With the prospect of a severe downturn on the horizon, minds are turning to cost reduction as part of an overall approach to managing organisations through tougher times. But the way in which costs are cut is crucial. If cost cutting is too severe and indiscriminate then directors risk damaging the long term prospects of the business, but too light a touch and they risk driving the business into losses more rapidly. The key to effective cost management is to understand the true nature of how costs are incurred and this is where Activity Based Costing, ABC is vital. Gary Simon, FSN’s managing editor explains how an ABC approach to costing can be so enlightening.
The notion that businesses truly understand the nature of their cost base is often misguided. No one disputes that costs incurred are recorded in a true and fair fashion, i.e. in proper financial accounting terms, but when it comes to understanding how they are incurred in the business there is frequently a yawning gap between theory and practice.
In broad terms allocable costs of bought in goods and services are normally recorded against chart of account lines and cost centres. Alternatively, absorption costing is used to distribute costs to cost centres on some arbitrary basis such as floor area, headcount or number of PC’s. Whether this represents the way that costs are actually consumed tends to be a rather hit or miss affair. Nevertheless this has been the largely unchallenged basis of financial accounting for a number of decades.
Faced with a down turn, or worse still a recession, businesses are no better informed. As a result, cost cutting tends to follow a fairly arbitrary pattern, such as a 5 percent reduction in headcount in every cost centre or a cut in marketing budget by 12 percent. Such broad brush approaches work in the short term because they yield immediate cost reductions but longer term this kind of knee-jerk reaction can be extremely damaging.
Skilled resources which were expensive to recruit and train, but laid off on a whim, can be very expensive to replace when an upturn arrives and slashing marketing budgets may be the last thing that a business should contemplate when competitors are weak and increased market share is there for the taking. Yet traditional costing techniques inevitably drive this kind of arbitrary behaviour because there is no reliable reference point, for example no way of telling which people should be retained and which marketing budgets remain effective.
The problems are exacerbated because of a major structural shift in western economies over the last 30 years towards service based industries. When countries such as the UK were heavily reliant on manufacturing capability most of the cost structure (80 percent of more) vested in machinery and factory activities, i.e. direct costs of production. Now the boot is on the other foot and most of the cost base of a modern services oriented business is in indirect costs or overheads. The major consequence of this is that it is impossible to see how these costs are consumed in services, products, direct sales and other channels to market.
Part of the reason for the confusion is that costs are allocated to cost centres rather than business activities and processes. Cost centres are often no more than clusters of personnel with a similar skill set, for example, sales, human resources, production and information technology but in practice costs are incurred across the business according to established business cycles. Take for example the ‘Quote to Cash’ cycle for a capital intensive business such as a large scale construction company. Marketing costs to get on the bid list, research, travel, qualifying meetings and the submission of an invitation to tender, which are often costly items, are frequently ‘lost’ in the marketing and sales cost centres with perhaps other significant costs relating to Board involvement simply not recorded at all. Managing the relationship, contract negotiations and variations to terms after a deal has commenced may also attract costs which are not attributed to the project in hand. It is not difficult to see that business deals previously seen as highly remunerative could be seen as anything but profitable when cast in a more realistic light.
John McKenzie, author, lecturer and acknowledged expert in Activity Based Costing (ABC techniques) lays bare in a very practical fashion, the limitations of traditional accounting in his newly released book, “ABC to the MAX”. He explains how ABC has transitioned form a technique which 20 years ago was confined to manufacturing industries but is finding increasing popularity across all service and industry sectors for measuring product, channel and customer profitability.
ABC, as the name suggests, identifies the main activities of the business and the cost drivers which dictate how these activities are associated with, say, customers and products. Using the technique for example it is possible to distinguish customers that are costly to serve (because they habitually change their order at the last moment or are frequently late payers) from those that are apparently less profitable, yet because they are more straightforward to manage, generate more profit.
Armed with ABC principles and facing a downturn, boards of management are empowered to look at their businesses through a fresh set of eyes which allows them to sift out genuinely profitable customer relationships. Similarly, apparently high margin products that suffer quality problems and high customer returns can be axed in favour of products that more reliably produce profits.
According to McKenzie, ABC techniques can be applied very quickly in almost any business setting with just 40 to 50 activities and cost drivers usually being sufficient to re-assess business performance. Rather than cutting costs to the bone – which is the temptation in a down turn – businesses should be re-assessing the cost base to truly understand how costs are incurred. ABC may not only be the key to survival but with its unique perspective it could also be the key to long term profitability.
