ABC AND THE BOTTOM LINE
ON CUSTOMERS
Activity-based costing provides new insight
on how a few customers subsidize many others,
and what you can do about it.
by Paul Sharman
Most managers acknowledge the quality maxim
that the customer is always right, but with today's accounting principles, they don't know
which customers generate profitable revenue and which do not. Mostly, they only understand
gross margin. At least they think they do! Activity-based costing provides the tool with
which to go beyond gross margin and penetrate the real economics of all aspects of cost
and profitability, including that of serving customers. This article describes why
understanding profitability of customers is worth pinning down and how to approach it.
Many people believe that as long as the
revenue of an incremental sale exceeds the marginal cost, it makes a contribution to fixed
cost and overheads. With standard costing, incremental sales volume yields favorable
overhead recoveries and positive variances. If the sale is incremental, most management
would perceive it as found money, because that is what the accounting numbers report. This
is only true if fixed costs are really fixed, but most people who have ever thought about
them know that they are not. In the past, people have tended to ignore the actual
composition of "fixed cost." If asked, they would say that fixed cost refers to
rent and depreciation. However, as much as 70 per cent of fixed cost is related to human
beings. Accounts consist of salaries, benefits, and facilities in which to house the
people and the supplies to keep them going. To refer to the cost of people as being fixed
is misleading.
The term "fixed" implies that
these costs are not variable, relative to changes in short-term sales volumes. However,
they do go up when the business is growing. In fact, many costs are highly influenced by
growth in transaction volumes or other measurable influences, but not necessarily volume
of goods produced in a factory. In service and distribution organizations where there is
no direct product cost as such, we still hear talk of fixed cost and overhead as though
these service businesses were involved some kind of factory operation. One reason for this
rational is the need for financially-oriented accountants to try to "correctly"
match revenue with costs and to apply a GAAP principle of "fair allocation of costs
to products." We find this principle to be highly misunderstood, because it is driven
primarily by the need to "close the books." Its value in providing management
information for making operational business decisions is highly questionable.
In the past, financial-accounting thinking
has influenced management accountants to prepare reports that allocate costs to product
lines, or in service industries, to lines of business. Management uses this information
when making decisions on products or services, even though costs are largely driven by a
variety of customer characteristics. To prepare product-line profitability-analysis
reports, sales, marketing and distribution costs are usually "allocated" to
products in proportion to sales, which is usually not at all representative of operational
reality. Product lines are sometimes mistakenly abandoned because "on a full-cost
basis," they appear to be unprofitable. Generally, it would be better if the very
notion of fixed and variable costs was abandoned and a broader organizational view was
taken, one that views all costs as a part of the total economic structure.
Over time, as organizations become more
complex, they take on new "opportunities" to grow the business. As new
opportunities materialize and become operationalized, people adapt, create approaches that
work, and develop organizational "habits." For example, one company had a
four-week production-scheduling lead time, and actual production time was only seven
hours. Extended lead time was due to excessive work-in-process inventory which, in turn,
was due to a high number of priority orders constantly being rushed through the plant.
Sales people placed orders on the plant six weeks prior to the required ship date,
although actual customer specifications were generally not available until two weeks prior
to the desired ship date. By placing the order early with dummy specifications, the
salesperson managed to secure a production slot. When final customer specifications became
available two weeks before ship date, the sales person would cancel the first order and
replace it with the real one, usually claiming a customer error or some such excuse. All
of this caused enormous confusion in the factory, because the original order had already
been launched, four weeks before ship date. This meant the original order was still
produced while the correct order was then being rushed through on a priority basis. All of
this activity drove significant cost without creating any appreciable revenue increase. It
also produced waste inventory. Over time, this seemingly absurd cycle had become ingrained
in the organization as a costly, unbroken habit. For accounting purposes, these costs of
waste were allocated to products on the basis of direct labor hours.
When examining activities performed by
people throughout various organizations, it becomes clear that there are many activities
which are caused to occur or "driven" by customer specific characteristics. For
example, a huge American retail chain is well known for its ability to control costs and
offer low-price produce to its customers. This is done by pushing costs back to its
suppliers. Apparently, one trick of the retail chain buyers is to call suppliers on a
collect basis, and for more frequent suppliers they demand that a 1-800 number be set up.
