In his first article for FSN, Brian Plowman, contributing FSN author and managing director of Develin & Partners showed how ABM brings a different perspective on how costs are treated and challenges the traditional approaches to product costing and measures such as gross margins. In this feature Brian takes the discussion a stage further to explore the nature of the differences that an ABM approach exposes and suggests what actions can be taken to improve profitability for products and customers that exhibit poor “ABM contribution”.
It is in the area of product costing that serious weaknesses in the traditional approach to product costing first became a cause for concern. In the days when traditional accounting practices were being formed and internationalised, the dominant industries were in the manufacturing sector. In a typical large manufacturing company, there would be as high as 90 per cent of employees concerned with direct manufacturing and 10 per cent in the overhead departments so it was important to get some accuracy in terms of the hours, and therefore costs, of actually making components and assemblies. Work-study and other techniques found a ready use in determining the direct labour content of any product. The direct material costs were also simple to calculate for each product based on raw material content, scrap rates, bought-out parts and so on. How much of the overhead activity was actually associated with each product was seen as a lot of effort to work out for such a small improvement in the accuracy of the product cost. This led to the use of the Overhead Recovery Rate (ORR) as the fundamental method of product costing.
To derive a method of calculating the proportion of overheads to allocate to each product a simple ratio was derived, known as the ORR. A company would simply find the overall ratio between total Overhead Costs and total Direct Labour, say ten per cent. The direct labour for each product made, and any new ones developed, would then have ten per cent added to account for the Overhead and so give the product cost.
As manufacturing became more complex, the proportion of overhead activities to direct activities started to increase. Product costs now became far more sensitive to the indirect and overhead costs associated with each product. The traditional overhead recovery rate became highly suspect as a means to calculate product costs. Some products could be seriously under-costed, and thus probably highly competitive, but an increase in sales volume would actually erode profitability. Conversely, over-costed products would be unattractively priced and few sales made.
As the proportion of overhead costs increased in a business, the more serious the distortion in product costing became through using the ORR method.
So how does ABM deal with this change in emphasis? In ABM the indirect and overhead costs associated with each product are determined for each product. The characteristics of two products can be quite different in the way they need overhead activity to support manufacture. Let’s look at an example.
A company that traditionally had made its name manufacturing bogies for railway trucks and carriages had branched out into making braking systems for long haul diesel road vehicles. While the technology surrounding the railway business had not developed significantly over the years, the road vehicle technologies had advanced in complexity at a rapid rate. Using direct labour as the determinant of the proportion of overhead costs had led to overpriced railway products and underpriced road vehicle products. The growth in the road vehicle business then seriously eroded overall profits and the stable rail business was drifting to competitors.
Using the ABM approach the direct and actual overhead costs reflected the real situation. In other words, in reality one product was less profitable than they thought while the other product was the converse.
In traditional accounting we find the term gross margin, defined as the revenue less the direct costs. As long as the gross margin is a positive number then the product is deemed to making a ‘contribution to overheads’. In other words, whatever the overheads actually are, at least there exist some funds to pay for them. So why, in ABM, is gross margin seen as such a dangerous measure?
The issue is that we do not know, other than at the overall company level, whether the gross margin has any bearing whatsoever on the real overheads involved in producing each particular product. In the product costing examples above, the ABM analysis uncovered the actual indirect and overhead costs associated with producing each product. Now when we calculate the revenue less the actual product costs we have a number that is called the ABM Product Contribution. In other words, if this is a positive number then we know that all direct and indirect product costs are covered and the sum left over now contributes to the other overhead costs in the business such as Sales, R&D, Invoicing and so on.
The ABM Product Contribution is a fairer basis by which to compare one product to another. We can show each product on a graph where we plot the cumulative product contribution, highest to lowest, for all the products. The resulting graph, the appropriately named ‘hook curve’ is shown in the figure below. The hook curve is one of the most powerful ways to display the outcome of the ABM analysis.
As we would expect, one product is something of a cash-cow, such as ‘Pr2’. The traditional gross margin calculation also gave a high figure and we now know that there are no issues concerning high levels of indirect and overhead activity. However, as we add more and more products to the graph, such as ‘Pr1’, we eventually find those where the revenue only just covers the real costs of manufacturing. The ABM Product Contribution gets smaller and smaller until some products balance out to zero.
