ABC 123

Jan 01, 2001 10:30 PM  By

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.