New software exposes the true costs of your products and services, and tells you which of your customers are less profitable than you think
Management at privately held Koehler Manufacturing Co. recently experienced a rude awakening: its best-selling product line--lead-acid batteries--was devouring company profits. More sophisticated than many other small manufacturers in its industry, the Marlboro, Mass., company had dutifully accounted for the costs of processing and disposing of the hazardous by-products of battery manufacturing. Even with those expenses, the books showed that the batteries were emphatically profitable. The books, however, were wrong.
Koehler Manufacturing's confusion is far from unique. It's quite possible that your most profitable product is actually a loser and that your best customers are costing you much more than they're worth. Does your company sell more than a dozen or so products? Are annual sales more than $3 million? Are your customers' buying patterns wildly divergent? Yes? Then I'll bet, like Koehler's managers, you don't know your costs as well as you think you do.
Richard Mitchell, vice-president of Koehler Manufacturing, acknowledges with some chagrin that until his company installed NetProphet, an activity-based cost-accounting software package, he had no idea that certain administrative costs were attributable to his battery business. When he found out, he says, the product's profitability dropped by nearly 30%. The company hadn't considered product-specific expenses incurred while it was dealing with environmental officials, applying for permits, and filing compliance reports.
Activity-based costing (ABC) exposes the truth about costs, and today several companies make software products that facilitate the ABC process. (See box, "ABC Software," below.) For about $10,000 you can get software and enough vendor-supplied training to get your system up and running. Most companies bring in consultants to help customize the off-the-shelf ABC software to reflect their specific operations.
The consulting services--which focus on analyzing activity and implementing data flows--might run an additional $10,000 to $20,000. But once everything's in place, with guidance from the software, most small companies can conduct an activity analysis once a year on their own. (You should make sure that the fees you pay cover training an employee--a capable bookkeeper or an accountant comfortable with the software--to support timely data collection, selection, and dissemination.)
The investment, users say, is worth it: within three to six weeks, most start seeing their operations in a clearer light. "All overhead ultimately stems from activity," explains Chris Pieper, CEO of ABC Technologies, a manufacturer of activity-based cost-accounting software in Beaverton, Oreg. "Somewhere in your organization somebody is doing something that leads to an overhead cost." Only if you correlate administrative activities with specific products and customers will you have reliable information on which to base pricing and other decisions.
Pieper should know--and not just because he sells the software. He recently implemented an activity-based program in his own company. "We were curious to know how we could improve our own operations, and we wanted to experience firsthand what we were putting our clients through," he says. "The results were startling."
In his company's early days, people wrote orders on paper forms and hand-delivered them to shipping. "If shipping discovered an error, the form was walked back to order entry," says Pieper. "When we grew, we entered orders on a computer but still printed paper orders for shipping and manufacturing. Errors were still walked back and forth, only now there were more departments."
It took ABC Technologies' software to reveal the secrets hidden in the overhead--particularly the exorbitant personnel costs of the order-processing system. "There in living color on an activity flowchart was evidence of how much time we wasted on the totally useless activity of pushing paper," says Pieper.
Traditional accounting approaches--calculating product cost by totaling the costs of raw materials, labor, and overhead--are not structured to reveal that kind of waste because they rely on arbitrary allocation formulas when it comes to overhead. For instance, say 20% of a company's employees are working on product A. If the company uses labor as the basis of allocation, it would likely look only at direct labor charges when calculating overhead costs and allocate 20% of rent, 20% of electric charges, and even 20% of the cost of the annual Christmas party to product A.
"Arbitrary allocation of overhead totally confuses the cost picture of a product," says Professor Bala Balachandran, director of the Accounting Research Center at Northwestern University's Kellogg Graduate School of Management. "The degree of error is so great that, in many instances, entrepreneurs might be better off if they had no information at all. I have seen cases where companies killed profitable products and increased production of unprofitable ones because they relied on inaccurate data."
Some companies seem to give up on overhead allocation. Their statements display a single, outsized line item for selling, general, and administrative expenses. "It's crazy," Balachandran says. "There are different costs associated with different customers and products. Why should you lump all of them together in a meaningless whole?"
ABC, on the other hand, calls for allocating costs on the basis of activities performed. Broadly described, the process has three steps:
- Define such cost categories as salaries, raw materials, travel, utilities, and so on.
