ABC 123

You’ve figured out your operations costs and allocated them correctly, as described in Part One of this article (November/December 2000). How do you use this information to cut expenses and improve processes? Logistics expert Terrance L. Pohlen shows you the ropes in the second of a two-part series

Information is valuable, but it isn’t everything. Even if you understand the exact cost of each of your logistics functions, that data alone won’t help you reduce customer service expenses or overhaul picking processes in your distribution center. To make activity-based costing (ABC) fully effective, you must integrate it with activity-based management (ABM). The latter combines ABC with non-financial performance measures, enabling you to focus on those activities having the greatest impact on profitability, cost reduction, or shareholder value.

Two of the most likely areas for applying ABM are supply chain costing and customer profitability analysis. In a 1998 study conducted by the Supply Chain Research Group at The Ohio State University, all of the companies that were using ABC indicated that they intended to implement some form of activity-based management. One-fourth of the respondents anticipated using supply chain costing to capture activity costs across multiple firms, and a third planned to use ABC to determine the cost of serving specific customers and their impact on profitability. These plans mesh closely with many businesses’ recent attempts to implement supply chain software and to work with their customers to reduce costs and increase performance. Activity-based management, combined with ABC, offers a full complement of tools and techniques to streamline the entire supply chain.

The whole shebang ABM places activity-based costing in the larger context of performance management. It employs ABC information to determine activity cost; measure the cost per activity output; reengineer the activity and determine the effect on activity cost; evaluate how different customers, products, or distribution channels consume the activity outputs; and analyze how altering the activity or other activities in the supply chain affects sales, customer service, and profitability. ABM represents more than a name change for ABC – it demonstrates that a better understanding of activities and their associated costs will lead to improved process performance and effectiveness.

When you implement ABM, you will look at activity costs from a horizontal or process viewpoint. This technique analyzes activities by linking activity outcomes or performance measures with the resources required to perform the activity (or set of activities comprising a process). The analysis attempts to determine each activity’s cost drivers, or those factors requiring the activity and influencing how well the activity is performed. Frequently, the analysis frequently reveals opportunities to improve activity performance as well as reduce the resources required to carry out the activity. By contrast, ABC views costs from the vertical or cost-assignment perspective. It attempts only to assign costs more accurately and does not specifically address how well or why an activity is performed.

With a horizontal view, you can combine information you may already possess in the form of non-financial performance measures with the cost information obtained from ABC. For example, you may have a special interest in the efficient and timely receipt and putaway of material and may have established measures to capture the effectiveness of the process, such as “total dock-to-stock” hours, a measure of the time from carrier arrival until the product is made available for order release.

The process consists of several activities ranging from unloading the truck and verifying the product quantity and condition to physically placing the item in a warehouse location. Each of these activities adds time to the dock-to-stock hours measurement. They also consume resources that ABC can trace to the activities within this process. To understand what drives the time and cost of these activities, you need to analyze the process from a financial (cost) as well as non-financial perspective. Factors such as the type of goods sold, carrier performance, equipment availability, and employee training all determine the amount of time and resources required to perform these activities.

The combination of ABC and ABM enables you to view performance from both dimensions and determine which activities offer the greatest opportunity for service improvement and cost reduction. The activity cost information helps to quickly decide where to focus action and obtain the greatest payback rather than attempt an across-the-board reengineering effort. You would be using cost information as a tool for direct action, not as an after-the-fact performance measure. By pinpointing the factors contributing to high costs or poor performance, you can seek to eliminate those factors.

For instance, you may be able to reduce the cost and improve the performance of the dock-to-stock process by selecting a carrier that provides consistent on-time deliveries with little or no damage. This move might also eliminate the need to conduct certain activities. ABM would identify the reduction in dock-to-stock hours as well as the costs incurred to perform this process. The resources that were no longer required could either be eliminated or reallocated to other tasks. Using a different carrier may increase freight rates, but the reduction in overall process costs and increased revenue resulting from improved customer service may more than offset the higher rates.

The combination of ABM and ABC enables you to view process changes from a total operational cost perspective and trace any improvements back to financial performance such as the corporate profit and loss statement. Many firms have begun using activity-based costing and activity-based management as vehicles to translate improved operations and fulfillment performance into increased profitability by product, customer, or distribution channel.

What price customers? Because ABC was initially focused on manufacturing operations, most ABC/ABM initiatives concentrate on product costing. However, customers frequently have a greater impact on operations and fulfillment costs. The size and type of customer will frequently result in different demands being placed on fulfillment processes.

