when we say it not necessary to do all these things, then people do swing from one extreme to the other. Their feeling is, if we are doing all this, then are we really doing ABC, or are we really going to get more accurate costs?

Let us see what kind of data is required for ABC models. We sill split this into two parts, first the efforts and data for the first time when we are creating the model and then the efforts and data required to maintain the model.

Efforts and data required for the first time –

1) Cost center accounting
2) Activities for the cost centers
3) Time taken by each activity (sustainable and repeatable)
4) Volume of those activities for various departments, products or customers
5) Output quantity or sold quantity

Efforts and data required for maintaining the ABC model –

1) Cost center accounting
2) Volume of the activities for various departments, products or customers
3) Output quantity or sold quantity

Out of all this, the definition of activities and the time taken for the same are the one time efforts. This information does not change unless the organization has really changed their way of working drastically. The new information that is to be collected is the volume of the activities. And I admit that there will be some resistance from the various departments to provide this data. This is not new. When we implemented the ERPs in our organization there was similar type resistance from various departments. For example the purchase department did not have to enter all the taxes in detail. They used to write ‘taxes as applicable’. Now in the ERPs they have to create a detailed ‘pricing schema’ with all the taxes mentioned with their accurate rates. This has to be done for each ‘item-vendor’ combination. Similar was the case for ‘Sales order’ and the sales function. The manufacturing (shop floor) people were not ready to confirm the various steps in ‘routing’ that was created for each part. But ERP (or OLTP) has become an integral part of most of the organization across globe. People have accepted these changes and working according to it. Of course technology has helped them to automate some these.

This was about the quantum of new data that is required. Now we will talk about the accuracy of the data required. This is important as the accuracy of the data decides the availability of the data as well as the efforts to collect the data if available. In the current state of It initiatives in various organizations 80% of the data required regularly is available in the systems running in the organization. The data that is not available generally is the time required to perform an activity and services provided by the internal shared service departments.

Time to complete an activity - To find out the time required to complete the activity does not need ‘time and motion study’, as it is expected by the people. We can find out the time just by observing ourselves for couple of days. We can also point out the variation in the ‘standard time’, reasons and occurrence of the same. Most of the time the variations are there but they are not so frequent. If at all they are frequent we can define them separately.

Volume of activities by internal shared service departments – This is data is generally not required in any MIS and hence not collected. So here the inaccuracy is generally for the initial period of time. Once this data is regularly collected it is available with accuracy. For example, the volume of services provided by the Administration department.

The accuracy of the data can also be increased over a period of time and more importantly if it is required. But if ABC models are generally used for strategic decision making and here the 80% accuracy of the data is good enough. Most of the times the accurate data is not available only because, it is never collected in the fashion that is required by the ABC model. Mere regular collection of data increases the accuracy of the data.

I will give you an example of, how the accuracy of the data was increased in one of the implementations. This is an Insurance organization with a head quarter and lot of branches all over the country. There are multiple channels for acquiring the customer. Multiple processes in which, the policy can be issued like STP (straight through process), non STP non Medical and non STP Medical. Of course, various products to be sold. We started with taking all the branches as one location but calculated the cost of acquisition separately for each type of acquisition channel. This information was very useful for the organization in the initial stage. The next step was to calculate the costs of acquisition, serving, retention and closure product wise. Here we also separated the ‘rework’ from the ‘clean process’, for each of the process. We also found in this way that there are various processes that do not change across the channel or products.

We should not wait for implementing the ABC model just because we do not have the most accurate data with us. We should not also deny ourselves more accurate information just because we do not have the data in our hands today. Because the old saying makes perfect sense here that says, ‘Incremental progress is better than delayed, or unattained, perfection’.

Workshop on Activity Based Management at Pune, India

2009-07-28T08:39:00.003+05:30

With ABC/M you can:
– Identify the most and least profitable products, services, customers, or sales Channels
– Accurately determine true costs for products and services
We are pleased to invite nominations from your organization for our One Day's Workshop on "Activity Based Management (ABM)". The details of the same are as under:

Date of Training Program - Saturday, 8th August, 2009.
Time - From 9:00 a.m. to 5.30 p.m.

Venue of the Workshop:
National Insurance Academy (NIA)
Opp. Chatrapati Shivaji Stedium, Balewadi,
Katraj - Dehu Road Bypass
Near Sadanand Resort
Pune-411045

Faculty:
Mr. Rajendra Patil

Who Should Attend the Workshop:
• CEOs, Senior as well as Middle Level professionals from Finance, Marketig, Costing, Operations, Sourcing who are keen to take their functional expertise to the next level.

• Note: This is not just a workshop but this can lead to Consultancy on ABM Projects. We assure that if you take ABM seriously and implement it, it will add to your bottom line in CRORES.

