Workshop on Profitability and Cost Management

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

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

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

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

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 "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

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

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?

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

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

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 myths.

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

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?

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

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.