In this blog post series I’ll be talking about a technique that you can use to evaluate the profitability of your organisation’s products and customers. The technique is designed to reflect the true cause-and-effect of how cost is incurred. For instance, a customer that causes you to do twice as much activity ought to be allocated twice the cost.
For this to work, you’ll need to understand the activities that your business carries out, and for this reason the technique is known as activity-based costing.
At the risk of insulting your intelligence:
- Businesses provide products to customers, and
- Businesses are measured on their profitability.
Starting from those first principles, it’s clear that a well-run company has to be able to understand and measure the profitability of its products, customers and channels. With this information, it can understand which products, customers and channels are most beneficial to the business, and which are holding it back. It can then take action. The goal is either to ditch the unprofitable, or – even better – to do something to make them profitable.
*A quick bit of terminology: I’m going to use the term “cost object” which basically means something to which cost is assigned. In the context of this post, it will refer to refer to something that the business produces or supplies. And really it’s just a quick, generic way of referring to a product, customer or channel*
Cost, revenue and profitability
So let’s think about calculating profitability for a given cost object. Well, the revenue side of the equation should be very easy. One way of getting the revenue by cost object is to simply pull it off the sales orders, or whatever the equivalent is in the business. If you can’t accurately get your revenue by product, customer and channel, you probably have deeper problems that you should address first.
So assuming that you can source the revenue data, it’s time to look at the trickier side of the equation: costs. You probably know (I hope) your resource costs, but you probably don’t know them by cost object.
The cost allocation problem
The difficulty comes in allocating the costs of the business’ resources to its outputs, and doing it fairly. It’s usually pretty easy to attribute direct costs, such raw materials, directly to the appropriate cost objects, but with overheads it’s harder. It’s not harder to do it per se, but it is harder to do it fairly.
Accurate allocation of non-attributable costs has become more important as the make-up of the overall cost base has changed. Nowadays organisations spend a larger proportion of their money of functions such as IT, Sales, Marketing, and all the other support costs. Some of these functions increase the efficiency of the rest of the business; others, such as good customer service, provide a competitive edge. Furthermore, plenty of the activities that the business performs are there to turn the business’s inputs into more valuable outputs. So it’s important, in order to understand the cost of the business’ outputs, that these costs are fairly apportioned to those outputs, and increasingly so as the proportion of indirect costs increases.
Even when the proportion of indirect costs is relatively low compared to the direct costs, the method for allocating indirect costs to outputs can make a material difference. In businesses where margins are tight, an inaccurate allocation of indirect costs, even if it’s a relatively small fraction of the total costs, can result in a product or customer being incorrectly rated as profitable or unprofitable.
Cause and effect
When a customer interacts with a business, they cause it to run up costs, and the way in which they interact with the business changes the level of those costs. For example, a customer that pays its invoices promptly incurs less cost than one that needs to be constantly chased up. A customer that orders one item a week is more expensive to serve that one that orders 52 items once a year, even though their annual order is for the same volume and value.
Or, consider products: if two products are sold, and one of these products is the subject of 90% of the calls to the customer service desk, it makes sense to allocate 90% of the cost of customer service activities to the difficult product.
This is about cause-and-effect. Its customers and products that cause a business to carry out the activities that they do, and it’s these activities that cause them to use resources (such as employees, our internal services, building costs, power, and so on and so on).
Activity-Based Costing in two bullets
This leads us to two important principles, which are the backbone of activity based costing (ABC).
- Activities consume resources
- Customers, products and channels consume activities.
In activity-based costing, rather than allocate directly from resources to outputs, a two-stage allocation process is performed. In the first stage we the resource costs are allocated to activities, and in the second the activity costs are allocated to outputs. This reflects the principles that its activities that consume resources, and its customers, products and channels that consume activities.
This shows that, if a business wants to properly cost products and customers, it needs to:
- Understand the stuff it does
- Quantify the cost of what it does
- Understand how its products and customers makes it do stuff.
Reaping the benefits of Activity-Based Costing
A lot of useful information comes out of the activity-based approach. Initially, you can start to understand the true profitability of the customers that you serve, the products that you create, and the channels that you use. You can then start to use that information to do things like set pricing, to negotiate with customers and to make build-or-buy decisions; you can look at the activity costs to identify and quantify work that doesn’t add value; you can look at internal service departments to set prices for shared services like IT; you can carry out benchmarking and identify best practice within the organisation.
In subsequent blog posts in this series, I’ll work through an example to illustrate these principles, and see how an activity-based approach gives us a very different view of profitability. I’ll then have a look at some of the application areas that the approach can help with, and finally SAP’s Profitability and Cost Management software, discussing the advantages of using a specialist software solution to implement ABC.