How a fine from the Debt Recovery and Prosecutions Unit got me thinking about Activity Based Costing

8 December 2014

Steve Mainprize

Steve Mainprize

Consultant

We recently received a letter from our regional train operator. On his way home from school my youngest had inadvertently (of course) boarded a train without the fare, and got nabbed by the ticket inspectors when he got off at our local station.

Not unreasonably, the train company wants us to pay the fare. But the letter drew one particular thought from me, and in a kind of informal social experiment I showed it to a few people and asked what they thought. As it turned out, most people I showed it to had the same initial reaction:

Surely it would have cost the company more to process and send the letter than the £1.10 they want to recover?

Well, yeah.

But I think they have three main options:

  1. Don’t check tickets at all, on the assumption that most people are honest
  2. Just recover the original fare. This makes it so that it’s just less hassle to buy your ticket in the first place.
  3. Try to recover the original fare, along with an additional charge to reflect the cost of recovering the fare.  This seems reasonable to me. 

They seem to be going for option 2, at least as long as I don’t file the letter in the wastepaper basket. So I guess, then, that the cost of recovering unpaid fares – the cost of inspecting tickets, printing and stuffing the letters, building the (probably rudimentary) IT system to control this process – is built into the face value of every ticket. But then, that means that all of us who are behaving ourselves and buying our tickets are subsidising those who are bunking the train, which doesn’t seem very equitable.

What about the other options?

Under option 1, you’d have to assume that a few people might take advantage but that ultimately it costs more to recover fares than you lose to fare dodgers. The supermarkets seem to have managed to make something similar work with self-checkouts, but they have the data to assess the stock that goes missing.  For the train companies, they don’t know how many customers are on a particular train, nor how many tickets have been sold for that train.  Furthermore, on busy commuter and intercity routes, where the train companies are managing peak demand with very expensive fares during the rush hour, abandoning ticket inspections would lead to chaos.

Option 3 can only work properly if you know what it costs to recover the fare.  Interestingly, this same information is also needed to support the decision about whether option 1 makes economic sense.

My guess would be that the train company doesn’t actually know what it costs to send the letter out.  And I don’t just mean in terms of the cost of the paper, and the envelope, and the postage charge.  There are all kinds of indirect costs in the business that support the activity of sending that letter – staff costs are the most obvious and likely to be the major part, but building costs, power, IT and many others may contribute small amounts of cost too.

We use the technique known as “Activity Based Costing” to figure out how each of these cost elements feeds into each activity that an organisation carries out.  Using an appropriate method of allocation ensures that each activity gets a fair share of the costs of each resource.  It then lets you figure out what it costs you to serve each customer, so long as you know how they behave and hence how they trigger activities within your business.

For instance, you may have two customers, “A” and “B”, who each order 12 items from you in a given year.  But if A orders 12 items from you at a rate of one every month, and B places a single order of 12 items, you will have to do less work to fulfil B’s order than A’s.  So it costs less to serve B, and B is a more profitable customer for you, but unless you carry out an exercise to quantify how profitable both customers are, you won’t know:

  • Whether A is profitable or not
  • How much of a discount you might be able to offer to encourage A to behave more like B
  • How much extra you can charge A.

Cause-and-effect can work either way here:  we can either use lower pricing to encourage behaviour that reduces our cost-to-serve, or we can use higher pricing to recover the additional costs that have been imposed.

Charging a customer more because they behave in a certain way isn’t always appropriate.  You’ll have noticed already that this is equivalent to charging our fare-dodger extra for the extra trouble we’ve gone to, but instead of guessing at what that extra charge might be, the train company would be confident that a charge of a particular amount was appropriate, and based on more than guesswork.

Whether you actually charge different customers differently according to how they consume your products and services is actually a market decision, of course, but it is important to at least understand – and quantify – how  your customers  consume your resources and hence incur costs in your business.  If you find that the customer’s behaviour is causing, say, £100 worth of cost in your business, and that charging them more than another £10 looks like commercial suicide, you might want to take a look at your processes.

 

 

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