• Workshop Charges / Fees - (Includes Course Material, Break-fast, Tea-Coffee & Lunch)

Rs.4412 /- (inclusive of Service Tax) for 1 participant
Rs.4081/- (inclusive of Service Tax) per participant for 2 participants from the same organization.
Rs.3750 /- (inclusive of Service Tax) per participant for 3 or more participants from the same organization.

Payment to be made by cheque in the name of "Human Capital Consultants".

Ajay Walimbe
Director
Human Capital Consultants
A/16, Pradnyangad Apartment
Opp. Haripriya Hall
Navsha Maruti Mandir Lane
Off Tanaji Malusare Marg
Pune - 411 030
Tel: 020-66203576
Mobile: +91-9881060190

ajaywalimbe@vsnl.net

Deeper cost accounting v/s Activity Based Costing

2009-07-13T14:23:00.004+05:30

Recently I met few professionals in India, who are the head of Management Accounting function of their respective organizations. This was in relation to selling my services of implementing Activity Based Costing (ABC) concept at their organization. Incidentally those were non-manufacturing organizations. While they were interested in understanding what ABC can do, at the very same time they also seemed to be convinced that ABC will not be any value addition to them. The primary reason they mentioned was, ABC is used for better allocation of the costs and we have designed our cost centers to such a detail that we need not do the allocation. We can find the cost centers directly for 90% of the expenses. Hence, there is no need to invest the time, money and other resources in ABC project. This is one of the reasons why professionals are saying ‘No’ to ABC in India. This made me think what could be the possible reasons behind this kind of thinking.

The costing has been used formally in manufacturing industry for a long time. The primary reason was to complete the Financial statement. The financial statement requires valuation of inventories (raw material, work-in-progress, finished goods etc.). This inventory valuation is generally considered with the costs up to the manufacturing stage. Eventually the same information was used for other management decisions like pricing. The post manufacturing costs were added and the organizations reached at a total cost of the product. With the good old days when price was cost plus margin, people added their expected margin and priced the product. Even in today’s business scenario professionals say the price is not always cost plus margin, but decided by the market, they use the ‘same cost’ for calculating the profitability of the product.

This has helped professionals believe that costing means ‘Product Costing’. Each and every unit of currency that is spent in the organization is linked to one or the other product that is produced and/or sold. Unfortunately the same logic has been used by the ‘Service Industry’ (banking, insurance etc.) when people started calculating the cost of the service (similar to the product in manufacturing industry). While doing this these professionals knew that there are no ‘labor hours’ or ‘machine hours’ available for taking the overheads to the services of the organization. In fact for service organizations almost every unit of currency spent is an overhead. Parallel to this the manufacturing organizations got a very important tool for automation the recording of their transaction, ‘the ERP’. Like all the other processes it also helped the management accountants to automate the basics of costing, that is ‘Cost center Accounting’. This automation helped them to manage more cost centers as well as booking of expenses to one or more cost centers at the source.

The ability to create, maintain more cost centers and identifying expenses to these cost centers at the source created a feeling that, if we can identify the expenses the source cost centre we can be more accurate in costing the product. To certain extent this is true also. These online transactional processing (OLTP) systems are now available for service industries like Banking, Insurance etc. That is when the ‘costing’ cells were created in these industries. The very difficulty of defining the product (for example we can calculate the cost of a television set, but how to calculate the cost of ‘Saving Account’ was an issue) probably led them to various options like identifying more cost centers.

I have already mentioned that, these professionals were interested in understanding about ABC, but they were trying to convince to themselves that ABC is no better (read as different) than the detail cost center accounting. Here in this post you will not find how ABC is different from traditional costing or Cost center accounting in detail way, but a comprehensive way of looking at costing model in any organization. More cost centers with more detailed information will not help a company decide whether or not to drop or add a product line, accept or reject new business, outsource business processes or bring others in-house, make a component or buy it, add a shift or work existing personnel overtime. They won’t help identify in-process movement and storage, order picking, or outside storage of raw materials as a major non-value adding issues. They won’t be able to tell you which customers or product lines are profitable and which are not. By itself, having “more cost centers” is entirely useless.

While talking on this subject to the veterans in this field, they put their views. One of the analogy that was used was the ‘Elephant and the seven blinds’. Anyone who honestly believes that “all they need are more cost centers” has a very narrow view of the impact cost information has on business decisions – they have only touched one elephant in one spot but now think they know everything there is to know about elephants.

An Economic Cost Model that Represents the Entire Elephant, by Doug Hicks

A valid economic cost model serves the needs of all interested parties in an organization. Such a model is an accurate representation of the company’s internal cost economics. By populating it with the appropriate data – data that will differ from one usage to another – a valid economic cost model will generate the accurate and relevant cost information required by all parts of the elephant. It will work whether the decision at hand is strategic or tactical. It will work whether the information needed is fully-absorbed or incremental. It will work using historical information or projected information. It will measure process costs, product costs, service costs, and customer costs. As shown in the Figure, it is the engine that takes the relevant data and processes it appropriately to provide support for management decisions and actions of all types.
Constructing a cost model based on only one blind man’s perception of an elephant is a terrible waste of a company’s resources. It solves only one problem, ignores all the others, and often adds many more. Until management accountants understand that a valid economic cost model of the entire organization is the key to providing management with the information it needs to survive and grow in an ever more competitive world, they will continue to “Rail on in utter ignorance of what each other mean, And prate about an Elephant not one of them has seen!” (DTH&Co. – Winter 2006 – Blind & Elephant).

