Understanding Activity Based Costing and Supply Chain Management

INTRODUCTION
The consumer will be king and queen. Customer retention is critical and treating customers as "a lifetime stream of revenues" is paramount. But each customer has unique desires and will increasingly look for customized goods and services. Technology can make this possible. How will supply chain manufacturers and distributors distinguish profitable customers from unprofitable ones?

Information technology from the enterprise resource planning (ERP) software vendors is enabling all of the trading partners along the value-creation chain to better coordinate and collaborate. Supply Chain authorities believe that there are four essential ingredients for successful Supply Chain management:

• Demand driven continuous replenishment (demand-pull material flow)
• Electronic commerce (EDI, bar coding)
• Category management
• True cost information activity based costing (ABC)

ABC translates the traditional (but incomplete, structurally deficient, and often inaccurate) cost accounting system's data into a more usable structure and supports various decisions by Supply Chain management teams and end-users.

The Quandary of Re-Engineering
An organization has re-engineered itself, become lean and agile, streamlined its business processes and workflows, and then it discovers that its board of directors and owners are demanding better performance and ever higher ROIs, EVAs and profits. What are the options? Functionally executed cost cutting may no longer be an option without risking rapid deterioration of customer service. One possibility is to raise prices to increase revenues, but in many markets small price increases.

Another possibility for the organization is to abandon unprofitable products, service lines, channels or customers; but this action first requires the ability to properly and accurately measure costs to determine true profit margins. Measuring the revenues is not a problem, but measuring costs is. With knowledge of profit contribution margins, the organization can more intelligently rationalize what to change. However, as an organization shifts focus, service lines and customers, in order for it to actually realize increased profits, management must simultaneously remove the unneeded costs, usually in the form of employees, at a faster rate relative to abandoned revenues.

A third, less draconian option is available: alter the behavior of the organization's trading partners. Through collaboration, persuasion, or creation of incentives for one's suppliers and/or customers, fewer demands are placed on the organization's employees. Newly freed-up time of employees plus their associated operating expenses can then serve new customers or handle increased business from existing customers. (Alternatively, employees can be transferred where needed in the organization.)

The last option is not commonly pursued because many organizations haven't adequately considered it. Most organizations are habitually inward-focused and concentrate on how they should manage internal costs. The thought of influencing a customer or supplier to behave differently in order to lessen employee workload is often outside the realm of many organizations' thinking. Supply chain management will force organizations to understand their inter-firm costs.

Altering trading partner behavior requires trust amongst suppliers and customers. Businesses have historically 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. Yet many organizations mistrust their partner's cost data. They operate with a resigned acceptance that cost accounting data is "a bunch of lies --we all agree to." Understanding true and actual costs is part of the solution to increase inter-firm trust and better manage costs.

The Weakest Link in the Value Chain
There are many popular prescriptions for business success in the supply chain. Bill Copacino, a Managing Partner for Accenture's Strategic Services Practice in North America, has distilled them to be: customer differentiation, low cost provider, effective asset utilization and flexibility. An organization's departments usually attempt to optimize those four success factors. The Supply Chain managers' contribution will be to make effective decisions with distribution network and warehouse planning and to develop logistics alternatives. Trade-off analysis will become increasingly critical for Supply Chain managers, but traditional cost accounting systems are not designed to accommodate "what-if analysis."

Figure 1.	Components of the supply chain

As organizations have begun to adopt "process-based" thinking, they begin recognizing the greater importance of managing their outputs, in contrast to just managing their hierarchical, stove-piped functions. Business processes create and deliver customer value as the work outputs traverse across organizational boundaries. Process-based organizations view themselves less as a stand-alone business, and more as a link in a value-chain that might possibly extend from the dirt and minerals in Mother Earth all the way through to the consumer hand-picking their product from a retailer's shelf.

In a very broad sense, these supply chains (of products and services) are competing against other supply chains for the same consumers' limited discretionary spending money and their keener sense for value. As shown in Figure 1, today's supply chain is considered to contain redundancies, waste, and low-value added costs.

