April 25, 2006
Volume 2 Issue 59

Four Steps to Making ABC Work for You

     In order to handle costs effectively a manager should center on the activities that cause such costs. When ABC systems are used to improve financial management, Activity Based Management is taking place. The objective of ABM is to perk up the value received by customers and in doing so improve profits. Furthermore, the key to ABM’s success lies in distinguishing between value-added costs and non-value added costs.

     A value-added cost is the cost of an activity that cannot be eliminated without affecting a product’s value to the customer. In contrast, a non-value added cost is a cost that can be eliminated without affecting a product’s value to the customer. Some value-added costs are always required, as long as the activity that drives such costs is performed in the most efficient way. However, non-value added costs should always be minimized because they are understood to be unnecessary. Examples of non-value added activities include transporting raw materials or partly finished products such as work in process inventory items from one part of the plant to another, and storing and managing inventory items. More often then not such non-value activities can be reduced or eliminated by a careful redesign of the plant layout or production process.

     The heart and soul of activity based costing is to assign operating expenses and overhead to specific customers/products/orders. It is easy to see how a outwardly profitable customer can become exceedingly unprofitable when you consider expenses associated with selling, purchasing, order processing, supply, and delivery. Follow the four steps outlined below to see how ABC would work for you.

·          Step 1 is to assign the company’s general ledger expenses (e.g. rent, utilities, salaries to specific departments (e.g. sales department, purchasing, accounting,) according to how the resources are used (e.g. square footage, headcount). These departments are represented collections of personnel performing similar task and where costs can be easily isolated (e.g. separate offices). For example, if the accounting department occupies 10% of the warehouse’s office space then hypothetically 10% of facility rent, property taxes, utilities, janitorial services, etc will be assigned to accounting.

·          Step 2 is to drive department expenses to activities. For example, if a sales force spends 50% of their time quoting customers, then 50% of their department’s expenses will be assigned to the activity of quoting.

In Step 3 activity costs are driven to cost objects (e.g. customers, products, projects, orders) in proportion to their use. Cost objects are your business. They generate your revenue, profits, and losses. You first have to decide which cost objects you will track costs and profitability. For example, knowing the costs associated with specific orders is critical in distribution industry because so many of the jobs are custom orders. Once the cost objects are defined, drive equations will be developed that will estimate the amount of time spent on a particular activity for a cost object. For example, the time it takes to process an order is influenced by the number of SKU’s, whether the customer is new, and whether the products are in stock. Gather the data for the items you can measure. The sample equation would look something like this:

Total Order Time = [1.5 mins X #of SKU’s] + [25 mins for Order Overhead (taking & inputing of order] + [5 mins X # of Stock Outs]

For this example these are the assumptions: 1.5 mins spent to browse through the SKU’s (with 10 line items to this order), 5 mins spent to check for stock outs (with 2 stock outs for this order), and it takes your staff 25 mins to take & input for this order. Therefore, armed with all this data, you would SUM those three parts together:

     If this customer places the order 3 X in a week and your paying your order entry clerk $10.00 an hour and your picker $12.00 an hour. Then this customer costs you around $55 in order processing activity cost alone. [50 mins * 3 orders] = 150 mins a week or 2.5 hours a week is spent on this customer alone. [$10 (clerk wage) * 2.5 hours] + [$12 (picker wage) * 2.5 hours] = $55.00 labor cost for this customer alone. Again, we are only looking at the order processing costs; don’t forget that you still have to factor in delivery costs, etc!! Next week’s newsletter will focus on delivery cost drivers.

·          Finally Step 4 calculates the profitably based on revenue and direct costs associated with each cost object. For example, if customer X incurred $100,000 in direct expenses during the 3^rd quarter, and we know that revenue was $150,000 and the cost of goods sold was $60,000. Then activity based costing would estimate an operating loss of $10,000.

     ABC provides managers with a much more unambiguous depiction of what is garnering their profitability and/or their losses. Once supplied with this critical information, a warehouse manager can narrow down not only which customers, but also which products and orders are to be held accountable for losing out on money for the company. The most favorable changes can therefore be made with this information. And as a result many companies then watch as their profits and productivity double.

ABC HELPS COMPANIES GET A BETTER HANDLE ON COSTS $$ AND PROFITS $$

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