Management accountants can perform an important role in the design of an ABC system. Based on their skills and training, they can help identify what is appropriate for analysis (product, customer, process, etc.) and explain the probable causes of an existing cost system’s deficiencies. In addition, based on their detailed knowledge of the information in their company’s costing information systems, they are uniquely qualified to judge the level of aggregation appropriate to the ABC costing system. They can use their understanding of costing methods to recommend appropriate methodologies for the assignment of costs to activities and cost objects. Finally, they will be able to use their understanding of the information and cost relationships to support the system once it is implemented. Gary_Cokins_SAS_IMA_on_Activity-Based_Costing

Activity Based Management results in Insurance Company

2009-06-03T05:35:00.001+05:30

Across the insurance industry, management is under pressure to deliver the multiple objectives of Cost Reduction and Profitability. Generally there is a lack of information in the financial and management systems to properly inform and to target opportunities for improved costs. The complex business models, including issues around multi-channel and multi-product are not being supported by the traditional cost accounting. The speed with which the change is happening in today’s business area has taken on a particular force in the insurance industry due to increased competition, intervention of statutory bodies on pricing, and the advent of new technologies and distribution channels.

For the pricing of a policy the actuarial information provides the basic premium to that the organizational overheads are added ad-hoc. This is done primarily due to the unavailability of the relevant information. With the use of a relevant Activity Based Management (ABM) model the same organization can get information on acquiring a customer, serving the requests, claims and closure of policy due to surrender or maturity payment etc. Let us see how an ABM model can provide sufficiently detail information of the overheads. The model calculates the cost of various transactions (aka processes) in the organization. These transactions are grouped across various dimensions as follows:

Customer lifecycle event – Acquire, Serve, Retain and Close are the four events in the lifecycle of a customer with the organization. Various transactions are grouped as per these events, so that the organization can understand their ‘cost focus’ on acquisition, retention etc. The total cost to acquire in any period could vary between 35-45% of the total overhead. Retention costs take next place which include the renewals and revivals and can go up to 6-10% of the overhead. Cost to serve is around 2% and the cost to close including the claims, surrender, maturity etc. varies.

The ‘cost to serve’ the policyholder is one which should be kept as minimum as possible. This is the section where the policyholder can request a change of address, nominee, a switch in unit linked policy etc. Some of the requests are only because they are not properly handled at the time of acquisition. These can be grouped as region wise and channel wise, so that with a proper training or incentive it can be reduced. Some of the requests can be handled via internet.

Region – The cost information separated by region gives at least two type of information. The cost of same transaction like ‘sales call’ can be seen across the various regions. We can use the information for internal benchmarking. It also tells about the type of products that are sold, the type of post issuance requests across regions. With this information organization can run internal (for advisors) or external (for customers) campaigns to improve the performance of in the respective regions.

Channel – The insurance companies are using various channels for the selling of the policies. They have their attached advisors (tied agency) as the main channel. They are using the alternate channels of which Bank is most commonly used. The others could be from corporate agents to just sharing database. Once we separate the cost of transactions across the channels we can understand the effectiveness of various channels. The acquisition cost is different across various channels. This acquisition cost including the commission and the rework that is required due to incomplete documents etc. The quality of the customer can also be seen across the channels for their effectiveness.

Apart from the segregation of transaction channel wise, there are good amount of expenses made to manage the various channels. These expenses are typically for hierarchy of people within the channel, recruiting the advisors, training them, retaining them through various campaigns. The expenses should be first separated into one for recruitment and the other for retaining them. The effectiveness of the same can be analyzed after that. Around 50% of the overheads are spent on managing the channels. This is a very huge cost in any insurance organization.

Product Group – The primary grouping can be done according to the fund type like Participatory, non Participatory, Unit Linked, Pension etc. the further classification can be done if required. As the transactions are separated product wise it is very useful for the product development team to price the product appropriately.

Like channel dimension, there are various transactions for products and separate expenses which are directly attributable to the products like the collaterals, advertisements or campaigns etc. These expenses should not be taken as general overheads and include in the pricing.

Issuance Process – This is typically applicable for the acquisition and close events. In the acquisition event typically the processes could be a straight through process or non straight through process. A straight through process has certain guidelines decided and once the applicant falls within that no other information is required and it can be issued a policy. The advertisements that show that, people got a policy within few minutes on internet ‘online’ fall under this category. The other non straight through process requires underwriting and sometimes medical tests also. So it can be further separated as non medical and medical. We can find the expenses on various processes for issuance of policy and the same can be used for pricing of the product.

