It's difficult to calculate the true cost of a product when the same resources are used to generate different goods, says Sarah Perrin. Activity-based costing may be the answer.
Businessmen may think they already know how profitable their widgets are. They know the materials and labour costs which, hopefully, are covered by the price. But what about those extra indirect costs? For example, does the marketing department spend a major percentage of its time on one product line, devising promotions to shift stock? Does the finance department have to keep chasing one customer for payment? All these activities incur a cost. Whenever the same resources are being devoted to different goods you need to look harder to calculate the true cost of a product.
Activity-based costing (ABC) is one answer. It takes every cost generated by the business and allocates it proportionately to the products or services that it has helped create. Customers too can be analysed to see whether some are more costly to serve than others. Only once all costs have been allocated do you have a complete picture of how profitable each of the different products or services really are.
That's the simple explanation, but the process is easier talked about than done. 'It's difficult to get a simple explanation of activity-based costing,' says Colin Drury, professor of accounting at the University of Huddersfield. 'It's about trying to break an organisation down into many different activities rather than departments. It's about finding the causes of costs.'
The process itself does appear complex to the uninitiated. It requires the identification of all the activities performed within the company.
'For small or medium-sized companies, I would expect to divide the business into 300-400 activities,' says John McKenzie, director of consulting for ABC software developer Armstrong Laing. Most departments could be broken down into 30-50 activities. Within accounts receivable, for example, one key activity would be chasing late payers. Having identified that activity, the next step is to establish how much time is spent on which customers.
This can be done by getting staff to fill out time sheets or answer questionnaires.
You can then estimate the cost of debt-chasing activity and allocate it proportionately over those late-paying accounts. Suddenly you have a better idea of how much each customer costs to service. By applying the technique to all the other departments, and all the activities within departments, the complete cost picture for each product or client appears.
So far so good. But it is what you do with the information that counts. Hence the term activity-based management (ABM). One example of ABM would involve looking at all the activities in the company and breaking them down into four types: those that add value to a customer; those that add value to the business; non-value-added activities (such as correcting mistakes in invoices); and sustaining activities (such as the annual audit, which is required by law). Those non-value-added costs can then be compared with their value-added counterparts.
If they make up a high proportion of the total, then there is scope for cost-cutting. 'Sustaining and non-value-added costs often come out at around 50% of the total,' says McKenzie.
'That's when you find you can eliminate some of them. That's when people get excited.'
Further analysis shows which products or customers are profitable. You can find yourself in the uncomfortable position of learning that, say, 10% of your company's products account for 100% of profits. In other words, 90% are loss-making or just breaking even. The advantages that stem from applying the ABC technique are clear. 'Activity-based costing will give you much more accurate product costs or service costs,' says Margaret May, director of the Management Accountants in Practice (MAP) consultancy, and a specialist in activity-based techniques. 'It gives you the opportunity to look for improvements in your operations.' That could be vital information for business process re-engineering projects, for example. Investment strategies can be revised to concentrate on products or customers that provide a greater return to profits. Even very small companies can benefit.
McKenzie's smallest client had a turnover of £1.5 million and 70 employees.
However, there are downsides to the ABC experience, not least the hassle of introducing it. Gathering the data takes time and effort. Staff need to be willing to participate. It causes an administrative burden in terms of filling out time sheets, charging every item to specific codes, accounts or products. 'It takes a lot of time for someone to dedicate to it,' says May. 'If you are looking at indirect (cost) areas, then people usually have no idea how they are spending their time.' Hugh Evans, the partner responsible for Ernst & Young's performance management practice, agrees.
'You need dedicated resources. 'You also need the managing director and the finance director to say it's important.'
Front-end consulting advice is helpful, if not essential. Exactly how much design input you need at the front-end depends partly on whether the activity-based costing is being performed as a one-off exercise, or as the start of an ongoing process. But those companies which use consultants should not allow them to do the actual activity-based costing work, nor lead the implementation team. A company that performs the activity-based costing process itself benefits through the in-house team broadening its knowledge of the business, through increased belief in the results, and the saving in consultancy fees. 'Most of the big consulting firms do their own activity analysis,' says Evans. 'They interview lots of people. But any organisation has a generic set of activities that you can pre-define. We use an "activity dictionary" and we customise it for clients. That allows them to go out and do the activity analysis and interviewing themselves.'
One of Evans' clients was an Irish nuts-and-bolts manufacturer - generating turnover of around £16 million - that started to customise its designs.
An ABC exercise revealed that the design costs associated with the new products had soared, but because they were spread over all the products the company hadn't realised that these new designs were loss-making. 'We showed them that the product cost was far higher for the niche nuts and bolts and they were losing money,' says Evans. 'They changed their sales strategy and turned the whole thing round. Now they are using ABC to help identify value-added and non-value-added costs.' The consulting fees totalled £25,000, the company doing most of the data collection and analysis themselves.
IT expense comes with the ABC experience. 'If you go beyond any basic analysis level, a spreadsheet won't do it for you,' says Evans. Luckily there are simple packages available, priced at between £4,000 and £8,000.
Leaders in the field include Armstrong Laing's HyperABC and ABC Technologies' OROS. But the data has to be analysed calmly. 'You have to use the information intelligently,' stresses McKenzie. 'You have to look underneath it. Like anything, ABC is for the guidance of wise men, but the obedience of fools.'
Activity-based costing provides information on which to base decisions.
It brings rewards, but is not for the faint-hearted. 'Some of the results are frightening when you look at them. It turns your whole perspective of the business upside down,' warns Evans. 'It means you can't hide behind a veil of ignorance any more.'
HOW SHARWOOD LEARNED ABOUT ITSELF
The ethnic foods producer, J A Sharwood & Co, which has a turnover of £60 million, ventured down the activity-based costing route last year.
Says finance director Robert Gould: 'We looked at the whole business.
We split the company into three groups - factory, head office and distribution. Then from around June to November 1996 we went through the process of data collection, preparation and modelling.' That data was then reconciled to the accounts, which took longer than expected. 'It was only about May this year that we got the first of the final numbers out.' Sharwood's, which has around 300 employees, has now set up a project team with two key tasks. 'The first is to refresh the data on an ongoing basis and get it embedded into the monthly reporting cycle,' says Gould. 'The second is to take action on the results.' Taking action means eliminating non-value-added activities and redeploying saved time and effort elsewhere.
It also means examining product and customer profitability and correcting poor performers. 'We also need to understand why some customers cost us a lot more than others,' says Gould. 'Once we are happy with the robustness of the numbers we will go back to the retailers and work through the figures in partnership with them.' Gould is satisfied that he does now have far better customer and product profitability data. 'It has made us ask a lot more questions than we thought,' he says. However, Sharwood's experience shows that you can't rush. 'Fully embedding it in our culture, referring to it each month and using it as a budgetary tool is the next step,' Gould says. 'There isn't a quick pay-back. The more you look into it, the more you find. We are still scratching at the surface.'
FIVE WAYS TO GET THE BEST FROM ABC
- What it is you are trying to cost
- Tailor an 'activity' dictionary that suits you
- Don't underestimate the resources you will need
- Get someone on the team familiar with both accounting issues and the business processes
- Get commitment from the top to act on results.