ABC/M and Profitability Measurement and Management
15th October 2007
So far in this series, we have examined the principles of ABC/M and a practical methodology for its implementation, John McKenzie, FSN contributing editor, now turns to applications of ABC/M starting with customer, product and distribution channel profitability analysis and management.
We all know that some customers are easy to do business with and that others are more demanding in the way we interact. With ABC/M techniques we examine the nature of the end to end transactional processes between ourselves and customers, i.e. the activities undertaken and the volumes of the associated drivers, and highlight the differences between customers and the costs incurred by ourselves
By focusing on these customer driven costs we can begin to build up a picture of the true costs of differing customer relationships as in the example below.
Frequently, judgments about customer attractiveness are based on revenue and gross margin. But as has already been shown, neither of these take into account many, if any, costs generated by customer behavior. In this example, customer A has a good payment history, tends to order in larger quantities but less often and requires little sales attention. Customer B however is a poor payer, orders frequently and has relatively low loyalty requiring sales attention. We see a reversal of our view of customer attractiveness having taken into account, on an activity basis, below the line costs such as sales, order processing and accounts receivable. These costs would all too often be simply absorbed onto product sales using arbitrary methods such as number of units sold, relative revenue or gross margin. Even were we to be a little smarter and apportion these costs by simply number of orders, we would seriously misstate the true picture – try it and see.
Case History 1
A very large, multi-national express distribution organisation undertook a full ABC study and found that many of its prized customers were not as profitable as they thought. Compared to the traditional view, some 10% of their upper quartile customers, when viewed by ABC fell in fact into the lower quartile. The ABC profitability profile, seen below, showed a significant concentration of profit amongst few customers with just under 30% of them accounting for “100%” of profit.
As can be seen, the profit potential in the business is some 32% higher with unprofitable customers “losing” profit potential. In reality, of course, businesses will always have some unprofitable customers for legitimate reasons, either new business or other, strategic reasons.... but the picture above is a far from happy one. In this case, the cost of rebating, customer specific behaviours, excessive sales force activity and onerous logistical requirements were driving the profitability of a number of key accounts way down. Standard costing failed to track the hoops that were being jumped through for prized and other customers and the company focus was simply on revenue and margins with this end result! This picture is not at all unusual to find following ABC analysis, indeed, it is the norm or even more extreme.
Turning to products, we find a similar situation. Our traditional accounting practices permit us to measure cost of goods sold (raw materials, direct factory labour etc.) with reasonable certainty, but there is an enormous amount of product related cost buried away in overhead. For example the cost of the activities undertaken in functions such as purchasing, supply chain management, accounts payable, goods inwards and many others are treated inappropriately in a standard or absorption cost environment. With ABC/M techniques we examine the nature of the end to end processes and activities that bring a product to readiness for sale.
Just as in the customer example, by focusing on these product driven costs we can begin to build up a picture of the true costs of a product as in the example below.
Case History 2
A well-known food manufacturer undertook an ABC analysis of its product contribution, i.e., sales revenue less raw materials, ABC attributable manufacturing costs and ABC product attributable non-manufacturing costs (e.g. product development, supply chain management, purchasing, advertising, direct product promotions, etc.). Excluded are all customer driven costs such as order processing, help desk, customer driven sales, marketing and promotional activity, etc. These must be paid for out of product contribution. The following product contribution profile shows the prevailing situation.
Here you see that c.70% of the product range fails to generate positive contribution having taken all product related costs into account and this is before the consideration of customer driven cost. In common with many other food manufacturers half of the product range is made in-house with the other half either contracted out to a small number of suppliers or simply bought in and branded. The analysis of made-in versus contracted out or bought-in products is revealing. Of the products made-in, c.80% lie in the right hand, “unprofitable” half of the graph. Conversely, 80% of bought-in products lie in the more profitable left hand side. This resulted in a major review of internal practices, working methods and technology and an external look at competitor methods that triggered a re-engineering program which showed very substantial savings.
Finally we turn to channel profitability. The way in which we choose to go to market can have a huge impact on subsequent costs yet we take important strategic channel decisions without a full understanding of these. Consider the following.
These channels have very different costs to serve, yet the majority are to be found, primarily, in overheads and allocated on some arbitrary volume basis. Opening up these costs through ABC/M provides revealing insights.
Case History 3
The above is a channel analysis performed by a large confectionery manufacturer. Their distribution strategy was confused, driven by a series of management and workforce incentives linked to gross margin. What the ABC/M study revealed was an inverse relationship between gross margin earned by each channel and the profitability, once channel costs had been correctly apportioned. Whilst for example, the small independent stores were generating high gross margins through lack of purchasing power, the cost to serve through a direct sales force, multiple delivery points and manual transactions was very high and more than negated the margins earned. The outcome of this study was a rationalsation of channel strategy, feeding business through the wholesale intermediaries and discontinuation of direct supply to the small independent trade, along with a shift away from margin triggered incentive schemes.
In the next article we will be examining service costing and profitability analysis and costing for the internal provision of shared services.