In case of claims it can be segregated as early claims and non early claims. The claims which are lodged within a year or two of the policy can have different expenses that the others. The patter can be seen channel wise and region wise so that fraudulent claim pattern can be found out.

Transactions – The various transactions (or processes) that are done can be primarily grouped as ‘Clean’ and ‘Rework’. The rework for the acquisition phase could be documents are not proper, medical test have to done again or different, policy that are not delivered, excess money refund etc. Like this we can separate the rework for each process and find out the costs of the same. This can be seen as around 1% of the total overhead and eating out your profitability.

Steps – For each transaction we can define various steps and the costs can be seen for each step within a transaction. For example in case of a clean process for issuance of new policy the steps could be sales call, receipt of documents, data entry, medical (if applicable), processing the request, issuance, dispatch, communication. The cost to serve can be defined as receipt of request, process, dispatch and communication. This helps in improving the process after looking at costs at various stages.

Apart from cost of performing transaction at various lifecycle events, cost to sustain the product and cost to sustain the channel, we have to segregate the overhead that has been used to build the capacity in the organization but not utilized (idle costs) and expenses on certain departments like finance (finalization section), internal audit, secretarial function which are not required by any product or customer but required to run the business or for statutory reporting purpose. We call this as ‘cost to sustain business’. This generally should not form the part of pricing, but it can change from organization to organization.

This type segregation of costs across various dimensions and the combination can help the organization in not only pricing of the product but also the improvement of the processes, improvement of the channel performance.

What is more important; the design of an organization’s activity-based cost model or the technology used to implement the model?

2009-05-14T12:02:00.002+05:30

What is Activity Based Management (ABM)?

Activity Based Management is a methodology that can be defined as, ‘A discipline focusing on the management of activities within business processes as the route to continuously improve both the value received by customers and the profit earned in providing that value’. If we convert this definition into more practical terms we can say that the purpose of Activity Based Management is to provide insights that enable decision makers to make more effective business decisions.

The types of decisions it can influence are;

A) Marketing, sales, customer service groups get to know what products and which customers or channels to focus on to improve profitability
b) Able to pinpoint why certain products, customers and market segments are unprofitable
c) Why company profit margin would suffer
d) Get to know where one can cut costs without negatively impacting operational performance
e) Can identify opportunities to improve processes and reduce costs
f) Can achieve business objectives and stay within the budget
g) Able to improve the product or service value because one doesn’t know the cost of non-value added activities
h) Customers are not unhappy because they do not think their departments are overcharged
i) Can justify budget and service value because one gets to know what his/her service is really costing to deliver
j) Able to improve service value because one knows the cost of non-value added activities

Modeling stage in an ABM assignment

Activity Based Management is a framework, which can be used and a particular design could be chosen to provide one or more deliverables mentioned above. Because of this the design of the model becomes important. According to me the model design includes,

a) Define the business need that drive the project
b) Engage with the stakeholders
c) Develop the organization’s capabilities to support and use ABC/M
d) Understand the business processes
e) Identify the decisions that need to be taken and how they are taken

Even if you have the best of the technology available, if the model is not designed properly, it would not give the required information for decision making. I have seen people moving from simple spreadsheet models to sophisticated software solution for ABM, but they just convert the spreadsheet model in the software, without understanding the capabilities of the tool. As a concept ABM is very ‘fluid’. One has to really use the past experience to convert the concept into an ‘ABM Model’, so as to deliver the information needed by the organization with required granularity. A ‘Paper model’ should be always prepared and validated.

Role of technology in ABM assignment

Since the evolution of the concept ABC, people have struggled to keep the project up and running. This was due various reasons like a detail model, data availability and of course (un)availability of the technology. Starting from the spreadsheets to stand alone software solutions to built-in module in ERPs to enterprise wide solution to pre-build solutions in BI, the availability of the technological solutions have also changed over a period.

Technology plays role in ABM project in multiple ways;

a) Sustaining the ABM model – In earlier days the ABM model used to be created for a particular business challenge. Once the model was created and possible information received from the model, the ABM project used to end there. Those who were using it for a longer period could not update the model frequently. The software solutions have helped the organizations to run the model more frequently and with an ease.

b) Modeling business complexity – The concept of costing was to calculate ‘Product Cost’. So ABC also in its initial stage calculated the product profitability. This was possible using the spreadsheets. As the business changed with multiple products, channels and customers etc., they wanted profitability of not only products, but channels, customers also. This is practically not possible using spreadsheets; you require proper software solution for that. In current scenario the industries like Banking, Telecom , Retail need the profitability at the account level, subscription level and SKU level respectively. This means at least few million cost objects. This is possible today with the technology.

