Topics
43. The Rule of Thumb doesn’t exist
CFOs very often make the choice of a Cost Accounting and related Reporting System based on the opinions, very detailed and introduced with in-depth specific topics, of the vendors about the related softwares.
I will be as straightforward as possible.
Most costing system implementations focus mainly on the decision to set either a standard mechanism or not and once this decision is made by the persons in charge of this task (usually the CFOs) great importance is attributed to the role of the software vendors.
In the end many CFOs choose the Cost Accounting and Reporting System related to that software that enables the best business cost breakdown by cost object and gives an immediate perception of those results, considering the information requirements independent on the kind of business processes, products and the strategy of the business.
In other terms they believe to get the most suitable system on the basis of the detail level and visualization ease.
But are that business cost breakdown and its results so easy to be monitored consistent with their information requirements?
Please listen to the Management Accountants or to the Controllers that are very knowledgeable about cost issues and are able to find the right “fit”.
In the following lines I am going to summarize the most used kinds of Cost Accounting Systems and related Reporting that a CFO may be deciding to implement into his business according to different criteria.
Let’s start.
As I said in the lines above, the main choice goes either to a Standard Cost system or to an Actual one, but between those measurement kinds of the costs there is another halfway.
Its name is Normal Costing.
Having said that, let’s take into consideration the resources and the related costs that are the basis of this choice: Direct Labor, Direct Materials and Industrial Overheads (I mean the Manufacturing ones while for the Service Industry those incurred for giving the Services to the customers)
When a portion of them is “predictable” about their amount as well as the unit cost with reference to each product/service referred to in a reasonable way under given and presumably steady conditions of efficiency of the manufacturing/delivery processes, the Standard Costing system is fully applicable.
Its usefulness goes to the cost control purposes, performance evaluation and continuous improvement when comparing the actual results (costs) to the standard amount and costs set a basis to look at.
As to the Actual System all we know that each product/service is charged with the expenses once they are incurred.
Very accurate for the decision-making purposes but it doesn’t allow an immediate perception of how things are going as quickly as Standard System does.
Of course, when there aren’t conditions that enable the Standard Costing adoption, the choice of the Actual one is mandatory
Then, what about the Normal Costing System and what are the main reasons leading to its use?
Take the case when your products have their own direct materials (also direct labour if the workforce is specialized in that specific make), differing very much from those concerning other products while all the manufacturing processes are instead similar.
In this case the Normal Costing provides the Actual system for the direct materials and an estimated unit cost per product/service of the other indirect expenses.
Whether you are using a Standard Cost Accounting or Actual one or Normal one, you are moving within either a Job Costing System or a Process Costing one or an Operation Costing one.
As a matter of fact, another canonical classification concerns the way one can attribute the costs to the cost objects.
When all the costs are charged directly to the product/service, you will be in a Job Costing method; when you attribute all the expenses to the process of manufacturing/providing the product/service (to be successfully allocated to the products/services), you will be in a Process Costing.
In the end, if you attribute the Material Costs (together or not with the Direct Labour ones or other Special Fixed Costs) to the cost objects and all the others to the process (eventually allocated to the products/services), then you are moving within the Operation Costing.
Of course the choice lays in the features of the products and processes and the specifity of the resources consumed with reference to the cost objects.
In making the kind of choice we have indicated, we have neglected the horizon of the business profitability, wheter its strategy is focused on the long term or on the short term.
In the former case the Activity approach comes up as one of the most indicated to meet the information requirements of the management (in particular when the industrial processes are not so uniform when referring to the products/services/customers/distribution channels).
As we all know, when the horizon is the long term, the fixed costs (with reference to the output volume) get much importance and the accuracy of their imputation to the cost objects is lifted to the highest degree.
At this point you can choose for instance GPK cost management technique that is very suitable for the business with multiple cost centers characterized by different capacity-related resources.
It enables the construction of many financial intermediate results, even distinguishing between short-run fixed resources and long-run ones.
If your fixed overheads (with reference to the long term) are the most part of the expenses, then the classical ABC (Activity-Based Costing) is the most appropriate tool, by identifying the right drivers of the consumption of the resources (when the time is the most appropriate driver, the Time-Driven ABC is a further option).
If your intention goes salso to the assessment of the Unused Capacity, a mix of ABC and GPK, the RCA (Resource Consumption Accounting), can also meet your needs.
