Seeing Activity-Based Costs
Dimensional profitability is the assignment of costs and revenues to business
segments as a means for
for evaluating each business segments contribution to the overall enterprise
profit and loss. Those business segments, also referred to as dimensions, typically
include such areas as product, customer, sales channel, and business.
An organization leverages profit and loss information by developing reporting structures consistent with its overall business strategy, aligning this information with organizational accountabilities, and ensuring that information is actionable. More than simply reflecting sources of value creation within the enterprise, dimensional profitability provides insight to help companies enhance business performance through:
- Pricing strategy development;
- Product and customer mix optimization;
- Go-to-market strategy development;
- Product rationalization; and
- Business process measurement and improvement.
Dimensional profitability relies upon meaningful expense data made available through activity- based costing and management (ABC/M). Once perceived to be limited to tactical process-based analysis, ABC/M plays a key role by linking operational data with strategic decision-making. When leveraged effectively, it can support performance improvements that drive better business unit results.
For example, a large telecommunications provider used profitability information to identify policy and process differences that were increasing product costs and reducing net income. Profitability reporting showed that residential telephone service maintenance costs were higher in one metro service area than another. By further examining the cost basis for specific activities using drill-down reporting, it was determined that service technicians in the high-cost area were being assigned a specific number of jobs to complete per day. In the low-cost service area, repair jobs were dispatched continuously (i.e., when one repair was completed, another was immediately assigned). The data, in conjunction with a closer inspection of regional processing differences, showed that continuous dispatch resulted in higher repair technician productivity, since it removed arbitrary quotas that limited technician output.
The Evolution of Cost Management
Many companies are limited in their ability to understand the cost structure of specific business segments and, as a result, cannot easily determine a segments profitability or contribution to margin. Revenue is relatively easy to determine since most key financial systems capture revenue origin details. Expense, however, is much more difficult to associate with even fundamental business segments such as product. One key reason for this is that shared infrastructure isnt directly attributable to any one product or service.
Advanced cost management techniques and support tools, including ABC/M, have evolved throughout the 90s to replace static allocation functionality available within most general ledger packages. Best-of-breed vendors readily adopted ABC/M as the means for showing how resources were consumed, supporting cost reduction through process improvement. Figure 1 illustrates the fundamental difference between traditional cost accounting and activity-based cost accounting.
Figure 1: Traditional Accounting vs. Activity-Based Costing
The road to more effective cost analysis and management hasnt stopped with ABC/M. New techniques are continuously being developed to accurately and efficiently generate cost management information. For example, Robert Kaplan, leading author and professor at Harvard Business School, introduced a modified approach to ABC/M in 1998 that addresses the tedious and subjective task of evaluating labor resource in performing activities. It also provides a framework for measuring organizational capacity to perform business process. Improvements like this will continue to emerge as the role of costing expands in the broader performance manage- ment landscape.
Although dimensional profitability can be performed without ABC/M, it becomes more difficult (if not impossible) to answer the question why when digging deeper into deviations exposed by standard profitability reporting. ABC/M is the component that provides muscle to answer questions such as:
- Why does a products cost structure differ across geographic regions?
- Why has a products contribution margin declined while revenue has increased? and
- Why is a customer unprofitable when it purchases products that generate profit?
ABC/M and Dimensional Profitability
The potential benefit of ABC/M and dimensional profitability increases when integrated with other performance management capabilities. In fact, ABC/M is ideally positioned at the core of the business performance management architecture. Figure 2 illustrates how various capabilities can be integrated to yield numerous performance reporting outputs. Three capabilities that benefit most from this data include planning and budgeting, transfer pricing, and balanced/corporate scorecards.
Figure 2: Integrating ABC/M with dimensional profitability yields multiple benefits.