c) Flexibility in modeling – None of the businesses are static. There are various changes happening in every business. New products are introduced, new plants are installed, new channels are created, new customers are added etc. The ABM model has to be updated accordingly. The methodologies in ABM have also changed over a period from ‘single-stage-ABC’ to ‘multi-stage-ABC’ to ‘time-driven-ABC’ etc.

d) A calculation engine - What ABC primarily does, it calculates costs. These costs could be for products only, customer wise product cost, channel wise customer wise product cost etc. A typical ABM model has to calculate at least half a million assignments. To calculate the cost at these levels one needs a very robust calculation engine. A reporting environment

e) Data integration – Now a day, almost all the industries have implemented generic or industry specific transaction processing system (read as ERP). Few have also implemented Supply chain (SCM) or Customer relation solutions CRM). This is getting converted into the warehouse and BI solutions. With this most of the data required by the ABM model is already available in one or the other solution. With the data integration tools that are available, make the transfer of the data easy. This has helped to sustain the ABM models, update the data more frequently and pass on the ABC results to the solutions like Customer Lifecycle Value (CLV).

Final comments

1) Model design is more critical than technology, but technology is also important if ABC/M is to be institutionalized and maintained as part of an organization’s management system.
2) Technology also makes it possible to integrate ABC/M with other solutions.
3) Model simplicity (without sacrificing fundamental relevance) is important if management is to understand and use its outputs

4) Although creating Excel-based models for “crunching” mass quantities of day-to-day data may be a nightmare, developing such models for periodic updating and projecting future cost scenarios is actually pretty simple using specific technological solutions.

Myths about Activity Based Costing - II

2009-04-15T06:44:00.002+05:30

Activity Based Costing (ABC) was developed to ascertain the accurate process cost data on activities and products and can be used for Product and Customer Profitability, Operational improvement and Resource Planning. Activity Based Costing has not became popular in India to whatever extent it deserves. There are so many Myths as far as this concept is concerned. Here are some of the myths about ABC and the facts around the myth.

Contd......

Myth - A cost system should be kept simple

Fact - This is true. It is actually true for any system. As it has been earlier explained, it is the skill of the implementation team to keep the model simple. At the same time is has to be seen that the simplicity is not compromising the results expected.

Alternatively, the complexity of the model in the conventional terms can be kept with the analysts and the business users are not exposed to it. The business users can use the various reports in different formats.

Myth - We do not need more accurate product costs

Fact - Yes, this true in case if the complexity of the processes from design to delivery of the products does not vary largely. If it is not so, then the typical revelation is that the products with higher volume get higher costs and those with lower volume (may be with higher complexity) get lower costs.

The traditional costing takes all the costs to the products directly. ABC is based on the concept that the cost should be traced to the entity that causes the cost. With this we understand that product is not the only entity that causes costs. There are other entities also like Customer, Channel, Capacity etc. We have to calculate Customer costs, Channel costs, Unused Capacity costs, together with the product costs.

Myth - We know what our products cost

Fact - It is not only the products that cause overheads. The complexity of the business causes overheads in the organization. This complexity is brought by the multiple products, customers, channels, regions etc. We should be able to segregate the costs that caused by the reasons other than the products only. Once we are able to do that, then we can understand the reasons for the same and business decisions can be taken. There is more to understand than only the product costs in ABM.

Myth - The market sets prices, so we do not need product costs

Fact - Let us take this statement as understanding or managing profitability of the organization. Firstly to understand the profit, one has to understand the proper costs. ABC helps to calculate cost more accurately. We also have to understand that the product profitability is different from customer profitability. The same product sold to different customers can bring different level of profit.

All customers are not equal. Generally the customers that bring more revenue are taken as most profitable customers. This may not be true, as various customers ask different prices, discounts, make changes in the schedule, ask non-standard products, order small quantities large number of times etc. This changes the profitability of the customers.

It has been observed typically that the top 15 percent of the customers bring the current level of profit. Top 45 percent of the customers bring 450 percent of the profit and last 20 percent of the customers take away the 350 percent of the profit away from the organization.

The best information for an organization is to understand whether their best customers are buying their best products.

Myth - Cost systems play a limited role

Fact - Traditionally this has been true and it has its own reasons. The calculations were not accurate. As it was based on spreading overheads as ‘peanut butter’, it did not reflect the changes in the business scenario into the costs.

ABM benefits the organization in various ways like

1. Information for effective decision-making
2. Information to continuously improve processes and reduce costs
3. A focus on significant costs
4. A relationship between organizational cost and organizational value
5. Methods to measure performance with accountability
6. ABM can be used strategically to understand and improve profitability of the organization, operational performance and resource planning.

Myth - We cannot do anything about fixed costs

Fact - We can look at fixed costs in couple of ways
Fixed costs are not fixed eternally. If we take into consideration a longer time horizon, then we can see the fixed costs are also changing. In that case we have to understand the drivers that are changing the ‘Fixed’ costs.

