The ROI of an Activity Based Costing (ABC) project

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.