Activity Based Management

Improving Processes and Profitability

Brian Plowman

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351808521
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Gestión

This title was first published in 2001: Product and particularly customer profitability are black holes in most managers' understanding of their business. Identifying customer revenue is easy but identifying what they cost - so we can understand whether or not they are profitable - is difficult. In a world in which competition, regulation and the increasing use of the Internet put ever greater pressure on margins it is vitally important to understand both product- and customer-profitability. Activity Based Management (ABM) enables you to do this. This book explains the power of using ABM to increase the profitability of your business. It provides step-by-step guidance on basic principles, comparisons between traditional methods, definitions of processes, activities and cost-drivers as well as details of data collection techniques and implementation steps. Through the book's numerous detailed examples a logical picture builds up of how to obtain the benefits that ABM can deliver. On its own ABM will change management decision-making: by showing how ABM also supports other profit improvement initiatives such as Business Process Reengineering, Shareholder Value Added and Customer Relationship Management, managers will learn how they can use the best possible toolkit to put their business firmly on the road to leaps in profitability.

1 Introduction

Customers

We know that customers are important to us. But even when we achieve the right orientation towards customers, we know, instinctively, that some customers are more profitable than others. We also know that some are probably loss-making. For some businesses, this doesn't matter much. If margins are good enough, for whatever reason (a captive market, or a patent, or regulatory protection, and so on), overall profitability is sufficient. But few businesses have that luxury.

We may also have some idea of which customers are the least profitable, and which are the most profitable. A walk around the business listening to anecdotes in different departments will tell us which customers are demanding of time and effort and cost: these are the customers who order unpredictably, amend their orders, change specifications at the last minute, delay payment, require special deliveries, and so on. Every department will have its own, separate experiences of customer behaviour. Nobody will have the whole picture. So anecdotal evidence will pick up the extremes – the 'worst' and the 'best' customers. What about the others?

Customer profitability is a black hole in most managers' understanding of their business. Identifying customer revenue is easy: it's shown in the sales ledger. Identifying what individual customers cost – so we can understand whether or not they are profitable – is difficult. In a world in which competition, and often regulation, put increasing pressure on margins, it is vital to understand both product and customer profitability.

As if competition were not enough to put pressure on margins, electronic commerce (e-commerce) promises lower unit costs and creates customer expectations of lower prices.

The Twenty-First Century is Electronic

Technology advances, rapidly. Now companies can record and process all available facts about their customers, logging their every purchase and preference, storing details of each transaction and interaction – be it through call-centre, e-mail or post. If customers visit a Web site, a company can know their every keystroke and click. And it is possible to analyse the information to death. If the marketeers have got it right, they can predict customers' every need and anticipate their every whim. Web routings, pages and menus can be programmed to reflect the history of the customer and the actions taken on-line. Just like good salespeople, but at a fraction of the cost, they can package and price offers not to target a niche, but an individual. Welcome to the world of one-to-one marketing.

Buying decisions become quicker and easier because customers are propositioned only with what they find attractive, in a process they judge convenient, safe and painless. Soon customers will have forgotten how on earth they managed in the scram of mass marketing when they had to do the donkey work. And on top of all this, sales costs plummet as the need for expensive salespeople and high street outlets, and for slow-turning showroom stock, disappears.

It is enough to make a chief executive salivate. So where's the catch? In fact there are two. The first is that all the competitors will be doing the same thing. Unless a company can take an early lead and then defend its additional market share, or unless the concoction of technology and marketing in this brave new world increases the size of the total market, the only hope is to do it better than the competitors-which is what organizations try to do every day. The second catch is that all the hyperbole about e-commerce usually has a special message to the customer. It says 'lower prices'. After all, why do we put up with the DIY purgatory of supermarket shopping if it isn't for cheaper groceries? Instead of being able to pass on to the customer the cost of all the expensive technical wizardry, companies will find that margins are squeezed even more!

So is electronic commerce merely a development in which companies are forced to participate as a defensive measure, to the benefit only of customers and systems suppliers? Not necessarily.