World-class planning and budgeting processes can be designed to take full advantage of information made available by ABC/M. The use of unit cost data to determine future enterprise resource requirements is known variously as activity-based budgeting, demand-based planning, or reverse-engineered ABC/M. To illustrate this concept, assume that marketing data suggests a particular level of future product sales. Demand-based planning uses historical data regarding per-output unit costs to estimate the magnitude and type of resources (i.e., labor, materials, or equipment capacity) required to support a future yield. Furthermore, by characterizing activities as either fixed or variable, it is possible to more accurately determine how resource costs scale with increasing output. For example, research and development is a relatively fixed cost when compared to product assembly and packing expense.
While dimensional profitability yields important information to support a companys go-to-market strategy, it can also support internal business management. Companies that adopt shared services models or maintain highly autonomous business unit structures often use the costing approaches inherent in dimensional profitability to support cost recovery within the enterprise. More importantly, the use of cost or cost-plus transfer pricing approaches can help socialize the true cost of internal services, potentially leading to make-versus-buy sourcing decisions for noncore business services such as finance, human resources, and information technology support functions. Companies considering spinning off or selling business units have found that transfer pricing is an effective way to obtain a more accurate snapshot of organizational profitability. As a result, accurate cost-reduction targets can be established and more likely realized upon the actual elimination of discrete business segments, whether they are organizations, products, customers, or other.
Business performance reported by dimensional profitability and balanced scorecard capabilities should be highly correlative. For example, improving profitability on a profit-and-loss statement should be reflected as positively trending financial and shareholder metrics on the corresponding corporate scorecard. In fact, key performance metrics reported in standard balanced scorecards and other dashboards are typically sourced from ABC/M applications. Understanding the integration points between these two capabilities is an important consideration in their design. Inconsistency could undermine the credibility of information.
Beginning With the End
Prior to embarking on the change journey to achieve better profitability information, few companies ask themselves a fundamental question: What is the key output of this capability and how will it be used? For example, is the goal to determine the most profitable combinations of customers, products, and/or sales channels? Or do the requirements include providing detailed activity data to better understand the how and why of costs?
Leading companies maximize the value of profit and margin information by aligning reporting structures with organizational accountabilities. Business segment performance can only be improved effectively when business owners are empowered to act on profitability information that is relevant to them. The product dimension is a common example of ineffective segment ownership. Marketing and product development organizations often struggle to understand which group has ultimate responsibility for overall product segment performance, since product effectiveness is a shared responsibility across these (and in some cases additional) organizations. Some companies address this issue by defining integrated business processes that allow multiple organizations to collaborate on shared business segments.
The structure of a segment profit-and-loss statement must be consistent with a business owners ability to control each line item. Profit-and-loss statements that include considerable indirect and other uncontrollable expenses are not likely to be embraced by business owners who lack sufficient leverage to influence business results. In the product example above, if marketing owns the product profit-and-loss statement, yet cannot influence product development strategies, accountability isnt complete and will hinder true performance stewardship and improvement.
A Sustainable Capability
Whether conducted as an ad hoc point-in-time analysis or a repeatable capability, dimensional profitability initiatives are notoriously complex. The underlying concepts can be difficult to grasp and the numerous design alternatives ridden with pitfalls. Many implementation failures are due to ineffective cost models, which define the flow of expenses by linking cost objects, activities, and cost drivers. Even companies that have achieved successful implementations have later found it difficult to sustain this capability on an ongoing basis due to causes usually rooted in the requirements or conceptual design stages.
These typically include:
- The value and credibility of profitability information is often compromised
when explicit business objectives are not defined up front. This leads to
subsequent modification to process and/or outputs after initial deployment;
- Defining the costing approach at an unnecessarily detailed level generates
significant volume and performance problems without providing better information;
- The use of inappropriate cost drivers undermines the credibility and subsequent
use of information, and leads to increased maintenance costs when legacy
systems are decommissioned, upgraded, or replaced; and
- Use of staff surveys to allocate resource costs to activities often require an overly burdensome update process, which can lead to obsolete information.