Fixed costs are generally attached with building capacities in the organization. The investments could be for adding capacities or replacing the old machines or improving productivity.
When we are adding capacities we should see that the capacity added is saleable in the market. It has also to be seen that if those additions or replacements are adding to the costs. If they are then we have to see if that added costs can be absorbed by the market.
The investments in fixed costs can also be made for having competitive advantage.
These fixed costs have to be taken to the products, customers or channels according to the ‘Cause-and-Effect’ relationship.

Myth - Only manufacturing costs are product costs; and Product costs are not useful for managing overhead activities.

Fact - ABC is based on the ‘Cause-and-Effect’ relationship. We have to see how every resource (people, facilities, expenses) is consumed by activities. In turn how these activities are consumed by the cost objects (products, customers, channels).

Unless we put all the resources and take them to the cost objects through the activities performed by the organizations, we cannot comment on what constitutes the ‘product costs’. The costs can be caused by product, customer, vendor, channel etc. We have to trace the expenses to the proper origin. This helps us to understand the relationship of the costs with the business scenario. With the help of this information we can take current business decisions as well as plan our costs in the future.

ABC is the best way to understand and assign overheads to their appropriate destination. Once this is done, then we can use various methods like root cause analysis, value analysis to find the drivers for the costs. Once we know the drivers, we can take actions to improve.

ABC is like a thermometer. It tells us the temperature. The doctor has to analyze, whether the patient has a fever or is hypothermic. The doctor will prescribe medicine accordingly. ABM is using the ABC data, analyzing it and taking proper action to improve.

Myth - It is very difficult to gather information and set rules for cost allocation

Fact - There are various techniques experts have created to collect the information starting from interviewing people, surveys, story-boarding to auto data transfer from the back-end processing business applications.

The rules are defined in the ‘paper model’ that is created for the organization. This paper model depends on the objectives that the organization has decided for the assignment. This model is different for different objective like profitability, cost improvement, resource planning etc.

Sometimes the main model remains the same but multiple small models can be created for specific business pains. The logic to flow the costs depends on the objective and the model.

Myth - If the company has the good information system (ERP), then it would be an overnight job to run to allocate the costs based on set rules. Otherwise ABC will be labor-intensive with Management Accountants spending lot of time gathering the information rather than analysis them

Fact - If the organization has a good OLTP (ERP) then collecting the data from the system is comparatively easier. Now days we have various ETL tools to get the data. Some of the ABM solutions have created their own adapter for the ERPs like SAP or Oracle etc.

Even if the organizations has any ERP, there is some part of the data that is still not available in those systems like the time spent on various activities or the no. of visits to a prospect (if CRM is also not present). This data has to come from various persons in the organization. Hence, the success of this assignment lies in the participation of the key personnel from various departments.
Technically this kind of data can be collected via web-based survey systems. The organization has to spend some time in the initial model creation and data collection systems, once that is done then the frequency of data collection is once in a quarter. So the people get ample time to analyze the data.

There are implementations methodologies like ‘Rapid Prototype’, where a first model which is very raw can be build in as less as two days. Then this model is expanded as required by the organization in those areas only. In the modeling the definition of the driver (the logic with which the cost flows) should be as accurate as possible. The corresponding data may not be accurate to start with. The accuracy of the data can be improved, but only when it is required. One should not wait for the accuracy for the data to the last minute or Re etc. This is used take business decisions and 80% accuracy in primary data is also good enough.

Now-a-days this collection of data and processing of it is being outsourced and various KPO organizations are available for outsourcing this activity.

Myth - ABC is not feasible for a company

Fact - It is feasible for all the organizations, which have multiple products, customers, channels, locations etc. These types of multiple options create the overheads in the organization which ABC puts using cause-and-effect logic. It would be easier

if one takes professional help in the initial implementation as well as using commercial software for the same. It helps the internal team on understanding how to analyze the data. The calculation of the numbers is better left to the software application.

Myths about Activity Based Costing - I

2009-04-08T09:04:00.003+05:30

Myth - ABC systems are too difficult to implements and use

Fact - This has to be discussed with respect to the time when ABC was introduced and today. Yes, it was too difficult to implement and use, when it was introduced and implemented in the initial years of it. This was due to the fact the consultants were enthusiastic and they created models that were in too detail and hence they looked too difficult to implement and use.

The same thing is a myth in today’s context. Now we can create models depending upon the objectives of the organizations. We can also use the ‘Rapid Prototype’ methodology in which we can build a small model in just two days, which can be expanded in multiple rounds as per the requirement.

With respect to the use of it, there are various ways in which the results can be surfaced. The various commercial software solutions can create reports that can be distributed, OLAP views as well the results can be integrated with the overall BI delivery in the organization.

Myth - ABC systems are too costly

Fact - This is a relative term. Even if take it absolutely, then we have to see the cost-benefit from the application. The general outcome that has been seen across the globe is, the organization can save its overheads to the tune of 5-15 %. If you consider this, then typically you would recover the investments not in months but weeks.