Customer behavior can influence differences in performance and resource consumption in a number of categories and activities, including order frequency, order size, exclusive SKUs, number of lines per order, expedited or routine handling, specialized packaging or labeling, and returns. As customer requirements become more diverse in their consumption of resources and operations and fulfillment activities, managers will increasingly need a greater understanding of the cost-to-serve and the profitability of specific customers or classes of trade.

Analyzing customer profitability provides several key benefits. It provides a “bill of activities” that identifies the total cost by activity for each customer. ABC accomplishes this by tracing the costs of operations and fulfillment activities directly to specific customers based on actual consumption. As a result, customer profitability analysis can identify those customers demanding specialized or resource-intensive activities that generate a disproportionate amount of cost. The assignment of costs by customer enables ABC to capture profitability by customer, and ABM provides detailed reasons for a particular customer being or not being profitable. Customer profitability analysis can also simulate how changes in customer service requirements will affect costs and profitability in response to customer requests. In addition, it can demonstrate how projected changes in operations and fulfillment processes may improve the profitability of specific accounts.

Traditional cost accounting does not capture costs at the activity level and cannot directly trace these expenses to specific customers. Instead, it typically uses sales to allocate costs to customers. However, two customers with equal sales volume can differ substantially in their service requirements. An ABC customer profitability analysis frequently produces a very different picture of how different customers or market segments contribute to corporate profitability (please refer to figures 1 and 2 from Part One of this series, O&F Nov./Dec. 2000). Managers must rely on a combination of ABC and ABM to work with their customers to decrease activity consumption and increase profitability.

As an executive responsible for operations and fulfillment, you can combine customer profitability analysis with ABM to improve account and overall profitability, as well as use this information to collaborate with your customers to change ordering practices. You may implement collaborative planning and forecasting to eliminate forecast error and reduce inventory levels. Moving from the telephone to electronic data interchange (EDI) or the Internet may reduce order processing costs for both parties. Furthermore, you can initiate independent actions within the firm to reduce the cost to serve a specific account by reengineering order fulfillment activities. Some firms advocate using “menu-based pricing” to charge customers only for the services they request, rather than applying a single national fee that penalizes customers who do not specify non-standard requirements. No matter which approach you take, customer profitability analysis provides a useful foundation for initiating a dialogue and targeting specific processes or activities for change.

Learn by example The following example illustrates how a change in customer ordering behavior might be simulated at a distribution center. In this example, the customer represents a single store and orders once every two weeks. The vendor pools orders destined for the customer’s region and uses a contract carrier for line haul, sorting at the carrier’s terminal, and local delivery. Transportation and order processing costs are lower for the vendor, but the customer must hold larger inventory levels and cannot respond quickly to shortages or increased demand. With annual orders amounting to ten pool shipments or truckloads, the customer requests the capability to order more frequently and in smaller quantities.

In this instance, the change in practice would increase costs by $18,900 per year. With a before-tax margin of 30%, the firm would have to generate an additional $63,000 in sales to compensate for this cost. It also must face the possibility of the entire chain changing its ordering practice. Management must determine how to reduce activity costs within the distribution center and work vigorously with customers to streamline the new business practice. The alternative? Lower profitability.

Chain links Another valuable technique to apply to operations is supply chain costing (SCC), which uses ABC and ABM to achieve a more comprehensive view of what drives cost as product moves to market. Measuring the costs of key processes spanning an entire supply chain, SCC attempts to facilitate collaboration among partners in a distribution network to increase value not only for the customer but also for the shareholders of each of the firms involved in moving product to market. Supply chain costing establishes a common language and financial and non-financial activity data among all supply chain participants. It differs from other approaches such as direct product profitability (DPP) and total cost of ownership (TCO) by capturing all variable cost information for the user and upstream and downstream partners.

Supply chain costing greatly expands the tools available to operations and fulfillment managers. Its capabilities include calculating the landed marketplace cost of a product accurately, determining how each member in the supply chain contributes to overall costs, targeting high-cost activities or processes for cost reduction, shifting functions within the supply chain to where they can be performed most efficiently, and selecting supply chain partners that have the greatest potential for establishing a competitive advantage through differentiated service offerings or low cost.