Building excessive detail into the design is perhaps the most common pitfall encountered by companies that believe greater detail yields improved precision. Although technological improvements have supported greater data processing capabilities, there are additional costs involved in handling those volumes.
An effective way to introduce dimensional profitability concepts is through pilot implementations that address a portion of the overall organization. This allows: introduction to a more limited user group; greater focus on fewer capability objectives; and the implementation team to learn by doing as a means for refining the rollout approach. An Asian mass transit provider opted to first implement activity-based costing within the operations department prior to rolling the capability out to the rest of the company. This proved a wise decision since the operations department was the most vocal supporter of the capability and was often the trendsetter for the rest of the organization.
The Right Technology
There are several options for configuring a financial systems architecture to generate dimensional profitability information. Three common approaches are: back-end best-of-breed; integrated enterprise resource planning packages; and performance management suites. The relative immaturity of larger vendors (e.g., Oracle, PeopleSoft, and SAP) performance management offerings has given best-of-breed vendors (e.g., Armstrong-Laing, SAS) the edge. Both ERP and best-of-breed vendors are actively developing performance management suites that attempt to integrate analytic functionality in the areas of ABC/M, dimensional profitability, planning and budgeting, and performance dashboarding in much the same way finance and accounting ERPs blossomed in the early to mid-90s.
An organization must decide whether to use an existing ERPs capabilities or leverage a best-of-breed application. Typical questions asked when considering the potential move to a best of breed include:
- What incremental investment will be required?
- What additional skills must be developed in-house?
- How will it be interfaced with current systems?
- Can it support the volumes of information that must be processed?
- Will existing reporting and productivity tools work together with a best-of-breed application?
Although ERP and best-of-breed functionality have historically converged, they each possess inherent features that may or may not align with a specific companys requirements. The right choice depends on several factors, including current use of an ERP, the number and complexity of operational data sources required to support costing, and plans for integration with other performance management capabilities. Figure 3 identifies key characteristics of either solution, as well as a description of why a company might use one or the other given its specific circumstances.
Figure 3: Characteristics of ERP vs. Best-of-Breed Applications
Regardless of whether a company goes the ERP or best-of-breed route, it must consider its specific application requirements in evaluating the many products available in the market. Specific considerations include such issues as integration, training, technical platforms, multicurrency environments, pricing, and many other factors.
The Value Proposition
The implementation of a comprehensive performance management architecture based upon ABC/M typically represents a considerable investment when developed properly. However, the potential benefits are significant and can justify the expense.
It is estimated that the effective use of ABC/M can help to reduce a companys overall cost structure by as much as 3 to 5 percent. A large part of this potential is associated with the identification and elimination of non-value-added activities. However, the objective of activity analysis is not limited to simply reducing work levels, but optimizing them as well. For example, many companies find that a disproportionate amount of effort is focused on activities required to address process failure in contrast to those performed as preventative measures.
There is significant potential upside for the top line as well. An enhanced focus on higher margin and growth products and the pursuit of better markets can translate to a 5 percent to 15 percent increase in revenue. This also includes improvements relating to customer and channel management.
Achieving the benefits described above requires a well-integrated and well-planned program. Since significant value is derived from the synergies inherent within the overall performance management framework, the realization of full benefit requires that ABC/M be fully integrated with other capabilities. Furthermore, since the change journey requires a sustained, multiyear focus, release staging can be an effective means of driving early benefits that have a positive impact on the underlying business case.
Final Words
Now more than ever, it is critical that organizations understand those components of the business that contribute value to the bottom line. Historically, companies have conducted one-off cost studies as the basis for a more detailed understanding of segment profitability within the business. However, the emergence of robust cost-analysis techniques and software applications based on improved technologies have enabled a repeatable and sustainable dimensional profitability capability. And though achieving this capability requires strategic vision, a considerable investment, and a potentially complex implementation, ABC/M-based dimensional profitability can assume its rightful position at the heart of business performance management.
