8.3 Activity-based costing (ABC) 202
8.3.4 Activity-based management: customer profi tability analysis 205
In many organisations, it is just as important to cost customers as it is to cost products.
Different customers or groups of customers differ in their profi tability. This is a relatively new ABM technique that ABC information makes possible because it creates cost pools for activities. Customers use some activities but not all, and different groups of customers have different ‘ activity profi les ’ .
Service organisations, such as a bank or a hotel, in particular need to cost customers.
A bank’s services for a customer will include the following types of activities:
● withdrawal of cash;
● unauthorised overdraft;
● request for a statement;
● stopping a cheque;
● returning a cheque because of insuffi cient funds.
Different customers or categories of customers will each use different amounts of these activities and so customer profi tability profi les can be built up, and customers can be charged according to the cost to serve them. A hotel may have activities that are provided for specifi c types of customers, such as well laid-out gardens, a swimming pool and a bar.
Older guests may appreciate and use the garden, families the swimming pool and business guests the bar. If the activities are charged to the relevant guests a correct cost per room- night can be calculated for this type of category. This will show the relative profi tability and lead to strategies for encouraging the more profi table guests.
Even a manufacturing organisation can benefi t from costing its customers. Not all customers cost the same to serve even if they require the same products. Some customers may be located a long way from the factory and transport may cost more. Other customers may be disruptive and place rush orders that interrupt production scheduling and require immediate, special transport. Some customers need after-sales service and help with tech- nical matters, etc. Table 8.3 contains information on four different customers, A, B, C and D in a manufacturing organisation. A single product is sold but the selling price
ACTIVITY-BASED APPROACHES
differs because of trade discounts offered. Table 8.4 contains the cost per unit of each busi- ness activity and Table 8.5 shows the results of the customer profi tability analysis.
In this example all four customers are profi table, but C and D are not particularly so when compared with A and B. When an organisation analyses the profi tability of its cus- tomers it is not unusual to fi nd that a Pareto curve exists (see Figure 8.1 ). That is, 20 per cent of customers provide 80 per cent of the profi t. In Figure 8.1 it can be seen that in this case the last 80 per cent of customers do not all generate profi t. The last 50 per cent actu- ally reduce the total profi t. There is no point in serving these customers as the situation stands but it may be foolish just to refuse to serve them. Instead it may be better to turn them into profi table customers if this is possible.
A multifunctional team should be set up to fi nd ways of making these customers profi t- able. Usually it is the small volume/order customers who are unprofi table because of high production batch costs and order processing, etc. One organisation introduced a third- party wholesaler into the supply chain and signifi cantly reduced the cost of serving the small order customers. At the same time the organisation found that the product-range and service to the small customers improved, and so the company saved costs and the customer received an improved service.
Table 8.3 Information on four customers
A B C D
No. of units sold 60,000 80,000 100,000 70,000
Selling price net of discount
25p 23p 21p 22p
No. of sales visits 2 4 6 3
No. of purchase orders
30 20 40 20
No. of deliveries 10 15 25 14
Kilometres per journey
20 30 10 50
No. of rush deliveries 1 2
Table 8.4 Costs of each activity
Sales visit £210 per visit
Order placing £60 per order
Product handling £0.10 per item
Normal delivery cost £2 per kilometre
Rushed delivery cost £200 per delivery
Table 8.5 Customer profi tability analysis
A B C D
£ £ £ £
Revenue net of discount 15,000 18,400 21,000 14,400
Costs:
Sales visits (£210 2, etc.) 420 840 1,260 630
Order processing (£60 30, etc.) 1,800 1,200 2,400 1,200
Product handling (£0.10 60,000, etc.) 6,000 8,000 10,000 7,000
Delivery (£2 20 10, etc.) 400 900 500 1,400
Rush deliveries (£200 1, etc.) 200 400
8,620 10,940 14,360 10,630
Operating profi t 6,380 7,460 6,640 3,770
Percentage profi tability 43% 41% 32% 26%
ACTIVITY-BASED APPROACHES
8.3.5 Distribution channel profitability
Distribution channels are in simple terms the means of transacting with customers. The channel is the point of purchase which need not necessarily be the point of communication, payment, delivery and after sales support. Companies may transact with their customers through direct channels e.g. sales teams, telephone, shops, Internet or through indirect channels e.g. retailers, wholesalers, resellers, agents.
Regardless of whether a company’s channels are direct or indirect they should always consider the ultimate needs of the customer and therefore use the channels to ensure that those needs are satisfi ed. Customers will look for ease of access to the supplier, recipro- cal communication, products and services which satisfy their needs, prompt delivery, after sales support to name but a few.
The channel a company selects is therefore a critical driver to business profi tability. A company should not only aim to satisfy the needs of the customer but must also ensure that the products and services that they are providing are profi table. The method of chan- nel distribution chosen can account for a signifi cant proportion of total cost and choosing the wrong channel can result in signifi cant losses for that particular product or service.
Key aspects that the company needs to consider in relation to their distribution channels include; access to the customer base, brand awareness, competitiveness, achieving sales and market targets, speed of payment, customer retention rates and most importantly of all profi tability.