Today's business competition focuses on addressing the needs of supply chain customers and their end-consumers. Sustained customer loyalty is now touted as a key organizational objective. Mass customization for consumers, by tailoring products and service lines, is key to addressing customer and consumer needs. Accurate cost data is important not only to understanding what is profitable today, but also how to drive future profits and new strategies.

Figure 2.	Eventually collaboration will replace mistrust

One can view each trading partner participating in the supply chain as having a vested interest in a reasonably high level of productivity and effective performance by all the other participants in their chain. By working together in a collaborative way, the trading partners will behave as an extended enterprise . They must perform together as if they are one company. It is no longer a what-is-good-for-me-is-bad-for-you era of business. Instead, it is "one team...one mission." As shown in Figure 2, the supply chain leverages information technology to perform as a value chain. Each participant, including each step they perform, will be increasingly scrutinized for the value they add to the process -- weak performance will result in removal from the chain, and many successful companies are relocating functional activities with key trading partners.

How trading partners create costs for each other is a seldom considered a phenomenon. As an example, a customer requests that one of its suppliers deliver goods five days per week. What would occur if the customer could get by with deliveries on only three days per week? The effect would be that the customer's change in its ordering habit would save their supplier considerable time and effort. Consider a purchasing agent who is required to physically examine and process a supplier's paperwork. Many companies have administrative paperwork handled electronically, or reduced, or not even required. The effect is that both parties save time and effort. Close observation of the supply chain reveals opportunities for significant cost savings.

Resolving Mistrust and Conflict through Cost Management
Presuming that the supply chain has substantial waste imbedded throughout its links, where might much of the waste be located? It has been observed that post-manufactured finished goods travel on average three times the distance actually required to get those same products to the end-consumer. These are costly ton-miles. During this journey each product may be handled forty to fifty times when only a fraction of those material handlings are actually required. How can some of these excesses be eliminated?

One way to encourage collaboration between trading partners is for each partner to better understand how they affect each others' cost structure. And better yet, consider the benefits if trading partners could credibly measure the cost impact that they create amongst themselves. Reliable measures can foster better communications, analysis, and understanding about how trading partners might collectively reduce costs.

A dilemma is measuring the relevant costs, be they inter-firm or intra-firm costs. The general ledger accounting system, although very useful for posting bookkeeping transactions to various accounts, is structurally deficient for reporting costs in a format useful to managers and employee teams for decision support.

Resolving Shortcomings from Traditional Accounting
Fortunately, Activity Based Costing (ABC) has become recognized and accepted as the standard approach to complete what the general ledger has started. ABC assigns all costs, including both direct costs and so-called indirect overhead costs, to products and customers. This provides a complete picture of how all of the organization's resources are consumed by the services and outputs produced for and provided to customers.

Figure 3.	Each Activity Has Its Cost Driver: In addition to seeing the "content of work," the activity view gives insights into what drives each activity's cost magnitude to fluctuate.

As shown in Figure 3, ABC activities are worded using an action verb-adjective-noun grammar convention. Employees relate better to costs described this way, and it motivates them to think about how they can favorably impact those activities. An activity's cost is the sum of the resource costs traced to that work activity. ABC next reassigns all of these activity costs into their work outputs. Then ABC reassigns all of the work output costs into the products, service lines, markets, sales channels and customers (i.e., the ultimate cost receivers) that are consuming the costs.

Note that ABC does not allocate (often implying misallocate!) costs; it traces costs based on the cause-and-effect relationship of how and for how much each product, order and customer places demands on the organization's work activities. ABC measures the consumption of costs through work. ABC variable-izes so-called fixed costs.

In short, with ABC the resources, such as people and their tools, supply costs for the work activities. (Sometimes there are temporary time periods where the supply of cost is available, but its usage is not immediately needed; this is referred to as unused or protective capacity cost.) Given an existing supply of resources providing activity costs, then the products, service lines and customers consume those work activities in widely varying proportions unique to their own diversity and individual differences. ABC accurately traces the consumption of resource costs through work activities into the products and customers.

