4. A Passionate Appeal for Activity-Based Costing (ABC)
Usually I am fairly rational and do not let my personal emotions interfere with how I interact with others. However, as the readers of my blogs and articles may have detected, my more recent writings increasingly reflect my frustrations with old school accountants. I cannot disguise my irritation and annoyance with accountants who refuse to be progressive.
Several of the titles of my articles these past few years provide hints and clues as to the source of my frustrations. They include “Are Accountants Homo Accounticus?”, “Some Accountants are the Blind Leading the Blind”, “Movie Sequel – Pirate Accounts of the Caribbean”, “Cowboy Accountants – The Lawless Frontier”, and “Do Accountants Lead or Mislead?”
Each time I post an article I’ve written like those I receive several personal e-mails that are supportive of my view. Some are even more vitriolic. Receiving these e-mails, and also the publicly posted website comments to my written pieces, further motivates me to continue broadcasting my message of frustration often shaming accountants. I call it MBE or “management by embarrassment.”
At this point some of you may be asking yourself, OK. What the heck is bugging Gary that he is so frustrated about?” The simple answer is it is the slow adoption rate of applying activity-based costing (ABC) principles as a replacement for the flawed and misleading traditional “cost allocation” methods from standard cost accounting systems. They typically use non-causal cost allocation factors. Examples are the number or amount of direct labor input hours or currency, units produced, sales volume, headcount, or square feet/meters.
Benefits from applying ABC in comparison to traditional cost allocation methods that violate “costing’s causality principle” are too numerous to list here. Key benefits are: (1) extremely more accurate profit and cost reporting of outputs, products, services, channels and customers; (2) transparency and visibility of the “drivers” for work activities and their magnitude; and (3) past period calibrated cost consumption rates that are essential to multiply against future forecasted demand volume and mix that determine resource capacity requirements – workforce headcounts and spending amounts. These rates are needed for what-if scenario analysis, make-versus-buy decisions, and capacity-sensitive driver-based rolling financial forecasts and budgets.
Causality is at the heart of ABC. For example, if the quantity of the activity driver increases 20% then its activity cost should also increase 20%. The work activities are what consume the resource capacity expenses. My opinion is that any CFO/ financial controller or FP&A analyst who are using traditional cost allocation methods and are not using ABC where it is applicable (which is for most organizations) is being irresponsible in their duty to provide valid information to managers and employees. The information they are providing is faulty, distorted and deceiving. Line managers deserve better to support their decisions.
Now read the first letter of the six prior paragraphs as if together they are a two word sentence. My message is blunt: USE ABC !
This article was published on
3. Put Your Money Where Your Strategy Is
Two easy ways for executive teams to attempt to raise profits is to lay off employees to cut costs or to lower prices to take away market share from their competitors. But these are merely short-term fixes. An organization cannot reduce its costs and prices to achieve long-term sustained prosperity.
Entrepreneurs know the age old adage “you need to spend money to make money.” However, belt-tightening an organization’s spending can be haphazard. Rather than evaluating where the company can cut costs, it is more prudent to switch views and ask where and how the organization should spend money to increase long-term sustained value. This involves budgeting for future expenses, but the budgeting process has deficiencies.
A problem with budgeting
Companies cannot succeed by standing still. If you are not improving, then others will soon catch up to you. This is one reason why Professor Michael E. Porter, author of the seminal 1970 book on competitive edge strategies, Competitive Strategy: Techniques for Analyzing Industries and Competitors, asserted that an important strategic approach is continuous differentiation of products and services to enable premium pricing. However, some organizations believed so firmly in their past successes that they went bankrupt because they had become risk-adverse to changing what they perceived to be effective strategies. Wang Labs, Borders, and Blockbuster are examples.
Strategy execution is considered one of the major failures of executive teams. Dr. David Norton, co-author of The Balanced Scorecard: Translating Strategy into Action, has reported, “Nine out of 10 organizations fail to successfully implement their strategy. … The problem is not that organizations don’t manage their strategy well; it is they do not formally manage their strategy.” In defense of executives, they often formulate good strategies – their problem is failure to successfully execute them.
