REALIZING THE POTENTIAL OF ACTIVITY BASED COSTING (ABC)
recently delighted, but surprised, to be booked to do a workshop at a fall ‘08,
distribution association convention on the topic of “Activity Based Costing” (ABC).
ABC is a cost modeling methodology for getting a better sense of the true profits
from - customers, services/products, suppliers and other business decisions –
that was first ‘productized” in 1987. Back then, it got a lot of
“this-will-revolutionize-business” hype, but the adoption rate has generally
been slow across all industries. Some industries – banking, casinos, large
logistics firms – are heavy users, but activity within independent distribution
channels is maybe about 10% or less.
have been personally involved in some terrific, distribution-company turnarounds
that were both guided and energized by ABC ranking reports (starting in 1976) for
profitability of – customers, suppliers, branches and employees – most distributors have not tapped the full
potential of ABC analysis or even philosophical thinking which raises at
least these questions:
Why the low, slow adoption rate for ABC by distributors
over the past 21 years?
Why the weak follow through at firms that do get first or
second-hand ABC insights?
How can we make ABC a more user-friendly and less
threatening tool with simple starts?
What would be the first, easiest distribution-specific,
ABC applications to try?
Is my recent booking a sign of broader interest within
And, from the non-user crowd: “First, what exactly is ABC
simply put, is an accounting method (not software, although there are ABC
software tools available) for assigning a firm's "resource costs" for
all activities that go into producing products and/or services by a more
detailed splitting up of and re-assignment of indirect or overhead costs. (Readers
can google ‘activity based costing” + “six steps” and find all that you need.)
example, if two customers of a distributor each bought $1000 of goods with $200
of margin dollars in the order, how much
profit did each order put to the bottom line? It depends, of course, on the
number and degree of service cost activities. What if one order involved every (extra)
service cost imaginable while the second was generated by a non-commissioned,
house account which was ordered electronically for standard, in-stock,
fast-turning goods and then picked up by the customer who paid in cash? We know
intuitively that the second order is more profitable, and we are grateful to
have it to cross-subsidize some of the losing orders that we know we have
everyday. Our financial reporting systems have been shaped to pay our taxes on
time and do asset-backed borrowing from banks; they don’t tell us which
suppliers, products and customer combinations make us the most money, which
really defines our competitive strategy.
the two order problem to customer profitability analysis for an entire year’s
worth of business, it is not uncommon for an ABC analysis to rank customers
from the most profitable to the biggest losers to reveal the following magnitudes:
The top 10% of the most profitable customers yield 90-100%
of company profits (The top 5 accounts are sensationally profitable; should we do
anything extra not to lose them? Or, to sell even more to the core more
The top 40% cumulatively yield 140-150%, which,
let’s say, is the breakeven point for the ranked customers.
The bottom 60% start as negligible losers to finish
with a few, shockingly-big losers at the bottom. The cumulative losses on the
bottom 60% offset the extra profits from the top 40%, so that 100% of the
accounts do total to 100% of the profit before interest and tax (PBIT).
But, the bottom 1-2% of the customers will, notably
and amazingly, lose as much as 20% of PBIT (Should we try to turn these “lead”
accounts into profitable “gold” accounts? How?)
the barriers to using ABC? Are there pitfalls? As we read about ABC on the
internet, it becomes quickly apparent why there is low usage of ABC by firms
that are small with less moving parts, owner-operated, sales-driven and without
good accounting expertise on staff:
A would-be practitioner must learn new: vocabulary,
building block concepts and spreadsheet ability before rethinking the overhead
costs assigned to product or service process steps that thread their way through
Mapping a process and interviewing everyone
involved in that process to get time allocation assumptions to compute activity
costs for an ABC model is tedious, although it can often reveal new process
The level of detail that goes into the model is a strategic-trade-off
choice that must balance the cost of getting and maintaining new information
with the immediate action value. Too much detail makes the model unwieldy and
difficult to use on an on-going basis; too few cost-assumptions can make the
model’s estimations of profitability less accurate. Because no model can simulate
the dynamic reality of a business perfectly; where is the optimum balance? And,
because no two similar distributors will make all of the same assumptions and
detail choices even when using the same “best practice’ distributor ABC
software tools, all models and results will vary to some degree.
It’s easy to get caught up in “analysis paralysis”,
especially if we don’t know what our intended, disciplined strategy is. ABC
analysis can help us optimize the past, but it does not directly reveal why the
most profitable customers became that way or how others could too.
Any remarkable ABC conclusions will then be a
direct challenge to the (unspoken) cultural rules that have been running the company
and helped shape and deliver the current results. ABC will typically reveal
huge, heretofore, hidden, internal cross-subsidies between: customers, SKUs,
suppliers, employees, truck routes, sales territories, branches, etc. Expect big
push back from the creators and leaders of the current system as well as any
team members who are suppose to change themselves before they then try to
change customer behavior, i.e., most of the management team and outside salesforce.
If a distributor principal decided to try an ABC
experiment, what should be the first, easiest and most fruitful effort? It
depends, I think, where the company’s industry and customer base are in a
life-cycle sense. If we were selling mobile phones in 2000 and had exclusive
product and service-contract franchises for a geographic area which we could
maintain as long as we pleased the supplier with great annual growth rates,
then we should apply ABC to our products to determine which ones we should sell,
preferentially to (frankly) new-demand, first-time, somewhat ignorant customers.
If we are selling experienced, consolidating customers who are buying commodity
products, which every distributor has, for the zillionth time and wants to buy
these products at the “lowest total procurement cost” (however they personally
define that), then we should start with customer profitability ranking reports.
choice of customer profitability ranking reports is supported by several more
If our simple, average, product mark-up practices
have (hidden?) cross-subsidies built into them, then so might our competitors.
This will create a pattern like we see in fast food restaurants where they
breakeven or loss-leader-promote entrees to then make more than 100% of their profits
on the drinks, fries and service items. What then becomes important is total
margin dollars generated per customer transaction/visit and best retention
rates for the best type(s) of customers. If a restaurant who tried to make the
same true profits on all of their products – as a result of ABC studies, it
would probably not do well.
If the product lines we stock and sell are not
exclusive and/or there are equally excellent alternative lines for all
competitors, then we have no competitive advantage from the tangible products
we sell, our profit power has now shifted to selling the best, one-stop-shop
assortment of items (in-stock, fill-rates are THE foundational service factor)
to the right, best, most-profitable
customers within a given target niche.
A simple, initial-model for customer profitability
can be created without much work.
Once we can rank all customers by an estimated PBIT
contribution, we can then manage the few (5-10) most profitable and
unprofitable accounts with more manual analysis. If we then want to do more
refined ABC model building to investigate greater numbers of customers in the
middle of the ranking report, we can. Start simple. Learn, act and then do a
next level ABC model analysis. Don’t get caught up initially in analysis
paralysis and arguments about all of the cost assumptions when people don’t
like the results of the study.
necessity is the mother of invention, then today’s tough economy might be the
spur that we need to try and look at our business in a radically new way
through ABC profit reports. In the spirit of testing cheaply, it isn’t
difficult or expensive to check out the support materials in this article’s
footnotes and try to run a first, simple model for customer profitability. If
any readers already have tried or subsequently create ABC modeling, then I
would be glad to hear about your case studies. Please don’t hesitate to contact
me via email at email@example.com.
Otherwise, may remarkable ABC discoveries come your way!
Consulting Group, Inc., Article 2.27