The Missing Dimension

Customer Relationship Management (CRM) is aimed at capturing information that will allow companies to create the circumstances in which customers will buy. It maximizes the attractiveness of the offer and the convenience of the sale by matching the selling process to the customer. But in making the match, it risks driving hidden costs into the business, be it by shortening delivery lead times, by encouraging complex product variants, by offering high levels of personal service, or by attracting customers who trigger excessive costs. It's as if CRM provides a more extravagant, indulgent courtship display, but pays no attention to the slog of making the marriage work in the long term.

It is not enough for companies to use CRM to anticipate every interaction the customer might have with the business, before, during and after the sale. They must understand the costs driven by those interactions.

When the dust has settled on the expensive new e-commerce implementation and its bewildering array of 'bundled' products and services, customer profitability becomes the missing dimension, hidden deep in the business. Understanding all the costs that are driven by customer behaviours, some of them maddeningly cryptic, is vital to designing the processes and setting the prices that companies offer. Otherwise, they risk making customer promises they cannot profitably fulfil.

Can All Customers be Kings?

Not all customers are created equal in the sight of the supplier. They behave differently from one another and have a variety of characteristics, so they generate different costs and margins. Some are highly profitable, others are spectacularly unprofitable, and many lie in between. Often, a small, anonymous group of customers contributes the major share of profits, while an equally invisible segment erodes it.

A clear understanding of customer profitability allows a business to differentiate the level of service it provides to various customer segments according to their needs and their value to the company. For example, it may offer individual attention to prized customers in the form of dedicated telephone lines, free delivery, incentive pricing or customized products. At the same time, it might choose to reduce service to unprofitable customers – or to increase prices – even at the risk of losing them. A comprehensive view of the costs that customers drive allows a business to refine its processes and policies and focus its resources where they will have the greatest effect on profits: cementing customer relationships; avoiding excessive costs; matching prices to the service given.

In many sectors, the customer continues to provide revenue and to drive costs well after the initial sale, through after-sales service, repeat purchasing or general administration. All these costs, as well as the revenues, need to be identified and analysed to ensure that the initial terms are profitable and that the customer segments a company targets have a high probability of being profitable over the lifetime of the relationship.

An added benefit of customer profitability analysis is that it highlights the costs of poorly designed internal processes. As the true costs of processes emerge, managers can sense which costs are suspiciously high. This triggers a cycle of further investigation, problem identification and process improvement, thereby correcting profit-harming defects that would otherwise continue undetected.

Activity Based Management

Activity Based Management (ABM) enables managers to understand product and customer profitability, the cost of business processes, and how to improve them. Since conventional management accounts and standard costing systems do not provide this information, it is perhaps surprising that ABM is not more widely used. Unlike many management techniques, research shows that 80 per cent of companies that have employed activity-based techniques found them to be successful.

Why? Activities consume resources – people, materials and equipment – and this consumption can be measured. Activities are triggered by events, which can be counted, or decisions, which can be reviewed. Activities produce outputs – products and services, which can be counted and measured. Activities can be undertaken by different methods, which will vary the unit cost. Activities are linked together to form business processes. Understanding what activities are, what they cost, what drives them, what they produce, how they are done and how they are linked together is useful.

We have understood manufacturing activities in this way for years. We measure the consumption of direct labour and materials in making products. On average, however, direct labour, materials and components account for around two-thirds of total costs in manufacturing businesses. The other, unmeasured, third is overhead activities and costs. In service industries, the ratio is the other way round – the unmeasured 'overhead' accounts for two-thirds or more of costs.

Overhead costs are the black hole in conventional management information systems. ABM shines light into the hole. Knowledge of a business at the level of activities is the basic building block upon which new understanding can be built of where profits are being made and where they are being eroded.

By making visible what was previously invisible, ABM throws a spotlight on those aspects of a business where action can directly improve business performance. Because it deals with 'financial numbers', ABM is often seen as the preserve of the Finance function. In fact, its real strength lies in providing genuinely useful information for all functions in an organization. Managers throughout the business need the right information to understand and address two key issues:

• how the company can position itself better in the market – for which accurate product and customer profitability information is vital
• how it can improve its internal capability and lower unit costs – for this, it needs to understand and change the procedures, systems and processes that create products and deliver services to customers.

