A Collaboration Enabler: Sharing Profit and Cost Data
The Internet is shifting power from the seller to the buyer - irreversibly. The ability for the buyer to access information about products and services is unbounded. Buyers' desire for unique requirements (mass customization) will likely force suppliers to respond with increasing flexibility, which may add cost.
Ironically, suppliers are assisting the power shift by providing more information about their products and services on their Web sites. Consumers will perform exhaustive searches to identify the exact model of an appliance they want, and then they will locate a much cheaper source to purchase the appliance. Competition will award consumers long-run savings generated from new technologies in the form of lower prices. Suppliers will no longer be capable of protecting a niche market or of enjoying the large or long-lasting profit margins as they had in the past.
Pressure on Prices: How Will Suppliers Counter?
How can suppliers counter this power shift? They should look to their trading
partners to:
• Understand customer profitability and share the data with their key customers
• Mutually measure and remove unnecessary costs that buyers and sellers create
for each other
• Alter customers' behavior with menu-pricing and service-level options
Sharing Customer Profitability Analysis with Customers
When profits are declining, suppliers usually raise prices to increase revenues,
but in many markets small price increases can lead customers to delay their
purchases or to switch to competitors, which lead to lost sales. Suppliers can
also abandon unprofitable products, channels, or customers. However, this requires
an accurate measurement of costs to determine true profit margins, which can
be a problem. The activity-based cost management (ABC/M) technique solves this.
With knowledge of profit contribution margins, an organization can more intelligently
decide what to change, which business lines or customers to drop, and which
to promote and emphasize.
Traditional accounting systems are ill-equipped to trace the costs associated
with unique demands. First, the order-fulfillment work of various departments
must be calculated. Then this cost must be reassigned to the customer in proportion
to usage. Initially, ledger account balances must be translated into activity
costs to trace or assign them to segment processes, products, and customers.
In a simple supply chain structure, some of the intermediaries are unclear about
how the behavior of one supplier can affect the margins of a particular group
of customers.
Resource expenses, which are exchanges of currency with third parties and employees, are converted into "calculated" costs based on their proportional demands on work. Various final cost objects consume other final cost objects. Calculating costs with ABC/M allows tracking the cost assignments for all work activity costs to reflect how each product, customer, channel, and market segment consumes the costs of being served.
With ABC/M, the reporting format of the traditional profit and loss (P&L) income statement becomes more like the layers of an onionskin. The sequence of margin-layering matters. As customers consume their unique quantities of product and service lines the "costs-to-serve" are combined to calculate the next contribution profit margin layer. Many costs-to-serve work activities traditionally are hidden in the customer support, marketing, and sales functions, but are traceable to customers.
An ABC/M system operates as a reassignment system - resourcing expenses into costs. The ABC/M system's structure is the key to revealing the profit margin layers for each customer and to generating customer-specific P&L statements. As costs flow from one final cost object to another final cost object, each will consume a unique mix of the upstream cost object. That is, an individual customer's total costs (apart from its direct costs-to-serve) are inclusive of only the product quantities and mix that it purchased.
Using ABC/M, each customer or groupings of customers can have a valid P&L statement (Figure 1). A tremendous amount of detail lies in each of these reports. For example, the individual products and service lines purchased can be examined in greater detail. They comprise a mix of high and low margins based on their own unit costs and prices. In a customer-specific P&L summary, the product or service line is reported as a composite average, but details about the mix are viewable. In addition, within each product or service line, the user can further examine the content and cost of the work activities and materials (bill of costs) for each product and service. ABC/M users call this data mining "multidimensional reporting," and use on-line analytical software tools for viewing the output from the ABC/M calculation engine. This is powerful information - the sum of all the customer P&L statements will total the entire enterprise-wide profit (or loss).
Figure 1 - ABC/M Customer P&L Statement
The ABC/M customer P&L report quantifies what everyone already suspected: all customers are not alike. Some customers may be more or less profitable, depending on how demanding their behavior is. Although customer satisfaction is important, a longer-term goal is to increase customer and corporate profitability. Because increasingly more customers will expect and demand customization rather than standard products, services, and orders, it will be important to keep the goal of profitability in mind. ABC/M data facilitates discussions about arriving at that goal, because some managers are unwilling to take any actions until presented with the facts. Customers with the highest sales don't also generate the highest profits (Figure 2). The objective is to make all customers more profitable by reducing each customer's costs-to-serve, establishing a surcharge for or re-pricing expensive costs-to-serve activities; reducing services or raising prices, increasing costs on preferred activities, shifting the customer's purchase mix to higher-margin products; and discounting to gain more volume with low costs-to-serve customers.
Figure 2 - "ABC/M Customer Profitability Matrix"
Each quadrant represents different types of customers
the composite margin of what each purchases
(reflecting net prices to the customer,) and its costs-to-serve.
With the information generated by ABC/M, each trading partner can understand the true and relevant costs for their products, SKUs, service lines, freight, channels, and customers from major advances in profit contribution reporting and analysis and margin management.
Open-book sharing of cost and profit data may be the catalyst needed to foster genuine seller-buyer collaboration. Many companies don't understand their how much of their cost structure is a consequence of the collective demands on work by suppliers and customers. Costs measure effects. Influencing a customer or supplier to behave differently to lessen the organization's employee workload is too often overlooked as a possibility.
Altering trading partner behavior requires supplier/customer trust. Businesses have been wary of releasing information to trading partners even when that information will aid mutual understanding — and one place where disclosure is needed is regarding an organization's cost structure. Since ABC/M systems are user-friendlier, trading partners are more motivated to collaborate using the data as a form of open-book management.