The relevance of this new visibility of costs and the insights to supply chain managers becomes apparent when one appreciates the decisions they must make. Managers are routinely asked to report and base decisions using costs by territory, commodity, channel, method of sale, class of trade, order size, stock keeping unit (SKU), delivery method, route, carrier type, terms of sale, and so on. With so much diversity in each of these, yet with all of these costs ultimately consumed by individual customers, ABC becomes a vehicle to measure how all of those different costs are individually consumed by each customer. As a bonus, ABC computes the costs of the intermediate work elements and outputs through the value-chain. ABC provides the detailed cost information to support contribution analysis and assess trade-offs. There will be continued pressures to understand the cost implications of merchandising, storage, space, purchasing, inventory investment, product handling, freight, discounts and allowances -- for products and for customers.

In summary, as organizations better measure and understand how they create costs for each other, they can begin thinking about how to help each other reduce their collective costs.

Moving Outside an Organization's Four Walls
An increasing number of ABC-proficient organizations have designed, developed and automated their ABC models into permanent, repeatable and reliable production reporting systems. Many ABC systems are integrated with their inventory cost accounting procedures legally mandated for external financial reporting. As managers and employee teams benefit from ongoing access to the cost data of their work activities and the units of work outputs, they begin understanding not only what things cost but what causes their costs to fluctuate -- their cost drivers.

Understanding cost drivers is central to understanding an organization's cost structure and cost behavior. As a result of using the data from ABC, an organization eventually realizes that it does not directly manage its costs. It actually manages: (1) what causes those costs to occur (i.e., its cost drivers) and (2) the effectiveness and efficiency of how well the organizations' people and equipment respond to those causal triggers. Through self-discovery and asking lots of new questions resulting from the ABC data, these ABC-proficient companies have begun to understand why their internal cost structure exists as it does. In effect ABC covers the complete enterprise -- inside the firm's four walls. ABC assures visibility for full cost recovery.

ABC provides essential data. However ABC, as practiced, has had an inward-looking focus. In the 1970's, an ABC-like method called "direct product profitability (DPP)" to measure the manpower effort of handling products relative to pricing. But DPP only included direct costs, not indirect and overhead costs.

In the 1980s, the purchasing function began examining the Total Cost of Ownership (TCO). TCO acknowledges that the item purchase price on a vendor's invoice represents only a portion of the total cost of acquiring that item.

ABC data enhances the TCO measure by revealing hidden costs and allowing them to be assigned to each vendor; then ABC re-assigns those costs into the purchased items, combining them with the purchased price -- hence the TCO. By applying TCO to its vendors, an organization can assess how inter-firm relationships affect its own costs. But the pressures for improvement to the entire supply chain costs are forcing organizations to each now look outside their four walls -- at the entire value chain.

With TCO, companies can negotiate with or select upstream channel members based on total acquisition costs. TCO measures can also enlighten the buyers as to how their own behavior affects their vendors' costs. It is a two-way street to cooperating trading partners in the supply chain. In the 1990s, TCO gave organizations a partial glimpse into how their internal reengineering and technology investments have impacted cost elsewhere in the supply chain.

Figure 4.	Supply Chain costing includes prior more narrow costing methods, but ABC captures all costs. The Extended Enterprise requires B-R-O-A-D-E-R scope beyond the enterprises' boundaries.

Ultimately the total landed marketplace costs of the supply chain is what matters to the consumer making the purchase choice at the end of the value-chain. As a consequence, the whole supply chain matters! DPP and TCO only capture an organization's intra-firm costs related to procuring, merchandising and stocking product. A more complete supply cChain costing system must also capture the downstream costs triggered by customers and their product and service orders -- these are called the "costs-to-serve." All of these costing methods are shown in Figure 4. A customer's needs may leapfrog over an organization and affect the costs of that organization's vendor. This likely means a higher purchase price that is passed on to the end-consumer. By not capturing costs needed to see and understand the cost structure both upstream and downstream, a company within the supply chain will miss the opportunities for making inter-firm cost trade-offs. And passing the excess costs all the way through to the end-consumer inevitably reduces overall product demand for the whole chain.

