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.

Cause and Effect in Activity Based Costing

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

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

What is wrong with this calculation?

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

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

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

What is the reason?

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

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

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

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

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

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

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