In companies it is just as important to cost channels as it is to cost products and cus- tomers. Different channels will differ in profi tability. Activity based costing information makes this possible because it creates cost pools for activities. Channels will use some activ- ities but not all, and different channels will have different ‘ activity profi les ’ . This makes channel profi tability analysis possible and allows company’s to build up distribution chan- nel profi tability profi les. It can be possible therefore for a company to identify costly dis- tribution channels for perhaps low margin products or services which they are supplying through direct channels which may best be offered through indirect channels thus result- ing in reduced channel distribution costs and a better profi tability profi le for the product or service.
0 80%
1,250
£‘000 Organisation’s total profit –
20% 100%
percentage of customers served Figure 8.1 Customer profitability curve
ACTIVITY-BASED APPROACHES
8.3.6 Activity-based management: strategic activity management
Strategic activity management recognises that individual activities are part of a wider proc- ess. Activities are grouped to form a total process or service. For example, serving a partic- ular customer involves a number of discrete activities that form the total service. Strategic activity management attempts to classify each activity within the whole as a value-added or non-value-added activity. Non-value-added activities are unnecessary and should be eliminated.
Bellis-Jones (1992) noted that typically prior to the introduction of ABM 35 per cent of staff time was spent on diversionary (non-value-added) activities. After the introduction of ABM, total staff time declined and the percentage of time spent on diversionary activities fell to 20 per cent of the reduced time.
Non-value-added activities are often caused by inadequacies within the existing proc- esses and cannot be eliminated unless the inadequacy is addressed. For example, dealing with customer complaints is a diversionary activity, but it cannot be eliminated unless the source of the complaints is eliminated. Another example is machine set-up time. Better product design so that fewer components or more standard components are used will reduce the set-up time between component runs. So management must concentrate on eliminating non-value-added activities.
But strategic activity management is more than just eliminating non-value-added activi- ties, important though this is.
By identifying the cost and value drivers for each activity, the fi rm can develop both the activities and the linkages between them, and so better differentiate the fi rm from its competitors. In addition, by understanding the factors which infl uence the costs of each activity, the fi rm can take action to minimize those costs in the medium term. ABC infor- mation can be used in an ABM system to assist strategic decisions, such as:
● Whether to continue with a particular activity.
● The effect on cost structure of a change in strategy, e.g. from mass production to smaller lots.
● How changes in activities and components affect the suppliers and the value chain.
The value chain is simply a large activity map for the organisation and its position in the industry chain. The chart in Figure 8.2 is a modifi ed version of Porter’s generic value chain. It consists of the main activities both primary (which should add value) and support (potentially non-value-adding unless they aid the primary activities to created more value- added). The organisation’s value chain can be linked with other organisations ’ value chains to form an industry value chain.
ORGANISATION SUPPORT ACTIVITIES
CUSTOMER PRIMARY ACTIVITIES
Inward movement of materials
Manufacture Marketing Distribution After-sales service Information database and structure
Human resource management SUPPLIER
Figure 8.2 The value chain for a single organisation
ACTIVITY-BASED APPROACHES
8.3.7 Using ABC in service industries and activities
Despite the concentration on manufacturing organisations so far in this chapter, ABC can be used by all types of organisation, such as retail, service, nationalised, etc., and in all areas of the business.
AT &T, the US telephone and telecommunications company, fi rst used ABC in the early 1990s as a pilot project in its sales invoicing department according to Hobdy et al. (1994). It used the following types of activities to collect costs:
– Monitoring billing records – Editing checks
– Validating data – Correcting errors
– Printing, sorting and dispatching invoices.
It then spread the activity cost pools on cost drivers that included the following:
– No. of customers tested – Change requests – Service orders – Customer locations – Printer hours – Pages printed.
AT &T found that ABC not only helped managers to manage the costs, but it also helped them improve operat- ing processes and supplier relationships and to raise customer satisfaction.
This shows another role for ABC, namely its use as a one-off attention-directing technique to assess an activity and its impact on the business. Whether it continues to be used as a one-off technique or becomes an integral part of the costing systems is up to management.
ABC is also used in a wide range of service industries, from hospitals to credit card companies. Research into hospital costs and activities by Huang and Kirby (1994) has identifi ed two main cost drivers for a hospital:
– The number of days spent in hospital. Costs included in this category were routine nursing care, meals and laundry.
– The number of admissions. Costs included in this category were obtaining and using the patient’s medical his- tory, preparation for surgery, after-surgery care and invoicing insurers and collecting funds.
This particular piece of research found that Medicare (i.e. the government reimbursement scheme) had been considerably over-charged because it dealt with older patients who stayed longer in hospital than others on pri- vate insurance. As a consequence the absorption rate used prior to ABC, which was a single day rate, gave a charge which was too high for long-stay patients.
8.3.8 Problems with implementing ABC
Much has been written in academic journals of the benefi ts of using ABC and ABM. The majority of organisations still do not use either. Why, if the majority of academics consider it to be so useful, do practitioners not employ ABC? The obvious reason is that they do not agree on its usefulness or cost effectiveness in terms of costs and benefi ts. For ABC to be effective an accurate system is required with as many as 50 different activities identifi ed and costs attributed to them. This requires considerable time and effort.
A certain amount of research has focused on the problems of implementing the system.
Friedman and Lyne (1999) provide some clues as to why ABC has not been taken up with more enthusiasm from case study research they carried out. Some reasons they draw attention to are:
● Where it was devised for a single project that was not taken up the system got dropped as well. As communication between business units in a large organisation is often not very good, the work was not developed further by other units.