In my previous post An introduction to Activity Based Costing I discussed the ideas behind activity-based costing (ABC), and introduced the principles behind ABC, namely:
- Activities consume resources
- Customers, products and channels consume activities.
Here, I’m going to run through a simple example to illustrate how an accurate understanding of activities is important to fully and fairly understand profitability by customer.
For simplicity’s sake, the example deals with a business that has just two customers. They know their cost of sales for each customer, and the revenue of course. So that gives them an accurate figure for the contribution.
They also have a known amount of overhead costs – £6,500 – that need to be allocated to the two customers to get a complete view of customer profitability. Without any better method, suppose they choose to allocate it in the same proportion that the Cost-of-Sales is already divided.
This suggests that Customer B is more profitable than Customer A.
The problem is that we allocated the overheads in a pretty arbitrary way, and gave no consideration to what’s causing those overhead costs.
So how could we allocate the overhead costs more fairly?
We should be thinking about what would make one customer more costly to deal with than another. And it would be because the way we interact with them, and they interact with us, causes us to do different amounts of work. If it takes half as many sales calls to get Customer A’s business as it does to get Customer B’s, then we ought to reflect that, and we ought to assign proportionately more of the cost of making those calls to Customer B. Similarly, if Customer B places an order with us weekly and Customer A places their orders monthly, then Customer B ought to be taking the lion’s share of the cost of processing orders.
So let’s suppose that the activities that we carry out in order to serve our customers are as follows:
- Make sales calls
- Process orders
- Pick and pack
- Make credit control calls
First, we need to evaluate the cost of each Activity. In order to do that, we have to reintroduce our first ABC principle - Activities consume resources.
So let’s think about our resources. In this example, we’re going to make it really simple and assume that the only resources that we have are staff and buildings. Let’s suppose that we’ve paid £2,500 in terms of staff costs, and £4,000 in terms of building costs. Because, according to our principle above, activities consume resources, we can apportion our resources to our activities, and we’re going to do this by using measures called “resource drivers”, which are measures of the resource that we want to apportion.
We pick a resource driver according to data that is available or measurable in our organisation. In this example, we’re going to apportion staff costs using the resource driver “FTE”, and building costs using the resource driver “Floor Area”.
Let’s summarise this in Table 3.
We’ll deal with staff costs and building costs separately: staff costs first.
We’re using FTE to allocate the £2,500 cost of staff to activities, so we need to collect the number of FTEs dedicated to each activity. We won’t go into how we extract this data, we’ll just assume that it’s available in the organisation somewhere, or we can undertake a survey or other exercise to get it. Either way, the FTE data is shown in the second column of Table 4. The £2,500 is then allocated to the same activities in the same proportion, giving the results in the third column of Table 4.
So we now know what each activity costs in terms of the staff resource, and we can do something similar for the building costs. Building costs have to be allocated to activities too, but in this case we’re using a different resource driver – floor area.
Table 5 shows the allocation of £4,000 of building costs to the same activities, but this time in different proportions, the proportions being determined by the floor area dedicated to each activity. (The “Pick and Pack” activity gets a larger share of the building costs than it did of the staff costs, for example.)
Finally, we can summarise the activity costs from Table 4 and the activity cost from Table 5 to give us a total activity costs for each activity, as shown below in Table 6.
Now that we know the cost of each activity, we can calculate the cost of each product, customer or channel, based on the second principle of activity-based costing - Customers, products and channels consume activities.
If you remember, we have two customers, named “Customer A” and “Customer B”. We need to decide the basis on which we’re going to split these activity costs between the customers. Let’s say that we’ll split “Make Sales Calls” according to the number of sales calls, and “Make Credit Control Calls” based on the number of credit control calls. The other three activities we will split according to the number of orders. These measures that we use to split activities to cost objects are known as “Activity Drivers”.
In Table 7, we reproduce the activity costs from Table 6, and for each activity we also show the name of driver that we’re going to use to allocate the activity’s costs, and the values of that driver for each customer.
In Table 8, we can see how each activity’s costs are allocated to customers, based on the activity drivers from Table 7. The costs allocated to Customer B are significantly more than those allocated to Customer A, because Customer B is placing a significantly larger numbers of orders, and because all our credit control checks are to Customer B.
So finally we can calculate the profitability of each customer by combining the total activity costs by customer from Table 8 with the contribution costs from Table 1. This is shown below in Table 9.
Contrary to what Table 2 told us, Table 9 is showing not only that Customer B is less profitable for us, but that it’s actually loss-making. The difference is that Table 9 has applied an activity-based approach, whereas in Table2 we apportioned the overheads in the same proportion as the cost of sales.
It’s easy to make the assumption that our “best” customers are the ones that we sell most to, like “Customer B” in the examples above. But this can be very misleading if we don’t take into account what we have to do to serve our customers, and if we don’t have a sensible way to quantify the cost of what we have to do.
Besides customer and product profitability, the activity-based approach to costing generates results that are useful in many other areas of management. In subsequent blogs in this series, I’ll discuss some of the use cases, as well as using SAP’s Profitability and Cost Management software to bring the theory into reality.