Inevitably costs spanning all of the supply chain firms will require understanding in order to simulate and test the effect of proposed changes on overall supply chain costs. The invisibility of costs combined with a reluctance by trading partners to share cost information each represent a significant hurdle for evaluating supply chain performance. One factor that may accelerate improvements in understanding is the increasing popularity of enterprise-wide resource planning (ERP) software systems.

ABC Integration with ERP Software -- A Dramatic Shift by Erp Vendors
Recently, there has been a dramatic shift in the integrated software industry. Major ERP vendors, such as SAP, have made significant moves into the "Analytical Applications" arena, including the ABC application. These applications perform as data mining and conversion tools since they use data that has already been accumulated or summarized from mainstream source transaction-intensive systems. For the ABC Analytical Application in particular, this indicates that:

• ABC may very well be the foundation for a number of senior management initiatives (e.g., strategy, value-based management, performance management, profitability assessment, business process reengineering, etc.)
• ABC has become a fundamental selection criterion for organizations evaluating financial/operational software applications resident in ERP systems.

The ABC data is clearly located at the intersection where an organization's level and type of resources meets with the level of profit and degree of alignment with senior management's vision and strategy.

As examples of this shift in ERP software vendor emphasis, SAP, the giant German ERP market leader, made a substantial equity investment in ABC Technologies Inc, an eleven year old company that is the worldwide market leader in stand-alone and open commercial ABC software.

The differences between how the ERP vendors have approached ABC involve two factors: (1) the amount of prior experience the ERP vendors have had with ABC systems, and (2) how passionate their end-users have been about ABC. (Yes, people can get excited about cost data, and surprisingly emotional about unfair cost allocations.) Oracle and PeopleSoft, prior to their foray into the activity accounting space, had minimal ABC functionality. However, SAP had ABC functionality for a number of years, in the form of its CO-ABC module. But SAP learned from its customers that there was much more to costing than just the math. There are substantial issues dealing with organizational learning rates and the human discovery experience that ABC can positively catalyze.

The ERP vendors are beginning to appreciate that non-accounting personnel, such as supply chain managers, truly benefit from being involved in determining the assumptions that have historically been made for them by those in the accounting functions. Operations and line personnel benefit from the exposure and involvement in designing and constructing their cost measurement systems. These people no longer wish to rely on convenient cost allocation rules selected to make the numbers tie-out and balance on a cost accountant's desktop computer. Managers, teams, and employees are increasingly in need of valid data to analyze and make trade-off decisions.

Another reason ERP vendors are increasingly receptive to analytical applications is because they accelerate attaining meaningful results from their software. ERP implementations have traditionally been phased in over time. This means that modules are implemented sequentially, rather than in parallel. One consequence of this is the implementation times for the entire ERP system greatly exceeds the timeline required to implement an ABC system. Customers of ERP vendors have stated that they traditionally implement the financial modules first, followed by purchasing, materials management, and the managerial modules. The managerial modules are the ERP analytical applications within which ABC functionality is usually contained. Typically, a large ERP implementation would not allow for the managerial modules to be implemented until after the transaction-intensive baseline modules are implemented. Also, by being addressed afterwards, the later modules suffer from the fanfare and resources dedicated to their earlier modules.

Four Wall Intra-Firm ABC Vs. Inter-Firm ABC
For those organizations that have already become lean and agile through reengineering efforts, a substantial portion of their cost structure now tends to exist to respond to the "demands on work" placed on them by their suppliers and customers. For example, certain work may be exclusively dedicated to either obtaining and fulfilling customer orders or to developing new products and services. (These two broad sets of tasks are consistently referred to as an organization's core business processes.) As a result of this new insight, lean organizations using ABC realize that managing their costs is best accomplished by managing how their trading partners place demands on them. In ABC lingo, these involve the frequency, quantity, and intensity of the activity drivers that cause activity cost.