Another method used by the retailer is to demand that suppliers deliver goods on a JIT
basis, causing them to either install JIT, a pull system, or to hold additional inventory.
In another example, a car manufacturer makes demands by sending it's auditors and
engineers to visit suppliers to reorganize their production lines, and then demands that
half of the savings be passed along in the form of lower prices. The savings are
calculated as the reduction in direct labor cost, grossed up to include overhead. Of
course, the suppliers overheads do not reduce.
In service businesses, it is quite typical
to allocate all operating costs to lines of business, such as loan or insurance policy
types, or residential telephone service. These categories are often perceived to be
products. In most instances, however, it is customer characteristics that drive the
service organization's cost. For example, wealthy people may keep more money in their bank
accounts and may write large cheques for their credit card bills, municipal taxes and
household expenses. Less wealthy people keep less money in accounts but they still get
statements, and while they write smaller cheques, they may write as many. Frequently, it
costs a financial organization almost as much to service a customer from whom they receive
less revenue as it does to service a higher-revenue-generating customer. Typical
financially-driven cost allocations mask the true economic relationship and the fact that
larger, high-value customers generate higher revenues per dollar of cost. In financial
services organizations, the cost of activities required to service customers often
comprise the largest proportion of operating costs.
Very few organizations actually measure the
variable characteristics of customers, few have even realized the potential magnitude of
the associated activities and drivers. Activities that are performed relative to customer
specific characteristics are best described as customer-serving activities. These are
activities that consume resources that cost money, but for which the customer does not pay
in a discrete fashion. In other words, the cost characteristics are specific to each
individual customer, but price is not.
The solution
Activity-based costing (ABC) provides a
more effective way to understand the economic structure of any organization. But first it
is necessary to abandon all forms of cost allocation except for financial reporting. The
next step is to develop an alternative cost-analysis framework in which it is recognized
that money (cost) is exchanged for resources, not products (Example: Joe is a salesman,
his time costs money, so does his car). Resources are consumed in performing activities
(Joe used his car to visit a customer to take an order). To determine how much cost to
assign to activities, it is necessary to measure what physical quantity of resources are
consumed in performing the activity (Joe and his car spent two hours on the sales call. In
Joe's case, the order received included a number of products, some in small quantities,
others large, but he might have received no order at all! So in ABC the sales call
activity is treated as customer-serving -- not product cost.)
Most organizations undertake activities
that are discreetly required to produce products and services, or serve customers. These
other activities are required to sustain the business. Whereas GAAP and typical financial
accounting practice allocates all costs to products, ABC assigns activity costs to the
categories of products, services, serving customers and business sustaining, specifically
without cross over or allocation. A customer-serving activity is never assigned to
products. All categories coexist within most ABC structures. These categories of activity
/ output are referred to as cost objects. The term cost objects is used because it
recognizes the potential diversity of outputs that exists for any organization. In doing
so, ABC explicitly recognizes the multi-dimensionality of organizations (see Figure 2).
Different results
By eliminating misleading allocations from
management cost information, vastly different performance results are recognized. Typical
ABC results identify that some proportion of customers consume more activities and
resources than the revenue they produce. The actual proportion of activity costs assigned
to the different categories of product/service, customer and business sustaining vary
substantially between organizations depending on the nature of their business. Service
organizations perform a significantly higher proportion of customer-serving activities
than do manufacturers of automotive parts, for example. Network type, railroad and
telephone, organizations incur high levels of both customer-serving and business-
sustaining costs.
This information has potentially
significant strategic consequences for the organization. For example, in a company that
has a high proportion of customer costs previously allocated to products, management is
informed that low-volume products are relatively more profitable than high-volume. It will
also think that the biggest influence on the size of a customer's gross-margin
contribution is primarily price. With ABC, management will discover that products may have
significant cost differences but that there are three influences on customer profitability
-- sales volume, price, and the amount of customer-serving activities consumed. In most
organizations, a relatively few number of customers produce high levels of profits which
subsidize losses on many small or demanding customers.