One of the obstacles preventing successful strategy achievement is the annual budgeting process. In the worst situations, the budgeting process is limited to a fiscal exercise administered by the accountants where the budget is typically disconnected from the executive team’s strategic intentions. A less poor situation, but still not a solution, is one in which the accountants do consider the executive team’s strategic objectives, but the initiatives required to achieve the strategy are not adequately funded in the budget. Remember, you have to spend money to make money.
Value is created from projects and initiatives, not the strategic objectives
A popular solution to failed strategy execution is the evolving method of a strategy map with its companion balanced scorecard. Their combined purpose is to link operations to strategy. By using these combined methods, alignment of the work and priorities of employees can be attained without any disruption from restructuring the organizational chart. The balanced scorecard directly connects to individuals regardless of their departments or matrix management arrangements.
Although many organizations claim to use dashboards and scorecards, there is little consensus on how to design or apply these tools. At best, the balanced scorecard has achieved a brand status but without prescribed rules on how to construct or use it. For example, many companies claim to have a balanced scorecard, but it may have been developed in the absence of a strategy map from executives. The strategy map is arguably many orders of magnitude more important than the balanced scorecard. Therefore, when organizations simply display their so-called scorecard of actual versus planned or targeted metrics on a dashboard, how do the users know that those measures displayed in the dials, commonly called key performance indicators (KPIs), reflect the strategic intent of their executives? They may not! At a basic level, the balanced scorecard is simply a feedback mechanism to inform users how they are performing on preselected measures that are ideally causally linked. To improve, much more information than just reporting your score is needed.
One source of confusion in the strategy management process involves misunderstandings of the role of projects and initiatives. For the minority of companies that realize the importance of first developing their strategy maps before jumping ahead to design their balanced scorecard KPIs, there is another method challenge. Should organizations first select and set the targets for the balanced scorecard KPIs, and subsequently determine the specific projects and initiatives that will help reach those targets? Or should the sequence be reversed? Should organizations first propose the projects and initiatives based on the strategy map’s various theme objectives, and then subsequently derive the KPIs with their target measures afterward?
We could debate the proper order, but what matters more is that the projects and initiatives be financially funded regardless of how they are identified. Value creation does not directly come from defining mission, vision and strategy maps. It is the alignment of employees’ priorities, work, projects and initiatives with the executive team’s objectives that directly creates value. Strategy is executed from the bottom to the top. Using a fishermen’s analogy to explain this: Strategy management tells you where the fish are, but it is the projects, initiatives and core business processes that catch the fish.
Four types of budget spending: operational, capital, strategic, and risk
The overarching process begins with strategy formulation and risk mitigation and ends with financial budgeting and rolling forecasts. Some budgets and rolling financial forecasts may distinguish the capital budget spending from operational budget spending, but rarely do organizations segregate the important strategic budget spending and risk budget spending for risk mitigation.
A key point is that the budget depends on and is derived from two separate sources: (1) a future demand-driven source (operational) and (2) three project-based sources (capital, strategy, and risk).
Ideally, the strategy formulation by the executive team uses meaningful managerial accounting information, such as understanding which products and customers are more or less profitable today and are potentially more valuable in the future. With this additional knowledge, the executives can determine which strategic objectives, as mentioned typically displayed in a strategy map with its associated balanced scorecard, to focus on.
The operational budget, those expenses required to continue with day-to-day repeatable processes, is calculated based on forecasted volume and mix of “drivers” of processes, such as the sales forecast, multiplied by planned unit level consumption rates that are calibrated from past time periods (and ideally with rates reflecting planned productivity gains). This demand-driven method contrasts with the too-often primitive budgeting method of simply increasing a cost center’s prior year’s spending level by a few percentage points to allow for inflation. The operational budget spending level is a dependent variable based on demand, so it should be calculated that way.