When some of the demands on work from customers or suppliers are questionable, are of low value, are a result of an error or non-conforming event, or are in some way a candidate for reduction or outright elimination of the cost driver, then further discussion amongst the trading partners becomes possible. By using ABC, these discussions can be based on fact-based data. In other cases, to better serve customers, a supplier may wish to self-impose increases for the demands placed on it through more services -- but perhaps it should charge for them. With ABC data, supply chain managers can evaluate alternative supply chain networks and structures. They can better understand the costs of the complexity they strive to manage. They may even select alternative supply chain trading partners.

If only one of the trading partners has ABC data and the others do not, discussions may be limited. The ABC-enriched company understands how its cost structure is being impacted by cost drivers; however, its trading partn ers will not adequately understand how their costs impact others. When all trading partners understand their costs at their boundary-spanning activity "touch points," they can better discuss how they might collectively shift, lessen or altogether remove costs. The combined effect of their actions can result in lower overall costs.

The "touch points," similar to an analogy of the flat surface that results from pressing two balloons together, will usually involve the following three pairs of organizational relationships:

• Supplier -- Customer
• Shipping -- receiving
• Sales -- purchasing
• Design engineers -- process engineers

For example, if the supplier packages their product in a complicated way, and perhaps uses non-standard containers, then there will likely be extra work by the customers' material handlers at the receiving dock. Figure 5 presents the inter-firm relations. Any changes that may be mutually beneficial will also imply reduced time and effort, resulting in increased capacity to be re-deployed or eliminated.

By better understanding inter-firm costs, opportunities will surface to restructure which trading partner may be more efficient at performing an activity. Redundancies can be eliminated. "Functional shiftability" can be deployed to re-organize as to which trading partner does what work activity. These costs are usually transparent to the consumer at the end-of-the-value-chain. In many cases, consumers may simply be interested in low cost.

Who Benefits?
When cost savings are indeed generated and realized, who benefits? How are the cost savings to be shared? This will always be a thorny problem. ABC will not provide the answer, but it will at least provide unarguable data used to discuss sharing ly generated savings.

Figure 5.	Inter-Firm Relations

There are three potential beneficiaries from improvements and cost savings: (1) the supplier, (2) the customer, and (3) the customer's customer. The last beneficiary could potentially be you or me in the form of a consumer benefiting from a lower price. But for that to occur, this means that the two upstream trading partners will have consciously agreed to a no-profit-impact arrangement where any change in cost is matched with an exact same change in price. In practice, this incremental savings "pie" from productivity improvements can be split three-ways -- with various sized portions.

Predictably, the profit motive of each trading partner will make the sharing of cost savings an awkward experience. ABC data can at least lessen any debates. The more proficient each trading partner is with their ABC system, the easier these discussions can be.

Initially some trading partners will exclusively use the ABC data for their own benefit. They will use it for incremental price and cost trade-off analysis. For example, to entice a customer to reduce its current level of services, they may require a reduced unbundled price incentive. Presuming the customer accepts arrangement, an organization must know how much costs will be available and realizable for savings. An unprofitable service can be converted into a profitable one by reducing both the service level and price ­ but the change in cost must decline more than the change in price for a positive profit impact.

ABC And The Supply Chain Council's SCOR Model
One way to increase the chances that trading partners are effectively communicating with each other is for them to share a common framework of understanding and terminology. A newly formed trade association called the Supply Chain Council International (SCCI) helps address this. One of the attractions to SCCI is it has constructed a descriptive framework, with a standard glossary of terms, named SCOR (Supply Chain Operations Reference-model). SCOR breaks down, from the highest level of any organization's four basic business processes (plan, source, make, and deliver), to a fifth level containing hundreds of recognized work activities.

The SCOR "template" is an ideal mate for ABC, because ABC reinforces SCCI's desire for consistent and standard measures. ABC calculates and reports allocation-free "unit costs" (e.g., cost per processed invoice) that traditional accounting can not.

Figure 6.	SCCI/SCOR/PHIOS

SCCI has contracted with PHIOS, a data repository vendor, to maintain the SCOR framework plus benchmark data submitted from participating companies and management consultants. Figure 6 displays where our ABC calculation engine (Oros ABCPlus) fits in as both an automation tool for economic data collection and reporting, but more importantly as a filter to purify the performance metrics destined for PHIOS. The output data of ABC will prevent the "apples-and-Oreos" problems that currently cause problems with conventional benchmarking.