Not to mention the in-depth applications of the Activity approaches dedicated to the concept of the Value such as the Capacity Cost Management and the Activity- Based Management.
In the former case the system is very useful to many decision-making purposes and very suitable in particular for the businesses adopting a Price Leadership Strategy (when the Price determination follows a mark-up method), by allowing the identification of the time and the costs of the Idle and Non-productive capacity and as a result the potential increase of the denominator (productive capacity) to which dividing the fixed costs and the calculation of a lower unit fixed cost to be charged to each product/service.
The latter is consistent with the value as it is perceived by the customers with reference to the attributes/functionalities of the product/service.
Putting aside the traditional dichotomy between Volume-Based methods and Actity-Based ones, we cannot neglect the Lean Accounting System.
That is good in particular when you have many product models whose manufacturing/providing processes are very similar so that you can build some homogeneous bundles (Value Streams) by grouping some of the numerous models, whose profitability can be built and perceived at once through less detailed reports.
This methodology is also a very good basis for continuous improvement purposes intended to cut waste and improve the efficiency in general of the business processes.
Of course this dissertation hasn’t the goal to analyze each Costing technique as in-depth as possible but to highlight the need for the CFOs to hang upon the professional opinions of their Management Accountants (or Controlling professionals) when deciding the implementation of a particulas Costing method in order to be able to make the best analyses and decisions
As a result this article isn’t the right “place” where listing all the advantages and disadvantages of the above-mentioned methodologies.
If you wish to read more about a particular technique you may find some articles on this page and get in touch with thestrategiccontroller.com for further details
As you may have understood after these lines, there are many factors, objective (about the products/services and the business processes) and subjective (about the strategy) ones, to be carefully considered.
This leads to the conclusion that the Rule of Thumb doesn’t exist.
42. Why is the Healthcare Cost Accounting so peculiar?
Controlling issues have their own characteristics for every industry and some of their tools require the appropriate adjustments to those features and the strategy of the companies.
Indicators, budgeting, cost accounting settings and others are the instruments that attract the attention of the management for enhancing their informative and predictive importance.
There are cases where such matters present even more peculiarities that make the tasks of the management more demanding at the setting stage and require the need for an in-depth knowledge of the internal processes.
A full cross-functional expertise and/or availability to acquire it are as essential as ever for "getting the things right".
One of this cases is without a doubt that of the healthcare companies as a result of the needs their output should meet. The good health of the patients is the goal that unavoidably puts the level of the healtcare services at a high quality ranking.
Nonetheless, it goes without saying that another feature of the healthcare industry that affects the controlling tools is the limited autonomy of the private organizations about the price in function of the public value of their services that attract the intervention of the regulator.
That intervention concerns directly the public healthcare, in most countries it is the predominant system, and has also a great influence in countries where the health insurance system is used.
In fact, the private hospitals cannot deviate very much from the prices "imposed" by the regulator through different ways to each of the services concerned falling into their "influence" and should rely on the high quality and the timeliness in providing the services in order to achieve as many as customers possible, by focusing at the same time on the search of the best efficiency possible in the cost management.
However, the subject at issue is not short and takes long time and attention to dedicate to every kind of the related dissertations; on this reason I make up my mind to focus on just one topic: the strategic cost accounting of the healthcare companies.
We all know that the cost accounting helps companies understand where and how the resources are consumed, identifying the processes more expensive in comparison with those cheaper.
At the same time the services/products and the responsibility centers are valued and classified according to their costs.
Let's get started with the main peculiarities:
1) With particular focus on the healthcare companies organizations, we can see they are genarally structured in costing centers and that number of the primary operating costing ones is high (identifying some centers as profit ones is very unusual in consideration of the difficulty of leveraging the revenue side as we wrote earlier).
2) Another feature is that usually the Labour Costs are the only ones classified as direct center costs.
Many expenses are general and are incurred for helping all the centers work.
In order to explain the impact of these peculiarities on the cost accounting, let's go deeper.
What are the primary operating centers?
Hospital wards (each of them dedicated to a medicine speciality), out-patients departments, day hospitals and others.
If we look into them, we can see the reason why the direct costs consist mainly of the labor ones.
Materials (every kind of consumables) are made available for each dpt and their consumption is only indirectly linked to the number of beds. In facts, the beds are just in few cases all occupied and the lenght of the patient stay is always different.
This combined with the high number of departments (costing centers) makes any attempt to attribute the related costs in a direct way hard enough.