At the tail end, we might be unfortunate to discover that some products, such as ‘Pr3’, which have a negative ABM Product Contribution. In other words, the revenue we obtain is insufficient to cover the actual manufacturing costs of the direct materials and labour and the appropriately assigned indirect and overhead costs. What is often surprising is finding products in this category where the gross margin is positive. We believe the situation is acceptable as long as they are making ‘a contribution’ to overheads. The reality is that any volume increase seriously erodes overall profitability rather than building up a useful contribution to cover overheads. The increased volume contributes only to losing even more money.
The discussion so far has emphasised comparing revenue to actual product costs to give the ABM Product Contribution, but this contribution has to pay for a number of significant costs associated with getting the sales in the first place, getting the products and services to the customers, and finally collecting payments. All these activities are customer-related costs. How does ABM treat such costs?
An ABM analysis of these activities enables businesses to assign the customer-related costs to each of the customers. In some cases, individual customers will be appropriate, whereas in others, meaningful segments or groups of customers will be the basis for the analysis.
In a particular company, customer ‘X’ manually raised large numbers of low value orders, raised many queries, made many returns due to ordering errors, and had a poor payment history. Customer ‘Y electronically raised a small number of high value orders, paid through Bank transfers and never raised any queries or made product returns.
The gross margins made from both customers could well be equal but the costs of doing business with one are significantly higher. By calculating revenue less the real costs of the products the customer is ordering and less the real cost of servicing the customer, one is left with the ABM Customer Contribution. This figure is an appropriate basis to compare one customer to another.
A graph of cumulative customer contribution (highest to lowest), for each customer. again generally results in a hook curve but usually flatter than for the products. Many customers could be giving no contribution at all as shown on the figure below with some seriously eroding profitability.
As one would expect, one customer could well be a cash-cow. The traditional gross margin calculation gave a high figure and we now know that there are no issues concerning high levels of overhead activity associated with the customer. However, as we add more and more customers to the graph, we find those where the revenue only just covers the real costs of the products and the real costs of servicing the customer. The ABM Customer Contribution gets smaller and smaller until some customers balance out to zero.
At the tail end, we might be unfortunate to discover than some customers have a negative ABM Customer Contribution. In other words, the revenue we obtain is insufficient to cover the actual manufacturing costs plus the customer servicing costs. What is often surprising is that customers in this category may have positive gross margins. Again we believe the situation is acceptable as long as they are making ‘a contribution’ to overheads. The reality is that any volume increase seriously erodes overall profitability rather than building up a useful contribution to cover overheads.
We know, instinctively, that some customers are more profitable than others. We also know that some are probably loss-making. We may also have some idea of which customers are probably the least profitable and which are the most profitable as anecdotal evidence will pick up the extremes. The hook curve shows the situation with the other 99%. This is often a profound shock to management. Hidden from view by the smoke screen of gross margins, the reality of products that lose money and customers that lose money are now shown in sharp relief. The question then arises over what to do about the low or negative ABM Contributions.
The first instinct is likely to be an instant desire to get rid of the products and customers who are in the negative part of the hook curve. But one needs to be cautious because it is in this area that the hidden additional profit lurks. The approach should be to convert the negatives into additional positives. The quick answer is to raise prices for the products or to specific customers. While this may seem fair, particularly to ‘awkward’ customers, in general, market forces probably determine the upper limit on prices, usually the current prices!
The first approach is to look at the characteristics of the products or customers in the high ABM Contribution end of the hook curve and then attempt to create these characteristics for the negative area. This would be the ‘best practice’ approach. In some cases the processes that interact with the customer may be creating problems for both parties. Resolving these types of issues opens up a constructive dialogue with customers where the outcome is likely to be a reduction in process costs for both. This is a win-win solution and should be the first outcome to search for.
Another consideration before eliminating customers is the amount of ‘fixed’ costs that may be affected. In ABM we argue that no costs are fixed, all of them can be influenced in some way. However, for a warehousing and distribution business, it is not easy to reduce the size of the warehousing facilities or vehicle fleet in the short term. In this situation, taking actions to change from a negative to a positive ABM Contribution is the first course to explore. As a last resort, letting negative customers go to competitors is one way of shifting known unprofitable business to other companies that will be glad of the volume but will not be aware of the unprofitable nature of the business.
Clearly there are a lot of fascinating and relevant analyses that ABM can deliver but the single most important difference about using ABM is that a business makes decisions with knowledge that it can trust. Traditional accounting no longer delivers answers that fit this role.
Related FSN reading
Activity Based Costing (ABC) and management opens new vistas on profitability
Why Activity Based Costing may be just the tonic in a downturn