- Identify key processes and the principal activities associated with each; determine activity costs.
- Assign costs to appropriate categories, like products or customers.
Order entry, for example, is a key process that includes activities such as typing order forms and checking customers' credit histories. You can calculate the cost of entering an order by totaling the salaries and benefits of your order-entry clerks and dividing that sum by the number of orders the clerks process. Then to assign that cost to individual products, you multiply the number of orders for each product by the cost of entering a single order. In any given activity you have to decide which costs are critical to include and which aren't. In the case of the order-entry clerks, the amount spent on rent and electricity is negligible compared with the amount spent on salaries and benefits--which is why those costs weren't included.
ABC also allows you to see which customers are serving you best. "For most companies, 20% of their customers account for 200% of profits," asserts Balachandran. "The remaining 80% of customers actually lose money, which is how companies end up with their final 100%."
What makes one customer less profitable than another? Small orders, back orders for out-of-stock products, requests for special handling, late payments after repeated follow-ups, demands for sales calls and customer assistance, rejects, returns, and so on. Most companies have no clue how much they spend to meet those demands.
One company that does is Qtron Inc. "We implemented an ABC system, EasyABC Plus, two years ago, so I know exactly what our costs are," says CEO Bob Van der Linde. The $30-million San Diegobased company provides contract manufacturing services--parts procurement, inventory management, and assembly--to the electronics industry.
"Overhead is 80% to 90% in our industry," says Van der Linde, "so allocation errors lead to pricing errors, which could easily bankrupt the company." Qtron's bids specify all activities--parts ordering, moving, manufacturing, inspections, and so on--along with the costs of those activities. Within five months of shifting to the ABC method, the company had gathered enough data to clarify the cost structure of each of its products.
Van der Linde believes that the company's demonstrable control of its margins has won competitive orders. What's more, not just every department but every customer now understands its role in cutting costs and increasing company profitability. "Customers don't make design changes after the start of production because they see how expensive it is," he says. "They ask us to buy parts and manage their inventory because we do it cheaper. We share the savings with them."
If activity-based cost accounting can make such a positive difference, why doesn't every company use it? "ABC is like a weight-loss program," says ABC Technologies' Pieper. "You start on one only when your clothes no longer fit. Companies start implementing ABC when losses are too great to ignore."
Bob Van der Linde, for one, is glad he finally started paying attention. He considers his company's sales growth--from $22 million in 1995 to $30 million last year--and its significant increase in profitability indisputable evidence of ABC's success.
Demo: XYZ Manufacturing Learns Its ABCs
Activity-based cost accounting is extremely complicated. The number of variables that go into an activity analysis can be mind-boggling. That's why the software--and the consulting fees--are so high. To show you the means, if not the method, ABC uses to reveal hidden costs, we've come up with the following very simple hypothetical example:
XYZ, a software-manufacturing company, markets a dozen office-software packages for small businesses. One of the company's best-selling items is WriteRight, a word-processing package that has been a best-seller long enough to reduce the cost of materials to nearly nothing. WriteRight sells for $100, and XYZ loves it because marketing, production, and packaging slice only $15 from the bottom line. Or so management thought.
In an effort to determine which of its products was devouring company margins, XYZ hired a consultant, purchased the recommended activity-based cost-accounting software, and saw its world turn upside down. Management's assumptions about WriteRight and its profitability were wrong, wrong, wrong. Apparently, loading the word-processing software onto local area networks was such a challenge for unsophisticated users that every sale was generating an average of four hours' worth of calls to XYZ's free help lines.
WriteRight: Its True Cost Structure
Price per WriteRight package $100
Packaging and disks $5Marketing and sales expenses $10Assumed margin $854 hours of help @ $30 per hour $120Real bottom line -$35
Here are three ABC programs currently on the market:
| EasyABC Plus, for Windows 3.1 or higher and Windows NT
$5,500 and up
ABC Technologies Beaverton, OR
| HyperABC, for Windows 3.1 or higher and Windows NT $7,000 and up
| NetProphet, for Windows 3.1 or higher, UNIX, and Macintosh |
$5,500 and up
Mississauga, Ont., Canada
Srikumar S. Rao is chairman of the marketing department at the C.W. Post campus of New York's Long Island University.