Regardless of whether an organization defines the strategic initiatives before or after setting the balanced scorecard’s KPI targets, it is important to set aside strategy spending and risk mitigation spending not much differently than budgeting for capital expenditures. Too often, the strategy funding is not cleanly segregated anywhere in the budget or in driver-based rolling financial forecasts. It is typically buried in an accounting ledger expense account. And enterprise risk management (ERM) spending must also be included. As a result, when financial performance inevitably falls short of expectations, it is the strategy projects’ “seed money” and the risk mitigation spending that gets deferred or eliminated. The priority must be reversed. Organizations must protect strategy and risk mitigation spending and allow them to go forward as they are key to competitive differentiation for successfully accomplishing the strategy – and doing it safely.
Put your money where your strategy is!
Managing strategy is learnable
Organizations with a formal strategy execution process dramatically outperform organizations without formal processes for this. Building a core competency in strategy execution creates a competitive advantage for commercial organizations and increases value for constituents of public sector organizations. Managing strategy is learnable. It is important to include and protect planned spending for strategic projects and initiatives and risk mitigation spending in budgets and driver-based rolling financial forecasts. The three types of projects (capital, strategy, risk) lead to long-term sustainable yet safe value creation. Driver-based operational expense planning assures that the correct level of employee head count and spending are in place to achieve planned profits.
This article has been published on
2. How Marketing and Finance Think Differently
This is a fictitious story about the wide gap and personality differences between the function of the chief marketing officer (CMO) and that of the chief financial officer (CFO). I made up the two characters in this story. But how different might they be from a real pair of a CMO and CFO that you may know (or who works for your employer)?
The haunting question
My fictitious CMO and CFO, Sandy and Jim, are both men, but their gender would not alter this story. They were hired into their C-suite roles at the same time about a year ago, and both were recruited from other companies.
Sandy and Jim have both had enough time in their first year to stabilize the moderately disorganized departments they inherited from their predecessor CMO and CFO that they replaced. Each of them feels that their time and opportunity are now to make real progress and substantial improvements for their company.
Last week by coincidence of timing Sandy and Jim met at the coffee station on the floor of their offices. The story’s plot began to thicken when without giving it much thought Jim, the CFO, asked Sandy, the CMO, what Jim considered to be a straightforward question. Jim asked, “Would marketing and sales behave differently if they knew how profitable to our company each of our company’s customers is? They currently know the amount of sales from each customer reported from the billing system, but the sales and marketing staff do not know the amount of profits that each customer contributes to our company’s bottom line.”
There was a long silence. Jim wondered to himself, “Ooh. Maybe Sandy thinks I’m intruding in his affairs.” Sandy eventually replied to Jim, “Hmmm. Let me think about that for a while. I’ll get back to you.” They then returned to their respective offices to resume the routine daily toil of their job and duties.
Second thoughts from the CFO’s question
Later that day Jim became uneasy. He began worrying if with his question he had adversely affected what until then had been a friendly relationship with Sandy and Sandy’s marketing team. Jim thought to himself, “I know it was just an innocent question. But golly. If all that marketing and sales focus on is increasing our market share and growing sales, then they may not be thinking about growing the most profitable sales.”
Meanwhile later that same day Sandy pondered Jim’s coffee station question. It stimulated Sandy to think about one of their customer segments that his marketing staff had just initiated a targeted marketing campaign to promote selling their kitty litter product. The promotion’s theme was “scoop that poop.” Sandy began to worry. He thought to himself, “I wonder if that theme might offend some of our customers and in turn their retail store consumers. Is this a problem?”
Third thoughts about the CFO’s question
The more that Jim thought about his chance coffee station encounter and his offhand question to Sandy, the more that Jim began to worry. Jim thought to himself, “I know that we have a wide range of low to high maintenance and demanding customers independent of their sales volume they purchase from us. I wonder if Sandy understands what differentiates the most profitable from the least profitable customers to us – and worse yet unprofitable customers. I wonder if Sandy knew this information if it would change his thinking and mindset about the marketing deals, offers, discounts, special services, and all those other things that his staff comes up with to lift sales volume.”