Right on Within an SCC framework, target costing and pricing become much more realistic. Supply chain participants can collectively target the marketplace price and cost that will yield a competitive advantage as well as an adequate margin for each company. They can work backward through the supply chain, analyzing how each activity performed by each firm adds cost and time within the order-fulfillment process. A supply chain view of order fulfillment may identify unnecessary duplication occurring between firms, activities that add cost or time but no value to the customer, or opportunities to reposition or shift functions from one firm to another that result in the lowest supply chain cost. This approach may result in lower marketplace price without decreasing the margins or profitability currently experienced by each firm. The reduced market price and process costs that result may actually produce higher revenue and greater profitability.

Few companies have successfully moved supply chain costing beyond their immediate upstream supplier or downstream customer or carrier. Difficulties in expanding SCC can stem from differences in accounting practices, unsophisticated costing systems, inability to break out costs by customer, lack of trust, weak working relationships, sensitive cost information, and the absence of a way to equitably share any benefits or additional costs that collaborative action may incur.

Despite these obstacles, however, several companies continue to pursue SCC. In the near term, they may rely on industry cost projections or their own estimates to forecast total supply chain costs. In the longer term, many firms have begun to work with other members in their supply chain to develop cost information for key processes. Some have even begun to demand the information as a requirement for doing business with the other partners in the venture. These companies believe that the benefits of supply chain costing outweigh the costs and that the difficulties associated with implementing SCC will preclude other firms from easily replicating the method, giving the SCC users a sustainable competitive advantage over their competitors.

When in doubt . . . Managers frequently question whether activity-based costing and activity-based management will work in their firms. Some doubt that the time spent on analyzing the costs of activities and tracing activity consumption to customers will yield any tangible results to their company. Others believe that their current cost systems, which rely on traditional allocation schemes, provide sufficient information to run their business.

In these cases, the managers need to consider what information they require to obtain an advantage over their competitors; what measures they would use to evaluate any initiatives; how they would communicate the benefits of these initiatives to their vendors or customers; and how they would translate improved operations and fulfillment performance into corporate profitability or shareholder value. Unless their companies have adopted some form of ABC and ABM, these executives will lack the necessary information to drive change and communicate the value of their process improvement efforts.

ABC provides the capability to find out the cost of specific activities and assign costs to specific customers or products, whereas ABM enables managers to demonstrate how improved process performance leads to reduced expenditure, higher levels of customer service, and an improved bottom line. After using these two techniques, managers questioning their utility will ask themselves how they ever survived without either.

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ABC, 123

Activity-based costing is a potent tool to calculate your direct and indirect costs accurately. In the first of a two-part series, logistics expert Terrance L. Pohlen defines and explains the technique

If you knew that one of the personalized services you offer cost your operation several thousand dollars of processing time last month, would you continue to provide it? And would you have invested in that new picking process if you had known the exact cost of the supervision it requires? Activity-based costing (ABC) enables you to answer those questions quickly and make the appropriate decisions. By allowing you to calculate the precise costs of specific operational functions and assign them to the correct areas, ABC serves as a powerful information management and cost-reduction method.

Despite ABC’s reported benefits, many companies have not implemented it because they fear a considerable up-front investment or lack of concrete results. However, a rapid prototyping approach for implementing ABC can provide tremendous insight with minimal time and effort. Part Two of this series, scheduled to run in the January 2001 issue, will discuss activity-based management (ABM), which uses ABC information to assist managers in reducing costs, analyzing customer profitability, and developing effective performance measures.

Operations and fulfillment managers urgently need accurate cost information. They need to understand what is driving costs; which customers or products consume the most time, money, and effort; and why costs may have changed when sales volume or some other leading indicator has not. These managers need to clearly understand and demonstrate how their performance affects corporate profitability, especially when competing for additional resources or capital investment. They also must continually review the order fulfillment process for opportunities to reduce costs and increase productivity.

Traditional cost accounting falls woefully short of providing the information managers require for improving their operations. The visibility of operations and fulfillment costs is lost because they are often rolled up as part of sales, general, and administrative (SG&A). Conventional cost accounting further distorts the information by allocating these costs to customers or products using an arbitrary yardstick such as total sales or cases shipped. Such measures assume that “a case is a case” or that “a customer is a customer” and fail to recognize any of the unique services provided to specific product lines or customer accounts. There is usually no attempt to determine the cost of performing specific activities such as order processing, and the difference between processing a small, routine order and a large, specialized one is certainly not captured. The resulting information precludes managers from accurately determining the costs and profitability of supporting different products, customers, or distribution channels. It may also lead them to make bad decisions based on faulty cost allocations suggesting that customers are profitable when they are really not.