Furthermore only a few drugs can be attributed directly to some costing centers and the respective patients in a timely and precise way.
Not to say that medical equipments are available for the use of all the departments which may need them according to the progress of the disease of the patients and are not of exclusive use of only some of them.
Of course, these are general indications and some exceptions can be found depending on the width of the care given to the patients by the businesses.
After a large-scale analysis of the healtcare organizations, the main result is that the indirect variable expenses are predominant and when we state this, we refer to the costing centers that provide their own services to the patients.
These overheads, as I wrote before, are incurred for the functioning of the all the organizations.
What does it mean?
First of all, we should choose the most appropriate cost drivers linking as realistically as possible the resource consumption to the costing centers (that concerns also the assessment of the "work" from the support centers to the primary ones).
The solution on the side of the cost accounting could be the use of statistical techniques that show these drivers up as best as possible.
Many state the use of the activity-based costing approach could be a good solution.
In my opinion the use of ABC is appropriate when the services provided to the customers are very heterogeneous and the fixed overheads are not neglegible so that a mapping and breakdown of the activities are even more important.
Another aspect resulting from the preceding lines is that the controllability of the costs by the respective dpt managers, just because of their features, is limited and if we consider that when the doctors work as employees, that involves "protected" work contracts, the influence is even more restricted.
It's very advisable linking a part of the compensation to some performance indicators, allowing a better control over the costs (another peculiar facet of the healthcare business controlling is that of the nonfinancial KPIs that isn't dealt with in this article).
LAST BUT NOT LEAST the great use by each costing center of the medical advice from doctors working in the same organization but within other dpts.
This brings up the issue of the right internal transfer price (more appropriately transfer cost in the healthcare company case) that the managers of the receiving center could see as an unfair way to be charged with the inefficiency of the origin center of the doctor that gives the advice, since the latter's costs are those to be taken into account.
The advisable choice might be the use of an hourly standard cost of the origin center set as a basis for the advice evaluation to be taken as an additional cost of the receiving center.
Further aspects show up about the cost accounting when it comes to dealing with the healtcare system and that's why if you wish to know more, you can get in touch with me on page Contacts.
41. The strategic sides of Target Costing
One of the most used customer-oriented cost management approaches is without a doubt what is called Target Costing.
Nonetheless not all of its users take it as a deep, synergetic and interactive method between the firm and its market, either by focusing only on the market price or not taking into account the preferences of the customers about the functionalities of the product/service.
Even when they look at the preferences of the customers, the managers don't put on a customer perspective. They take their "feelings" about the customer needs as the most important reference for taking the right cost cuts.
However, in order to dig deep into these facets of the matter we need to make a step back and explain as best as possible the main features of this cost management approach.
Here we go!
We should know most of the costs a business incurs at the manufacturing/providing phase of the product/service's cost life cycle depend on how the product/service itself is designed/planned.
At the same time the after-sales service costs concerning a product may be a consequence of the choices made at the Design step.
Just at this step Target Costing comes up to help the managers accountable for the expenses to incur in many of the costs centers of the business.
How does it work?
The starting point is the magical formula:
Market Price - Desired Profit = Target Cost
The first term of the equation is as well the first to be determined by the businesses and that is made through different methods that I don't explain here.
Secondly a desired profit is set and the difference achieved is the reference for the main decisions and actions of the business.
We can easily see how this approach is not a mark-up based one that determines first of all the cost per unit of product service and then apply the share of the desired profit per unit (usually a percentage).
Having said that, now we can go on with the following steps without neglecting to do some considerations.
During my experiences I encountered both firms operating in luxury markets and ones manufacturing large consumption products that started from the price to get to the Target Cost.
At this point I could state that the businesses more suitable to make use of this method are the formers just because they have usually customers less sensitive to the price and that gives less pressure to operate on the costs.
I said "at this point" because I haven't exposed yet the additional steps of the Target Costing that highlight the functionalities of the product/service that are the main features that the customers of the large consumption products look at (more than the "rich" do).
In other terms if we focus only on the magical formula, we can take this cost management technique just as a maths equation and nothing more, without putting the customer needs at the hearth of our business and furthermore missing out on the great adaptability of this method to all the industries.
Instead, if a consumer analysis is made and it refers exclusively to the preferences expressed by the customers about the criteria used as the main drivers for their purchase, Target Costing is one of the most successful cost management techniques.
