Why ABC/M and Profitability Measurement is crucial to services and shared services businesses
19th November 2007 The notion that Activity Based Costing is only relevant for manufacturing entities is wildly misplaced. Whilst it is true that ABC methodology is rooted in manufacturing processes it has now established itself as a major performance management tool in the services sector. In fact, John McKenzie, FSN contributing editor argues that with increasing competitive pressures the case for applying ABC techniques in services oriented businesses becomes even more compelling. In this feature he follows up his article on customer, product and distribution channel profitability analysis with an in depth look at service profitability and shared services costing.
It is often said that ABC/M was developed to provide greater insights into the management of costs and understanding profitability in product driven, manufacturing based companies. Nothing could be further from the truth. Whilst early applications and case histories were more manufacturing focussed, equal importance has been given to its application in service sectors. The methodology and principles that have been discussed in this series hold just as true for the costing and profitability assessment of services as for products. It is becoming increasingly common for service organisations to talk about the products they provide. Indeed, go behind the scenes in many of the major financial service providers, for example, and they talk about product development and manufacturing, even having organisational functions named this way.
Just as a series of activities and workflows combine to produce tangible products that can be physically held, the same happens to provide an intangible service and it is the unlocking of the costs of these service driven activities that give the required insight. Even more so than with products, our accounting practices fall short in dealing with the tracking, measurement and assignment of service costs. For most services there are very few traditional direct, “cost of goods sold” such as raw materials and direct labour. The majority of costs fall below the line and so apportionment is often even more arbitrary than in manufacturing. Furthermore, there are a number of factors that differentiate service companies from manufacturing that make the application of ABC/M even more imperative.
The above table points to factors which make higher degrees of competition a certainty in many service sectors, price becoming a major driving force and hence the understanding costs of provision of service vital to preserve or enhance profitability.
ABC/M has found widespread application in financial services, gas, water and electricity utilities, retailing, logistics, government bodies, local authorities, charities.... the list is endless.
Case Study 1
The major UK electricity utilities, at the time of industry privatisation, recognised that the opening up of the supply market was bound to put huge pressure on prices that could be charged to the consumer because of industry price regulation and the creation of competition giving consumer's choice of supplier. This, coupled with the advent of shareholders and their expectations of satisfactory returns on investment meant that serious steps would have to be taken to control costs in a falling price environment. ABC/M was used by one of the major electricity supply companies to break down its provided services into costed workflows such as change of address, debt recovery, meter reading, customer acquisition, consumer call handling and more. This highlighted a number of deficiencies and opportunities that could be addressed.
As consumers we might have paid, at the time of privatisation, a typical average electricity bill of £300 of which in the order of £230 covered the costs of power generation and primary distribution leaving only around £70 accumulating to the Regional Electricity Companies (REC's) as their margin, Out of this, all of their activities of supply had to be paid for. It was found that the change of address process alone cost on average £32 covering closing and opening meter reads, customer account closure, opening or amendment! Debt Management cost a further £18 on average rising steeply if recovery went beyond simple reminders and into active debt recovery and legal action. Customer acquisition cost £16 per acquisition given the low percentage rate of conversion. The story goes on. Even regular meter reading was shown to have abnormally high costs with the errors on usage estimation and customer self reads and the subsequent bill corrections indicating that a return to regular quarterly meter reads – the “knock on the door” – was likely to reduce overall costs unless deficiencies were corrected.
This knowledge enabled customer acquisition to be targeted more carefully towards customers with behaviour profiles that were more likely to generate lower costs and to revise working methods and processes to increase efficiency. Given the costs shown above, imagine the overall yield on a low usage customer, who changes address twice in a year, pays consistently late, has erratic consumption profiles and makes multiple calls with queries or concerns.
Shared Service Provision
Traditionally, organisations have covered the costs of internally provided services through corporate recharges, typically formulated at the time of the annual budget. These recharges are rarely understood outside of the finance function, lack transparency, have little relation to the way in which costs are actually driven and are often resented by management on the receiving end who are under constant pressure to perform within their budgets and receive monthly, microscopic examination of performance through variances, yet have little say or control over levied recharges which they are expected to cover. Furthermore, the lack of transparency and automatic coverage of these recharges leads to little incentive to reduce these costs on the part of the provider.
Increasingly, organisations are seeking to provide these internal services on a more “commercial” footing, charging for services provided on an actual consumption basis and governed by “arms length” service level agreements. ABC/M is finding widespread application in the costing of internal service provision leading to “rate card” billing on a monthly or quarterly basis against the drivers of consumption. The transparency attained allows both provider and user of services to work in partnership to reduce or limit costs as well as permitting benchmarking against external providers of similar services. Functional areas such as I.T., Finance, H.R. Internal Distribution and others have all been treated, successfully, in this way.
Case Study 2
With escalating I.T. costs, one of the major U.K. banking organizations sought to put its I.T service provision to its branch network on a more transparent footing. Below is an extract of the resultant rate card produced on which I.T. service charges were levied, branch by branch on a consumption basis.
These and other elements replaced the recharges by which I.T had traditionally recovered its costs. The transparency enabled individual branch managers to take actions to reduce consumption locally and also to work with I.T. in achieving greater efficiency. The fixed cost element was kept low, covering only basic essential background infrastructure. All staff costs, for example, were to be found in the variable elements. The outcome enabled the rate of I.T. spend to be slowed down to the extent that it was estimated that around 20% cost avoidance was achieved in the following 3 years.
Case Study 3
A leading retail organization, concerned at its high level of overhead spends, sought to create transparency and awareness, amongst management, of the true drivers of internal service costs and to create a shared service environment. Recharges were replaced, as in the case above, with quarterly billing for provided services. Below is an extract from the rate card produced, through ABC/M, covering the finance function.
Again, governed by service level agreements and charged on an as incurred basis. This enabled management to take steps resulting in significant cost reductions and comparison to external service providers. This latter action resulted ultimately in the outsourcing of a number of functions such as payroll and debt collection where greater cost efficiency could be obtained.
The next article in this series will turn to the use of ABC/M for budgeting, both as an aid to improving our existing budgetary processes and full Activity Based Budgeting.