Meanwhile Sandy also continued to ponder Jim’s question. For the kitty litter “scoop the poop” marketing campaign, they provided their customers’ retail stores with cardboard floor displays of an attractive blond hair female model holding a red kitty litter scooper. Sandy now worried and questioned to himself, “Should we have selected a less attractive and brunette model that more women might relate to? Should the color of the scooper been green representing ‘go’ and not the red one implying ‘stop’?”
Fourth thoughts about Jim’s CFO question
That night Jim lost sleep. He began to question if he was successfully fulfilling his CFO governance role to have fiduciary control of the corporate assets and effectively serve as a strategic advisor to the CEO and the board of directors. Jim worried. He wondered, “Should I be forcing Sandy to shift his mindset along with the sales vice president to view customers as investments in a portfolio? This shift would maximize the return on investment (ROI) from customers which in turn would optimize the rate of shareholder wealth creation.”
That same night Sandy also lost sleep. His marketing team was instructing their customers’ store outlets to position the kitty litter cardboard display with the attractive blond to be located near the retailer’s food aisle. Sandy worried. He thought to himself, “Maybe there would be relatively higher sales if the display was positioned near the retailer’s hardware goods aisle.”
A butterfly’s wings – marketing versus finance
It has been said that the random flap of a butterfly’s wings in Africa can impact the wind in the Sahara desert that evolves into the hurricanes that causes devastation to the Eastern United States of America. Sandy thought to himself, “What little marketing tweak here might we do to stimulate a consumer’s purchase there?”
In contrast, Jim disturbed himself into a cold sweat conflicted with fear for keeping his position as CFO. He thought to himself, “Am I failing to defend the profit maximizing interests of our company’s shareholders and defending global Capitalism?”
The wide gap between marketing and finance
As I stated in the opening to this article, there is a wide gap and personality differences between the function of the CMO and CFO.
But maybe the gap is not that wide. Marketing thinks to act locally for global impacts to increase sales. Accounting thinks to take actions that lift the most profitable sales. Their common focus is what actions to take. Accounting should provide marketing the insights for decisions, and marketing should take actions.
Later that week Jim updated his resume and Sandy asked the product development team, “Can we possibly change the color of our kitty litter?”
This article has been published on
1. Measuring and managing customer profitability
The only value a company will ever create for its shareholders and owners is the value that comes from its customers—current ones and new ones acquired in the future. To remain competitive, companies must determine how to keep customers longer, grow them into bigger customers, make them more profitable, serve them more efficiently, and acquire more profitable customers.
But there’s a problem with pursuing these ideals. Customers increasingly view suppliers’ products and standard service lines as commodities. This means that suppliers must shift their actions toward differentiating their services, offers, discounts, and deals to different types of existing customers to retain and grow them. Further, they should concentrate their marketing and sales efforts on acquiring new customers who have traits comparable to those of their more profitable customers.
As companies shift from a product-centric focus to a customer-centric focus, a myth that almost all current customers are profitable needs to be replaced with the truth. Some high-demanding customers may indeed be unprofitable! Unfortunately, many companies’ managerial accounting systems aren’t able to report customer profitability information to support analysis for how to rationalize which types of customers to retain, grow, or win back, and which types of new customers to acquire. With this shift in attention from products to customers, managers are increasingly seeking granular non-product-associated costs to serve customer-related information, as well as information about intangibles, such as customer loyalty and social media messaging about their company and its competitors. Today in many companies there’s a wide gap between the CFO’s function and the marketing and sales function. That gap needs to be closed.
Here’s the basic problem. With accounting’s traditional product gross profit margin reporting, managers cannot see the more important and relevant “bottom half” of the total income statement picture—all the profit margin layers that exist and should be reported from customer-related expenses, such as distribution channel, selling, customer service, credit, and marketing expenses.
The marketing and sales functions already intuitively suspect that there are highly profitable and highly unprofitable customers, but management accountants have been slow to reform their measurement practices and systems to support marketing and sales by providing the evidence. To complicate matters, the compensation incentives for a sales force (e.g., commissions) typically are based exclusively on revenues. Companies need to not just increase market share and grow sales but to grow profitable sales. Compensation incentives should be a blend of both customer sales volume and profits.