The second alternative for suppliers to manage the reduction in their power resulting from the Internet is to entice or manipulate their customers to select a different service-level option at a different price.
Menu-Based Pricing and Service-Level Options with ABR/P
Suppliers can alter the behavior of their trading partners. Through collaboration, persuasion, or the creation of incentives for suppliers and/or customers, fewer demands can be placed on the organization's employees. The freed-up employee time can be used to either gain new customers or to increase business from existing customers.
Initially, suppliers will exclusively use their ABC/M data for private benefit. They will use it for incremental price and cost trade-off analysis; for example, to entice a customer to reduce their service usage, they may offer a reduced unbundled price incentive. The supplier must know in advance how much of the cost can be saved. The critical test equation comes from basic economics: for service reductions, the incremental change in revenues must always be superior to the incremental change in cost (and vice-versa for service increases, where changes in revenues must always exceed changes in costs). A supplier can attempt to convert an unprofitable customer into a profitable one by reducing both service level and price to that customer, but the change in cost must decline more than the change in price and revenues for a positive profit impact. The trade-off of price and cost can go in both directions. The service level can be raised, but presumably the price and resulting revenues will rise even more than the incremental costs to yield incremental profit.
The supplier must alter the behavior of its customers, but they need to know their own cost structure and how it varies with changes. ABC/M data is essential for this.
Forget the past methods of pricing and quoting. When a customer asks what the price is for a personalized order, the reply must be quick. In some industries, supplier auctioning and reverse-bidding systems will be commonplace. In order to validate an acceptable profit margin, the supplier's host computer system will require a rule-based predictive cost system.
When analyzing customers and their profit contributions, there are some dangers that result from flawed thinking. Most companies extrapolate cost rates based on historical standards. But if the future reveals a shift in the mix and volume of products, services, and types of customers, then those pre-set cost rates are less valid, or even invalid. The impact may be that the company will have too many resources it no longer needs and not enough of it will need. Senior management will tend to include the needed resource expenses or risk service-level erosion, but fail to remove the excess resources (capacity) - especially in the short term.
Capacity planning is the key to the solution. Planners and budgeters have focused on the direct and recurring resource expenses, not the indirect and overhead support expenses. They usually begin with future demand estimates in volumes and mix. Then, using standards and averages, planners and budgeters calculate the future required levels of resources. The activity-based resource planning (ABR/P) method suggests that this same approach can be applied to the indirect and overhead expense areas as well.
Today's generation of ABC/M software tools have added the necessary functionality to calculate an ABC/M model "in reverse" - but using physical consumption rates, not cost rates. The ABC/M software vendors recognized that ABR/P begins with the cost objects, such as sales forecasts of products. Demand volume drives activity and resource requirements. ABR/P is forward-focused, but it uses actual historical performance data to develop baseline consumption rates and compute resource requirements.
Activity-based resource planning (ABR/P) assesses the quantities of workload demands that are ultimately placed on resources. ABR/P first finds how much activity workload is required for each output of cost object. These are the activity requirements. Then ABR/P finds how many resources are needed to meet that activity workload. In other words, a workload can be measured as the number of units of an activity required to produce a quantity of cost objects.
The determination of the required expenses to match the forecasted demand does not occur until after the activity volume has been translated into resource capacity using the physical resource driver rates from the ABC/M model. These rates are regularly expressed in hours, full time equivalents, square feet, pounds, gallons, and so forth.
There will always be a difference between the existing resources and resource requirements. At this stage, organizations usually discover that suppliers have too much of what they do not need and not enough of what they do need to meet the customers' expected service levels. The consequence of having too much implies a cost of unused capacity. The consequence of having too little is a limiting constraint that if not addressed implies erosion in customer service levels.
A reasonable balance must be achieved between the operational and financial measures. One option is for the budgeters, planners, or management accountants to evaluate how to adjust the shortage and excess of actual resources to respond to the future demand load. Senior management may or may not allow the changes. There is a maximum expense impact that near-term financial targets will tolerate. These capacity adjustments represent real resources with real changes in cash outlay expenses. Assuming that management agrees to the new level of resources without further analysis or debate, the new level of resource expenditures can be determined and then translated into the costs of the work centers and eventually into the costs of the products, service lines, channels, and customers. The quantities of the projected drivers are applied; and new budgeted or planned costs can be calculated for products, service lines, outputs, customers, and service recipients.
When the financial result is unacceptable, management has options other than re-adjusting resource capacity levels. Demand can be throttled, prices cautiously raised or lowered, and suppliers or employees can be pressured for lower prices or wage and benefit arrangements. This approach has been called a "closed loop activity-based planning" framework. In summary, ABR/P calculations introduce technology that supports the economic thinking behind marginal cost analysis.
Better Cost Data Leads to Better Decisions
How can suppliers recover any of the power they are losing to buyers due to the Internet? Information technology is their ace in the hole. ABC/M and ABR/P will be part of the supplier's solution, but many suppliers mistrust their own cost data. Most companies operate with a resigned acceptance that their cost accounting data is "a bunch of lies - but we all agree to it." Understanding costs is not the entire solution, but it is a part of the solution to increase trust along the supply chain and to better manage the entire chain's costs and profit margins.
Information technology is enabling trading partners to better coordinate and
collaborate for mutual benefit. But trading partners will require cost accounting
systems, including ABC/M and ABR/P, that are superior to the conventional accounting
systems they all struggle with today.