Managers handling direct-to-customer fulfillment cannot directly determine what drives their costs or explain why costs have risen or fallen based on financial performance, nor can they engage in discussions with their supply chain partners on how to jointly lower costs and improve profitability. Companies such as Sears Logistics Services, Schneider, and others have turned to ABC as a means to overcome these problems.

ABC is a technique to assign the direct and indirect costs of a firm to the activities it performs and the costs to the customer or products consuming those activities. It differs from traditional cost accounting by using multiple drivers to assign costs, developing the costs of performing specific activities, and determining the costs of supporting specific customers or products. Thus, ABC translates traditional costing into actionable information for operations and fulfillment decision makers.

By the way it assigns costs, ABC provides considerable management insight. First, activity costs are determined by assigning the amount, or cost, of each resource used by that activity. Next, activity costs are assigned to products or customers on a per-activity basis. This two-stage approach enables managers to view costs at three different levels: resource, activity, and cost object (customer or product). Each level portrays costs in a different manner, demonstrating how costs are actually being consumed and indicating opportunities to reduce them.

Need for speed Rapid prototyping can greatly reduce the time and expense associated with ABC implementation. Typical implementation efforts require a team of three to seven individuals working for three to four months with a total fee topping $300,000, including software, just to obtain an initial breakout of costs. Prototyping, by contrast, reduces time and expense by keeping the project focused and using standardized templates to collect information quickly. A rapid-prototype ABC model for a 100- to 200-person division can be developed in two to four weeks, and can be adapted or revised based on the resulting management feedback. The quick results help sustain management interest and use.

The primary disadvantage stems from the limited scope of rapid prototyping – it may not answer all of the key questions later posed by management. ABC development should begin with a clear understanding of what questions senior management needs answered; however, the method generally provokes a whole new set of questions once management has access to detailed costs by activity or by customer. Rapid prototyping overcomes this constraint by quickly producing a model and rapidly revising it if management requires additional detail.

Let’s take a closer look at the information ABC can provide. ABC begins by identifying the resources required by an organization to perform its mission. Resource costs are obtained by pulling together the budget and general ledger account information for the company. The result should provide a complete picture of all the resources that the business consumes, including assignable indirect costs such as personnel and payroll. In many instances, information within the general ledger or budget will require reclassification or breakdown to reflect how resources are actually managed. An organization typically does not manage “labor” but instead manages individuals with specific skills. The labor account would be subdivided into traffic management, purchasing, order processing, order picking, and so on. The reclassification makes assigning costs to activities much easier; for example, order-picking labor would be assigned only to order-picking activities. This also makes the model more intelligible to decision makers, because they manage specific resources and not general ledger accounts.

Cost of resources The resource view of costs provides the linkage from ABC to the financial system. Resource costs can be traced back to the general ledger or budgets. In many cases, ABC may include costs not included in traditional cost accounting. For example, inventory carrying cost may appear in ABC to demonstrate the cost trade-offs associated with holding inventory. Traditional financial reports would not reflect this cost because the firm does not actually incur this expense. However, most managers consider inventory carrying costs in their decisions and attempt to minimize them. ABC simply makes this cost visible so that managers can more effectively demonstrate cost trade-offs such as “trading information for inventory.”

This capability to include information such as inventory carrying costs raises an important point. ABC is meant to make cost information relevant and useful. It should not be viewed as rigid, inflexible, or just another financial management system.

When the first stage is completed, what appears is a full view of the resources consumed by the organization. In many cases, managers have never seen the total resources required to perform their activities. The resource view provides another useful benefit by no longer placing resources in large cost buckets such as overhead. Instead, costs such as personnel are directly traceable, enabling managers to determine how their activities and performance drive the need, or lack thereof, for these resources.

The next step of ABC assigns resource costs to the activities performed by the organization. The cost assigned depends directly on how much of each resource an activity consumes. For example, ABC would assign the cost associated with shrinkwrap to an activity labeled “shrinkwrapping.” In many cases, labor represents the largest single resource and its assignment generates the most interest. Most firms rely on interviews to assign labor costs. A rapid prototyping approach would begin with interviews of functional experts to determine the activities performed by each labor resource. Next, a template would be developed for the remainder of the workforce in each functional area. For instance, warehouse workers would receive a template that included only warehousing activities. They would complete the template simply by using percentages to assign the amount of time spent on each activity. The process occurs very quickly and does not disrupt the workforce. This approach provides the additional benefit of accelerating implementation by rapidly compiling the information needed to assign labor resources to each of the activities.