Who are the troublesome customers, and how much do they drag down profit margins? Who are the more profitable customers and why? More important, once these questions are answered, what corrective actions should managers and employees take to increase the profit from a customer? Measurements are the key.
Good vs. Bad Customers
Some customers purchase a mix of mainly low-profit-margin products. After adding the non-product-related costs to serve for those customers, apart from the costs of the mix of products and standard service lines they purchase, these customers may be unprofitable to a supplier. But customers who purchase a mix of relatively high-profit-margin products may demand so much in extra services that they also could be unprofitable. How does a company measure customer profitability properly? In extreme cases, how does it deselect or “fire” a customer that shows no promise of ever being profitable?
Every supplier has what I call good and bad customers. Low-maintenance “good” customers place standard orders with no fuss, whereas high-maintenance “bad” customers always demand nonstandard offers and services, such as special delivery requirements. For example, the latter constantly returns goods or contacts the supplier’s help desk. In contrast, the former just purchases a company’s products or service lines and is rarely bothersome to the supplier. The extra expenses for high-maintenance customers add up. What can be done? After the level of profitability for all customers is measured, they all can be migrated toward higher profits using “profit margin management” techniques, which I’ll discuss later.
Pursuit of Truth about Profits
To be competitive, a company must know its sources of profit and understand its own expenses and cost structure. For outright unprofitable customers, a company can explore passive options of gradually raising prices or surcharging for extra work, hoping the customer will go elsewhere. For profitable customers, a company may want to reduce customer-related causes of extra work for its employees (e.g., unneeded extra product packaging), streamline its delivery process, or alter the customers’ behavior with pricing incentives so those customers place fewer workload demands on the company.
Activity-based costing (ABC) is the method that will economically and accurately trace the consumption of an organization’s resource expenses (e.g., salaries, supplies) to products and to the types and kinds of channels and customer segments that place varying degrees of workload demand on the company. It should no longer be acceptable not to have a management accounting system where so-called non-traceable costs are assigned to their sources of origin. ABC is that system. Yet many companies still don’t use it.
ABC Is a Multilevel Cost Reassignment Network
ABC uses multiple stages to trace and segment all the resource expenses as calculated costs through a network of cost assignments into the final cost objects: products, service lines, channels, and customers. It facilitates more accurate reporting because it honors costing’s causality principle (i.e., the relationship between cause and effect) for expense consumption relationships.
In complex, support-intensive organizations, there can be a substantial chain of indirect work activities that occur prior to the direct ones that eventually trace into the final cost objects. These chains result in activity-to-activity cost assignments, and they rely on intermediate activity cost drivers traced to consuming activities in the same way that final cost objects rely on activity cost drivers to reassign costs into final cost objects based on their diversity and variation.
Turning indirect costs into direct costs is no longer as insurmountable a problem as it was in the past. Integrated ABC software allows intermediate direct costing to a local process or to an internal customer or required component that is causing the demand for work. It further allows tracing costs among the final cost objects. Resource and activity cost drivers reassign expenses into costs with a more local, granular work activity level than in traditional systems. An example would be the accountant’s rigid cost center stepdown cost allocation method that reduces costing accuracy by relying on a single cost allocation factor for an entire support department.
Figure 1 displays the design of an ABC cost assignment network. ABC software is arterial in design, so it flows costs flexibly and proportionately. ABC consists of three modules connected by cost assignment paths. Eventually via this expense assignment and tracing network, ABC reassigns 100% of the resource expenses into the final accumulated costs of products, service lines, channels, customers, and business sustaining work. Visibility of costs is provided everywhere throughout the cost assignment network, including for how costs are “driven” by the activity cost drivers that comply with the cause-and-effect relationships. This visibility aids in identifying where to focus improvement efforts.