Management actions
Figure 2
Management actions are considerably
different when there is an understanding about which customers are profitable and which
are not. This understanding is fundamental in helping managers take action to improve
performance.
In a recent example, a process manufacturer
of a homogeneous extruded product discovered that 100 of its 500 customers produced 150
per cent of its profits, 200 of the others made small contributions, while the balance
were unprofitable. Most of the customer-serving activities were associated with order
processing, cutting, storing, packaging, shipping and invoicing -- these were explicitly
driven by customer requirements which drove 35 per cent of the total resource costs of the
organization. The solution was to change the sales policy so that customer inventory would
be held for a fee, more costly packaging would be priced as a separate item, and prices
would be varied for precut goods.
Typical ABC results identify
that some proportion
of customers consume more activities and resources than
the revenue they produce.
Customer profitability is a very basic concept that few
organizations have performed well.
In the case of the organization that had
problems with lead time, the solution was to install a pull-manufacturing process (JIT),
reduce the order-to-ship lead time to two weeks or less, and to disallow rush orders
inside the two weeks. There are other examples of companies that, after doing ABC
analysis, discontinued direct service to a large proportion of their small customers
(those producing 10 to 20 per cent of their sales volume) by establishing value-added
distributors to serve them. Banks, for instance, steer wealthy customers to "private
banking" services where relationship managers provide personalized service in private
offices.
In summary, management actions can be
substantially different where there is a reasonable understanding of cost and
profitability of products/services, customers and business-sustaining activities.
Solutions which are shaped by allocated product-cost information are often inadequate and
potentially risky. Customer- serving costs are highly influential in many organizations
where there is a high proportion of resources dedicated to activities other than producing
tangible products.
Management accountants should strive to add
value to their organizations by
moving beyond simple financial accounting requirements, and make a concerted effort to
provide meaningful operational information to business managers. Understanding the
dimensions of cost associated with all of the dimensions of a business is fundamental to
good management. Customer profitability is a very basic concept that few organizations
have performed well, but should. It is the management accountant's professional
responsibility to focus the organization on economic reality, as opposed to bureaucratic
and redundant financial accounting practices that add no value.
Managing customers through cost-to-serve
by Peter Gebert, controller, global
sales and merketing, VLSI Technology, Inc.; Charles B. Goldenberg, partner, Deloitte &
Touche Consulting Group; Daniel Peters, senior manager, KPMG Peat Marwick LLP
Before VLSI embarked on its cost-to-serve
project, the company had focused its cost-management efforts primarily on above-the-line
cost associated with manufacturing its application-specific integrated circuits (ASICs).
In 1994, VLSI decided to apply the activity-based costing tool to its customers' costs,
taking into account all costs associated with its U.S. sales organization and its design
centres, called technical centres. The project objectives were to develop a specific
cost-to-serve for each customer and to identify high cost-to-serve customers. Out of this
analysis, the company hoped to create a framework to assess the impact of customer mix on
overall profitability.
Case study company profile
VLSI Technology, Inc., designs and
manufactures application-specific integrated circuits (ASICs) and application-specific
standard products, targeting the communications, computing, and consumer digital
entertainment markets. The company is based in
San Jose, California, with 1995 revenues of $720 million, and
2,700 employees worldwide.
The company also sought to identify
profit-improvement opportunities, by analysing the costs of various activities and
processes related to customer service and to eliminate redundancies or low value-added
activities. Finally, it hoped to identify a set of tools for on-going customer-profit
management.
A simple analysis of revenue by customer
revealed that 11 per cent of the customer base was supplying 86 per cent of the company's
revenue (see Figure 1). Meanwhile, 58 per cent of active customers generated less than $2
million in annualized revenue. Thirty per cent of active customers had no revenue
associated with them at all -- either because they were prospective customers or because
they had already passed through the revenue stream.
A process map was then constructed that
broke down the costs of each of the activities within the sales organization and technical
centre. The most striking result of this exercise was the discovery that almost 20 per
cent of those total organization costs was associated with the business process termed
"order fulfilment and delivery." These included many low value-added activities,
like tracking problems through the manufacturing facility. Another observation was that
the company was expending less resources than perceived on "relationship and new
customer discovery" -- only 10 per cent of the total costs of the sales and TC
(technical centre) organization. The study also pointed out another potential concern in
the "post sales design support" process chain -- documentation. Management had
an intuitive feeling that the company wasn't expending sufficient resources in this area.
