"Most entrepreneurs have no idea what it really costs them to produce a product or service," asserts Al Sloman. He's the veteran industry consultant recommended to Post by the friend who had examined her books and sounded the alarm. When he was hired to help her, Sloman made it his mission to get Post to understand more than the operational side of the courier business. She knew all about that. His goal was to teach her the business side of the business -- to get her to understand and acknowledge that in addition to dollars in (sales), she also had to deal with dollars out (costs). If Post was going to be the chief executive of Diamond Courier, not just its chief salesperson, Sloman believed, she would need the management-accounting tools that would let her test her assumptions. Over several months in the fall of 1994, Sloman helped Post learn to use several of those tools. But just as important, he also gave her a clearer understanding of what her job as owner and manager of a fast-growing company had to be.
Chief among the tools that Sloman showed Post how to use was profit-center analysis, which amounted to showing her how to build an income statement for every business line Diamond was in. A profit-center analysis can reveal which activities -- or, for that matter, which sales territories or branch operations -- are making money and which are not. For Post the analysis proved to be eye-opening.
The key to building a profit-center statement is knowing how to identify all the costs associated with a particular business activity. Sloman helped Post extract sales and cost data for each of the businesses Diamond was in by poring over work records and computer files. Line by line, they compiled the labor costs, the operating costs, and the administrative costs directly linked to each of the six business lines. They could have stopped there, but the profit picture would have been incomplete. Because Post's back office had grown so rapidly and come to generate such a large portion of total costs (sales, general, and administrative costs made up about 30%), they also had to allocate those indirect costs among the various businesses. How the overhead costs were allocated was crucial, because the allocation rationale would, in part, determine which businesses showed a profit and which did not. Sloman urged Post to use an allocation system known as activity-based costing. (See "Resources," below.) Essentially, activity-based costing assigns overhead costs to the various businesses not in proportion to their revenue shares (which is the conventional technique) but in proportion to their respective use of the company's resources. "If employees and managers could say how they used their time, we used that," says Sloman. "If not, we looked at the level of activity, say, the number of jobs per profit center" as the basis for allocating overhead.
As they proceeded through that exercise over a period of weeks, the scales began to fall from Post's eyes, and the errors induced by her earlier assumptions became painfully apparent. Nowhere had they been more misleading than in Diamond's original business -- downtown bicycle-courier services.
For instance, Post had assumed that if competitors could make a living with prices lower than hers, then she had to be making money, too. She had assumed that the revenues generated by her bike-messenger business contributed handsomely to total company revenues and profit, since the bike customers were among her oldest and largest accounts. (Besides, to Post's thinking, Diamond's downtown image was the colorfully shirted Diamond Courier cyclist.) Because the back office was always busy, Post assumed that her bike messengers were busy, too, which meant that they were working on commission, not for the minimum hourly wage she guaranteed them. And since the commission was roughly a 50-50 split, Post assumed that 50% was her gross margin.
How wrong she found that she was. The bicycle division, which she thought of as Diamond's core business, generated just 10% of total revenues and barely covered its own direct-labor and insurance costs. (See "Bike Delivery: Profit and Loss," below.) Worse, the division created more logistical and customer-service nightmares than any other single business, thereby generating a disproportionate share of overhead costs. Diamond wasn't making money on bicycle deliveries. It was charging customers $4.69 per job, but with fully allocated costs of $9.24 per job, the company was losing $4.55 every time a cyclist picked up a package.
Post's assumptions about her bike couriers' productivity had been completely wrong. Instead of the three deliveries an hour she assumed they made, the real figure was less than half that. So, instead of the 50% gross margins she assumed she collected on each $4.69 bike job, the real margin worked out to only 10% -- not even enough to cover her overhead, never mind providing a profit.