Most organizations are complex. Building an ABM model of a business requires a structured approach and the dedication of a team to achieve a result in a reasonable timescale. But building a model is only the start. Embedding ABM into the business means giving managers not only a new understanding of what drives costs, but the means to measure and act on the drivers to reverse adverse trends.

ABM is about management. This book is intended for 'general management' in any type of organization. The following chapters discuss the basic principles of the approach, describe how to approach the development of ABM models and the implementation of ABM thinking in a business, and use numerous case studies to illustrate how ABM can make a difference to business performance.

Key Points

• We know customers are important but without knowing the costs that customers impose on us, we'll never know which ones are profitable.
• When we know the costs that are driven by customer behaviours, we can differentiate the level of service we provide to various customer segments.
• In manufacturing businesses, direct labour, materials and components account for around two-thirds of total costs. The other, unmeasured, third is overhead activities and costs. In service industries, the unmeasured 'overhead' accounts for two-thirds or more of costs.
• ABM helps companies position themselves more advantageously in the market by providing accurate product and customer profitability information.
• ABM helps companies to improve their internal capability and lower unit costs.
• ABM is often seen as the preserve of the Finance function. In fact, its real strength lies in providing genuinely useful information for all functions in an organization.
• E-commerce channels currently give certain companies cost advantages. But not for long. Competitors will soon be doing the same thing.
• In e-commerce, customers want a share of lower costs, reflected in lower prices. In the future, it will be even more important to know customer profitability.

Part I
The Context

2 Historical perspective

The First Serious Questions

In the late 1980s and throughout the 1990s, the relevance of traditional accounting practices was seriously questioned. Conventional costing, budgeting and management accounts became ever less able to support the business decisions that were now relevant. The relevance debate was founded on three key criticisms.

The first criticism was levelled at the lack of technical developments in management accounting practice despite major changes in manufacturing technology. These major changes had resulted in greatly increased productivity, flexibility and quality, together with reduced lead times and inventory. Further, the significant changes in the proportions of 'direct' costs to 'overheads' had created major distortions in calculating product costs based on simplistic overhead recovery rates.

The second criticism held that management accounting was nothing more than financial reporting, leading to information that was too distorted, too aggregated and too late to be of much value to management.

The final criticism was concerned with the history of management accounting. A mature management accounting tradition was well established in the 1920s. In those days, traditional accounting had served business needs well in terms of cost management, management controls and performance measurement. However, the worldwide dominance of accountancy practice, standard training and examinations means that significant inertia towards change still exists.

The relevance discussions were published during a period of concerns over America's need to regenerate its industry in the context of the emergent global economy and the lessons from the success of Japan at that time. The moves in management accountancy were towards cost management and away from cost accounting. Developments since have included a concern with understanding such aspects as value-adding processes, life cycle costing, market-driven target costing, product and customer profitability, customer relationship management, Shareholder Value Added and the emergence of e-commerce.

New Costing Approaches Gather Pace

Costs have been addressed in many ways in businesses, although traditional practice had formed around the major manufacturing sectors. The key problems with trying to determine accurate product costs started to gain the attention of a body called CAM-I (Consortium for Advanced Manufacturing-International). This body researches all aspects of the manufacturing sector in its struggle to come to terms with the changes that modern methods have introduced.

The CAM-I Cost Management Systems (CMS) Program is internationally recognized as a leading forum for the advancement of cost and resource management practices. Organized in 1986 as a coalition of leading thinkers from industry, government and academia, the CMS Program has accomplished extensive research and development of new management methods. The CMS Program is acknowledged worldwide for raising the awareness of Activity Based Costing (ABC) and Activity Based Management.

Although the manufacturing sector was the first to find that traditional accounting had lost its relevance, the service sector began to catch up. In financial services, what is a direct cost, and what is an overhead? Tracking the real cost of its products, services and customers became an issue as the recession and severe competition star...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Contents
• List of figures and tables
• Foreword
• 1 Introduction
• Part I The Context
• Part II ABM in Practice
• Part III Case Studies
• Part IV Conclusions
• Appendix: Glossary of terms
• Index