But the quantification of this expenditure, which represented only 1.6 per cent of the
post-sales design- support activity pool, convinced management to address the issue
directly.
At the time the study was conducted, we
identified 16 separate job functions that were being conducted. The analysis identified
improvement opportunities within the order fulfilment and delivery process. We found a
total of 12 different functions and 38 full-time-equivalent employees that were directly
involved in providing the activities. The study defined fragmentation as the preponderance
of employees or functions involved in a particular activity or process. Order fulfilment
was performed by many employees and functions, but each employee was spending only a small
fraction of his or her time, on average, on the activity. The results of this analysis led
VLSI to fundamentally rethink its order fulfilment and delivery methods, and the
organization is currently working to re-engineer this process flow.
One of the most dramatic findings was that
fully 60 per cent of the salesperson's time was spent on order fulfilment and
administrative functions, and only 40 per cent on direct sales efforts. This discovery has
already motivated management to undertake a major re-engineering effort to strengthen the
customer service organization. The objective is to free up sales people's time for more
direct, revenue-generating activities.
In addition to the above operational
opportunities, the cost-to-serve analysis also suggested a number of strategic
opportunities that potentially have a much higher level impact on the business. The
biggest surprise was that the largest customers had a dramatically lower cost-to-serve
ratio. For example, a small number of larger customers generated a large portion of the
revenue stream with a cost-to-serve ratio that was 25 per cent of the average ratio for
all customers (cost-to-serve as a percentage of revenue). As customer size declined, the
cost-to-serve increased dramatically. A large number of customers generated a relatively
small portion of the revenue stream, but had an average cost-to-serve that was more than
twice the average cost-to-serve ratio. The cost-to-serve differential was even more
dramatic for the smallest customers -- they had a cost-to-serve that was more than three
times the average ratio.
The clear alternative to better serve some
existing small customers was the highly under-utilized distribution channel. During the
six month period studied, VLSI used only two distributors and generated only a small
amount of revenue from this sales channel. However, the average cost-to-serve for
distributors was substantially lower than the cost-to-serve for VLSI's smaller customers.
Serving the smallest customers through the
distribution channel would have a number of payoffs. First, it would allow some sales
force and technical resources to focus on larger revenue opportunities. The small customer
would get better service from distributors, whose sales and service organization was
specifically designed to service small customers. The company would also no longer have to
perform credit analysis and negotiate terms with all of its smaller customers.
Distributors also tend to "batch order" into larger lot sizes, potentially
creating some manufacturing efficiencies for VLSI.
Figure 1: Cumulative revenue by
number of
customers. Eleven per cent of customers provide
86 per cent of revenue.
VLSI formulated what it considers to be a
very conservative "what-if" analysis, illustrating the bottom-line impact of
shifting some small customers into the distribution channel, and refocusing sales efforts
on higher revenue generators, using data from the six-month period studied. First the
company would substantially reduce the number of its smallest customers by transitioning
them into the distribution channel. The reduction in revenue from those direct customers
would likely be offset by an increase in sales revenue from distributors.
The company pays a fee to the distributors
that results in slightly lower gross margins. However, eliminating the low revenue/high
cost-to-serve customers from the direct channel frees up resources to serve larger
customers. VLSI assumed under this scenario that it could increase its large account
revenue. This increase would be achieved by re-deploying marketing and sales resources
previously focused on small customers. Based on what the company considered to be
conservative estimates, the overall revenue and margin could increase substantially.
Meanwhile the average cost-to-serve for all customers would be reduced by up to two per
cent of sales.
We believe it is possible to generalize
from VLSI's findings. In industries selling a technical or customized product to numerous
customers where capacity and sales force are at least somewhat constrained, there is
usually a major opportunity to rationalize customers and customer-related activities and
dramatically impact profitability by applying the ABC, customer-cost-to-serve methodology.
cma
Paul Sharman, features editor for
CMA magazine, is president of Focused Management Information, a company that helps
organizations implement new cost-management techniques. |