The organizations have money to invest in such solutions. It has been observed that the CxOs can see this as a Strategic Initiative and not mere a Costing system. When this happens, then the view of the management is different. Incidentally ABM supports any other initiative that is going on in the organization like BSC, Lean, Six Sigma, CRM, SCM, TQM, JIT, Kaizen etc.

Myth - ABC systems are too complex to understand

Fact - There is always a ‘First Time’. The complexity depends on the design of the ABC model. There are various methodologies to develop the ABC model like Paper Model, Story Board, Rapid Prototype etc. Once we create the model outside the software solution, then we understand the design very well.

The commercial software solutions that are available today are quite user friendly. Once you start using it and providing results to the management, it can be integrated with the dashboards also.

Myth - Improving our existing system will do the job

Fact - Yes, this is true, but one has to understand, what kind of improvement is needed. ABM is a strategic tool and it has to given the corresponding infrastructure.

Traditional costing systems trace all the costs directly to the products only. Have we thought about the ‘Customer Costs’? Most probably the answer would be ‘No’. Do we know who our best customers are? More importantly who are the worst? Generally those customers with high revenue are treated as God. Have we seen how much resource that they are eating out? Once we put the 2x2 diagram of Customer revenue v/s Customer profit, we understand the difference.

We have to understand the characteristics of the customers in each quadrant. We have to try to bring them in the ‘Top-Right’ quadrant.

Myth - All that we need are more cost centers

Fact - More cost centers would help you to get more accurate ‘Cost center accounting’. ABC is based on the ‘Cause-and-effect’ relationship. This causal relationship is lost when we try to relate the costs at various cost centers directly to the products.

When we use the ‘Cause-and-effect’ relationship, we understand that, the products are not the only entities that are causing the costs. With this reasoning we can segregate the costs as Product Costs (caused by products), Customer Costs (caused by customers), Business sustaining Costs (compliance related costs) and Available to use Costs (caused by the capacity that is built but not utilized). Use this information to improve the performance of the organization.

Myth - Machine-hour systems save the time

Fact - Machine hour system is related to the calculation of cost of production only. The experience has shown that we can take the cost of production from the conventional costing system. The accuracy is enough for the ABC models used for strategic decisions purpose. The accuracy of the production cost can also be improved, if needed using ABC. ABC is actually for assigning the ‘overheads’ with a causal relationship.

Understanding Customer Profitability for profit optimization

2009-03-16T07:16:00.002+05:30

In an economic environment where downsizing, reduced funding, and budget cuts have become a necessity for many organizations, so has the consequential need to identify where non value-add activities really exist and where unnecessary costs in operational activities can be eliminated in order to effectively reduce operating expenditures. Today’s economy has also spurred many businesses to place a greater focus on their customers and on increasing overall product profitability, yet many are finding that their largest customers or best-selling products are not necessarily the most profitable ones until they perform activity-based costing analysis.

Whenever I have asked the question in an open workshop or during a client presentation, ‘are your all customers profitable?’, all the time I have got the same answer ‘YES’. People see that products are profitable or unprofitable, but customers are always profitable. We have seen the ‘whale curve’ for the customer profitability in my last posting. You can see here similar diagram for a retail bank, wherein the top 40% of the customers bring 327% of the current profitability, but unfortunately the next 60% of the customers eat out the 227% of the profit to bring the profit to the current level of 100%.

Then I ask a similar question but probably simpler to answer, ‘are all of your customers equal?’ The answer here is ‘NO’. And this ‘no’ is primarily because the revenue brought by the customer is not the same. But revenue is not the only factor that distinguishes the customer. There are various other reasons like the products that they buy, the # of orders, the locations for delivery, discounts, # of special requests that they make etc. Generally the customers that bring more revenue are treated like king in any organization. On the other hand when the customer knows that it a ‘valued’ customer for the organization they the customer starts making various special requests.

I liked the concept that is mentioned in the book ‘Angel Customers & Demon Customers’ by Larry Selden and Geoffrey Colvin. They have mentioned that the organizations should look at their business not only as group of products or functions or regional territories but as portfolio of customers. These portfolios of customers should constantly bring superior shareholder value to the organization. Organization can enhance customer profitability by creating, communicating, and executing competitively dominant customer value propositions.

It is not far away that the Boards of directors will begin to demand customer-- profitability data and will challenge management to act on it; investors will demand that companies report it. This is going to be one of key information that the organizations would use to run their business, define business strategy and enhance the value to the stakeholders. Technological advancements are also going to help the organizations to achieve this. Earlier it was very difficult to calculate the profitability at customer level or even at customer segment level. But today we can not only calculate the profitability at customer level but even at account level for banks or subscription level for telecom industry.

Once we have calculated the customer level profitability, it can be used in various ways. If we plot a scatter diagram based on the customer profitability information of customer revenue v/s customer profit, we can segregate the customers in four quadrants.