Activity costs provide a level of information typically not available within most companies. The activity view provides the total cost of all the resources required to perform each activity. When coupled with non-financial data about the number of times an activity has been performed, ABC can further provide the cost per activity output – for example, the cost to dispatch a truck or the cost to process a telephone order. The activity cost can be broken down to show all of the resources, direct and indirect, required to perform the activity. Managers can use this information to better understand how activities actually consume resources, decide whether sufficient capacity exists to absorb additional workload for an activity, or determine how much of a resource would be freed up or released for other purposes if an activity were eliminated.

How much is too much? The number of activities to include in an ABC model represents one of the most critical decisions affecting the success of the implementation effort. Too many activities make the model complex, time-consuming, and difficult to maintain. Too few activities, and the model will not provide any significant insight into the factors driving costs or answer key management questions. Most successful rapid prototyping models use 20 to 40 activities as a starting point. With 40 activities, each activity would on average represent only 2.5% of total cost – a level probably too detailed for management consumption, but generally providing ample detail to answer most questions.

Here are some rules of thumb to apply when deciding whether to add or delete an activity from your ABC model:

Diversity. Does the activity capture differences in how it is performed? An activity labeled “pick orders” would not distinguish between case, tier, or pallet picks. It also may not capture differences based on the number of lines in an order. Capturing these differences would enable the model to more accurately assign costs as well as offer greater insight into what drives order-picking costs. The “pick orders” activity should be disaggregated into more discrete activities to capture the key differences. On the other hand, if the activity is homogenous – orders are orders – and no major differences exist in how the activity is performed, the activity should not be split further.

Cost. Will the cost of the activity warrant tracking? Tracking too many small activities adds tremendous complexity to the model without providing much additional value. Too many activities will overwhelm users with unnecessary detail, divert their attention from the activities having the greatest impact, and make it much more difficult to update the model on a frequent basis since each resource must be traced to an activity.

Measurement. Can the organization track the activity and determine the resources it consumes? If not, the activity adds little value to the model. It should be considered for elimination unless it represents a major cost or will significantly distort the costing of the organization’s activities.

Management focus. Will excluding the activity prevent the model from answering a key management question? Early in the implementation process, management should identify the major questions they needed to be answered. These questions will shape the design and scope of the ABC model and determine which activities to include.

ABC assigns activity costs on a per-activity or output basis. The per-activity cost is determined by dividing the activity cost by the number of times it is performed. Consumption of the activity’s output determines how much to assign to a specific customer or product. For example, if the total cost of the activity “process customer returns” is $386,000 and the activity is performed 2,700 times, then the cost per customer return would be $143.12. The proportion of the customer returns activity assigned to each cost object, in this example a product division, would be based on the volume of customer returns processed for that division at $143.12 each. The assignment of activity costs to the cost objects provides the final view of costs within ABC.

The cost object view shows where the organization’s outputs are finally consumed, at what cost, and in what quantity. Customers (internal or external) or products are the most frequently used cost objects in ABC.

Some firms use product divisions when internal customers consume the outputs of their activities, and the cost of their services is assigned to these internal customers. The information contained in this view of ABC provides the “bill of activities” required for supporting a specific customer (cost object) and the amount of each activity consumed. Operations managers can quickly determine which customers consume a disproportionate amount of their output for the revenue and profit generated.

Firms have used this information to develop customer profitability reports, generate product contribution statements, or accurately assign the cost of pooled support organizations, such as operations and fulfillment activities, to the profit and loss statements of the business units.

This view quickly answers whether a customer is generating a profit or loss and, more important, why. Some firms have gone beyond internal cost reduction efforts to share this information with their customers, a move that can reduce costs and increase performance across the supply chain, possibly yielding a competitive advantage in price and performance.

The three views of cost that ABC provides can assist logistics and operations managers in several ways. They can determine how changes in service requirements will affect logistics costs. ABC also provides managers the capability to analyze how changes in the performance of operations and fulfillment activities will affect the need for indirect resources such as personnel, payroll, and administration.

Management can focus on high-cost activities or those having the most immediate impact on customer profitability. Viewing costs from three dimensions enables executives at all levels to make effective cost trade-offs and lower overall expenses. An especially important capability is that they can finally understand how the performance of the activities they manage directly translates into corporate profitability as well as how these activities affect customer and product profitability.

The second part of this series will demonstrate techniques for using ABC information to drive performance improvements and reduce costs. The discussion will cover techniques such as activity-based management (ABM), activity-based budgeting, and the development of cost-based performance measures. ABC only supplies more accurate cost information; management must act on the results to achieve the potential savings and performance gains.

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