For those interested in understanding the mechanics of this design, here is a link to a PDF file of a Statement of Management Accounting (SMA) that I authored on ABC for the Institute of Management Accountants: http://www.garycokins.com/images/pdfs/Cokins%20IMA%20SMA%20Implementing%20ABC.pdf
Beneath the Iceberg: Unrealized Profits
With a valid ABC cost model, Figure 2 displays a graph line referred to as the “profit cliff” (and sometimes the “humpback whale” curve). This line is the cumulative buildup of each customer’s profit. Customers are rank-ordered from the most profitable to the least profitable, including those who are unprofitable (i.e., customers with a financial loss where their costs exceed their revenues). The last data point reconciles exactly with the company’s total profit and loss (P&L) statement.
The graph illustrates how a substantial amount of unrealized profits can be hidden because of inadequate existing cost allocation methods, and because of incomplete costing below the product gross profit margin line. Managers usually believe that the curve will be relatively flat. The broad averaging of traditional non-causal overhead cost allocations is crushing the cost accuracy and results in this flat-curve belief. ABC detects the unique variations of the final cost objects’ consumption of the work activities and their related capacity-providing resource expenses. ABC information usually shocks executives and managers the first time they see it because they have typically presumed that almost all of their customers are profitable. Instead, they have large profit-makers and profit-takers.
By using ABC, there can now be a valid P&L statement for each customer as well as for logical segments or groupings of similar types of customers. The shape of this graph is typical for most companies. From left to right, the graph line reveals the company earns a substantial amount of profit from a minority of customers, roughly breaks even on some, and then loses profits on the remainder. Figure 3 is an example of an individual customer profitability statement.
Migrating Customers to Higher Profitability
The crucial challenge is not to use ABC just to calculate valid customer profitability information from transactional data, but to really use the information—and use it wisely. The benefit comes from identifying the profit-lift potential from customers and then realizing that potential with smart decisions and actions.
Although customer satisfaction and loyalty are important, a longer-term goal is to increase corporate profitability for the shareholders derived from increasing profits from customers as if each customer were an investment in a stock portfolio. Think that the purpose of actions taken is to increase the financial “return on customer” (ROC). There should always be a balance between managing the level of customer service to earn customer loyalty and the spending impact that doing that will have on shareholder wealth.
In any company’s P&L, there are two major “layers” of profit margin:
- By the mix of products and service lines purchased
- By the “costs to serve” apart from the unique mix of products and service lines (This is that “bottom half of the picture” I referred to earlier.)
Figure 4 combines these two layers as a two-axis grid: (1) the “composite product mix profit margin” of what each customer purchases (reflecting net prices to the customer), and (2) their costs to serve. Individual customers (or grouped clusters of customers with similar traits) are located at intersections where the size of the circle diameters reflects each customer’s revenues. Note that migrating customers to the grid’s upper-left corner is equivalent to moving individual data points in the “profit cliff” profile in Figure 2 from right to left. Knowing where customers are located on the matrix requires ABC data.
Figure 4 debunks the myth that customers with the highest sales volume are also generating the highest profits. The objective is to generate more profits from all customers regardless of their intersection location. This is represented by driving customers to the upper-left corner of the grid. Examples of actions that will do this are surcharge fee pricing, up-selling, and cross-selling. Those actions come from the sales and marketing function. The point here is the CFO’s accounting function needs to provide them the information.
A critical reason for knowing where each customer is located on the profit matrix is to protect the most profitable customers from competitors. Because so few customers typically account for a significant portion of the profits, the risk exposure from losing them is substantial. In Figure 2, the farther to the left side of the “profit cliff” profile distribution curve that the curve’s peak is located, the more sensitive and vulnerable the bottom line corporate profit is to competitor attacks from winning a company’s key customers.
Expand the Function
Much has been written about the increasing role of CFOs as strategic advisors and their shift from bean counter to bean grower. Now is the time for the CFO’s accounting and finance function to expand beyond financial accounting, reporting, governance responsibilities, and cost control. They can support sales and marketing by helping them (1) target the more attractive customers to retain, grow, and win back, and (2) acquire the relatively more profitable and valuable customers.
This article has been published on