Once we plot the diagram and segregate the customers in four quadrants, we can also see who is falling in which quadrant. We can also see the various reasons that are making them remain in those quadrants. We can get the actions to be taken for various customers of our organization.
APQC has come out with many best practices after conducting a study on the same. I am mentioning some of them here.

1) Best-practice organizations secure buy-in from the users and upper-level support for customer profitability initiatives.
2) Best-practice organizations use customer profitability and segmentation to appropriately align sales and marketing resources.
3) Best-practice organizations have specific programs/sales efforts geared to their more valuable customers.
4) Best-practice organizations successfully convert unprofitable customers to profitable customers.
5) Best-practice organizations hold employees accountable for customer profitability.

In the end, I would add a portion of the newsletter that I got from Douglas T. Hicks recently;

“Whether you believe that activity-based concepts are the solution or not, the fact remains that the misinformation (or non-information) accountants perpetuate about process, product, service, and customer costs has been a significant contributor to the underachievement of our organizations and sometimes a major cause of their failure. It’s not just the numbers – it’s the dysfunctional behavior and inappropriate decisions invalid economic cost models cause that make business success so elusive. Management uses information generated by their accountants to judge their performance and direct their actions. When that information is based on invalid models of the business, financial performance suffers.”

Cost reduction only or Profit optimization too?

2009-03-09T07:39:00.001+05:30

Now days wherever we are, with friends or colleagues or customers or conferences we are sure to hear about the downturn and the various ways people are trying to sustain in this kind of scenario. People are talking about the postponement of projects, reduction in people, reduction in expenses like from travel, communication up to printing stationery. Quite a few organizations are also looking for the programs to improve the costs in the organization using productivity improvements, process management and waste removal in processes. Some organizations are asking their vendors to reduce the prices, accept longer payment schedules. At some places there is only a directive from the top management to reduce ‘x’ percentage from the operational expenses and then the department heads are chopping expenses like anything.

All these steps are being taken to maintain or maximize the retained money with the organization when there is a reduction in the revenue. This retained money is nothing but the net profitability of the organization. This is even more important for the publicly listed companies where the ‘quarterly results’ pressures are even bigger.

On this background when I go for making people understand the benefits of Activity Based Management (ABM) to their organization, they are still in the same mind set. I mean they are thinking of the same ways of reduction of cost and then try to see how your concept or solution is going to help them. The solution providers are also in the race to show them the ‘cost benefit analyses’ of their solutions. I am not saying this is a wrong way to look at the situation or even handle the situation, but there is another angle to this also and people are less attentive to.
My position is that understanding profitability is always important for any organization and it is even more important in the current economic scenario. This profitability is about product profitability as well as customer profitability of the organizations. It not true that, the organizations do not know their product or customer profitability, but is not the ‘true profitability’. This is because the way in which the traditional costing calculates the profitability of the products and it calculates the cost of product by taking all the expenses to the product.

When we calculate the customer profitability using ABM we are segregating products costs from cost of selling those products to various customers and hence it gives accurate customer profitability. In the diagram where customer profitability is plotted we can see that the first 10-12 % of the customer bring the 100% profit that you are getting. So if we speak theoretically, we can say, we will deal with only these customers and still get the same profit for the organization. But is that the potential of the organization? I would say no. A big ‘NO’. Because there are next 30-40% of the customer that take you to the 300-400% of current profit levels. The next 30% of the customer that are almost ‘no profit-no loss’ type of customers and the last 20% of the customer bring you to the current level of profitability.

Organizations should understand this potential in their organization and get the visibility of the real ‘culprits’ for the situation. By understanding who those customers are, that are eating the profits earned from the organization and also finding the behavior pattern would help the organization retain profit at a higher level than today.

Using Activity Based Management can help organization to find out the true profitability of the products and customers and build a graph like this. The efforts that the organizations are putting in the improvement of costs with various methods will definitely help them in the current situation, but unearthing this huge ‘profit potential’ in the organization and acting on that will make the organization to remain healthy in the current economic scenario.

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

2009-03-02T07:15:00.000+05:30

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.

Cause and Effect in Activity Based Costing

2009-02-23T07:13:00.003+05:30

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

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

What is wrong with this calculation?

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

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

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

What is the reason?

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

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

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

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

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

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

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

Do Accountants Lead or Mislead?

2009-02-16T05:47:00.002+05:30

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

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

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

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

Perils of poor navigation equipment

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

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

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

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

Perils of poor managerial accounting

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

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

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

The accountant as a bad navigator

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

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

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

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

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

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

Profitability Solutions and Business Intelligence

2009-02-09T08:53:00.002+05:30

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

Customer Intelligence

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

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

Operational Intelligence

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

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

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

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

Doing right things and Doing things right

2009-02-02T09:18:00.003+05:30

ABM can help in both ways

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

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

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