As supply chain management consultants (internal or external) and ERP vendors further encourage organizations to adopt SCOR as a framework to think, communicate and accelerate learning towards solution, ABC will likely become the accepted basis for measuring costs.

The Future Of ABC and ERP
Management and employee teams are now benefiting from a more sober and mature understanding of what ABC is. When it was initially promoted in the late 1980s and early 1990s it was somewhat hyped as a cure-all answer to management's problems. One of the major misconceptions of ABC is still that it is an improvement program. It is not! The ABC data is simply a means to an end. That is why ABC itself should not be labeled as an improvement program. If employees and managers are given the impression that ABC will be the next magic pill, then it becomes a candidate for "fad of the month." ABC data simply makes visible the economics of the organization and the cost consumption that is occurring with or without ABC present. With this more mature view of what ABC is and how it relates to an organization's core transaction-intensive systems, the management accountant should have a rosier picture ahead.

In today's environment, a business' road is no longer long and straight, but it is windy with bends and hills which don't give much visibility or certainty to the future. Organizations need to be agile and continuously transform their cost structure and work activities. This is difficult to do when employees and managers do not understand their own strategies, cost structure and economics. It is much easier for organizations to transform themselves when their information links and communicates their strategies to the behavior of their employees.

An overarching issue with ABC involves its perception as just another way to spin financial data rather than its use as mission-critical managerial information. The Information Age we are entering can be mind-boggling. In our future, as technology advances, so will the demand to access massive amounts of relevant information. The companies that survive will be those that can answer these questions:

"How do we access all this data?"

"What do we do with it?"

"How do we shape the data and put it in a form with which we can work?"

"What will happen when we apply technologies developed during the Information Age for the Information Age?"

CONCLUSION
Clearly, as information technology evolves, organizations will increase their effectiveness. Further, as markets change, companies and organizations will run into global competitors that increasingly look to information and information technology for competitive advantage. Sound management information systems and ABC are both involved in this broad arena of "outsmartmanship." Effective performance measures align employee behavior to the organization's strategies; and ABC puts the "management" back into management reporting. It will be fun watching organizations move from their learning stages into mastery of building, and using integrated ERP, performance measurement and ABC systems.

About the Author
Gary Cokins, CPIM
Director, Industry Relations
E-mail: garyfarms@aol.com
Phone: 248.642.1296
ABC Technologies, Inc.,

Gary Cokins is the Director of Industry Relations for ABC Technologies, Inc., the worldwide leader in activity-based information software. He is an internationally recognized expert, speaker and author in advanced cost management and performance improvement systems. Gary began his career with FMC Corporation's Link-Belt Division where he served as Financial Controller and then Production Manager. In 1981 Gary began his management consulting career first with Deloitte & Touche, and next with KPMG Peat Marwick, initially implementing integrated business systems and ultimately focusing on cost management systems, including Activity-Based Costing (ABC). From 1991 to 1995, Gary headed the National Cost Management Consulting Services for Electronic Data Systems (EDS).

Gary is Certified in Production and Inventory Management (CPIM) by the American Production and Inventory Control Society (APICS) and is a certified implementor of theory of constraints (TOC). He serves on activity-based information committees including CAM-I, the Automotive Industry Action Group (AIAG), the National Center for Manufacturing Sciences (NCMS), the Agility Forum, Textile & Clothing/Corporation, the Society of Manufacturing Engineers (SME), Grocery Manufacturer's Association (GMA) and SEMATECH.

He is the author of An ABC Manager's Primer (ISBN 0-86641-220-4) and Activity-Based Cost Management: Making It Work (ISBN 0-7863-0740-4), both McGraw-Hill, and the recipient of CAM-I's 1993 Robert A. Bonsack Award for Distinguished Contribution to the Field of Cost Management.

Gary resides in Bingham Farms, Michigan with his wife Pam Tower. They have two grown daughters, Jennifer and Kristen. Their interests include cinema, astronomy bridge and international travel.

ABC Technologies Inc. website http://www.abctech.com