As you may have noticed, I have written in the previous sentence "it refers exclusively to the preferences expressed" because in many cases the opinions of the managers about the needs of the customers replace the results of the customer surveys as a starting point of the Target Costing, that is the great error of every kind of business.
As a matter of fact, in particular when you are running a firm operating in a fast-changing environment, the feelings/opinions of the managers are not so timely and accurate.
The marketing managers should read the results from those surveys as best as they can, by leveraging their expertise, but the starting poing should always be the voice of the market.
However, after this considerations let's go back to the subject of the article and resume just from the result of the customer surveys.
The preferences showed there require some activities and related costs being carried out and incurred by the business to manufacture or provide the functionalities/features meeting with those preferences.
In order to target the desired Cost identified by the "magical formula", an analysis on the relationships between functionality and costs must be made.
Some methods come up to spot these links in terms of costs spent by the companies on each of these functionalities.
I bear in mind the Activity-Based Management and the Cost Function Development.
The former requires the adoption of an Activity-Based costing method that is linked to the customer-driven value concept.
The latter (see article 6 of this webpage, "Are you customer-oriented? Here's how you can know about that") can be used when the components of the products are material, in other terms, important "cost aggregates". The calculation of the indirect costs attributed to each of the components may be made both on Volume-based approaches and Activity-Based Costing.
What have we to point out about the effects on the work organization?
Target Costing requires a strong interaction among various dpts such as R&D, Marketing and Finance.
Only this interaction makes accessible and workable different kinds of data that would otherwise be useless.
An in-depth coordination work by the top management is needed and the setting of databases gathering a lot of data is important to the same extent.
Once the relationships between functionalities and costs have been spot the socalled Value Engineering comes up.
It is the fourth step of Target Costing and has the goal to look over the tradeoff between those elements and see what its best level is.
The articulation of Value Engineering depends on the editability of the product features.
If the features and related functionalities can be easily added or modified singularly, we'll have the Functionality Analysis that considers the above mentioned tradeoff for each of the features of the product/service.
One example of the industries concerned is the fashion one that is the opposite of the automotive sector where the features of the product are dealt with in a bundle related to a given model.
In this case the Engineers design (Design Analysis) different models of product, each of them with a group of functionalities and related performances together with a given amount of costs.
Don't forget the costs taken into account cover all the product's life cycle including the after-sales service whose expenses may be a consequence of the choices made at the Design step.
One example?
Amongst the different solutions you may have also the possibility to include a same component of other models into the one you are analyzing in order to reduce the manufacturing costs but what happens for the whole business if the part is defective?
The warranty costs will increase importantly.
After this further specification, the choice in both cases (Functionality and Design analyses) goes toward the solution that satisfies the customers as best as possible and at the same time doesn't go beyond the Target Cost.
Of course the cost drivers, the elements related to each functionalities that explain the extent and the direction of the expenses, can be better identified statistically by the use of some techniques whose discussion doesn't fall within the reach of this "strategic" article and if you want to know of them, you can resort to page Contacts.
At this point we can state Target Costing is suitable particularly for the businesses with a strategy that falls halfway between Differentiation an Price Leadership.
Nonetheless this conclusion is not complete because this costing approach when combined with the Continous Improvement "philosophy" is its best guidance possible because it gives a very good direction to it.
What do I mean by that?
In consideration that Kaizen (Continuos Improvement) is adopted to a great extent by the manufacturing companies with a Price Leadership strategy and that are in continuous search for manufacturing cost reduction methods, we cannot help but stating the universal usefulness of the Target Costing that fits every company and every industry (including service one)
Last point.
What stage of the Sales Life Cycle is Target Costing fit best?
Remembering that Sales Life Cycle of every product/service consists of 4 steps (Introduction, Growth, Maturity, Decline), my opinion is that, considering the level of knowledge of the product/service acquired by the customers at that stage and taking into account the interaction between them and company, the use of Target Costing, always important, shouldn't be underestimated at the Maturity stage.
You want to dig deep within Target Costing!!??
Page Contacts of this website
40. The great implications of the true Capacity Costs (PART TWO)
This article will be better understood if you had a look at the article n. 31 of this webpage.
We have seen the categories the Capacity is broken into and the way to achieve them and assessing them by the use of Committed Cost per hour, Managed Cost per Hour and Available Cost per Hour.
Nevertheless, even more detailed classifications of the Idle Capacity (that make the decisions whether to resort to new investments or not even easier) are possible but it goes withouth saying that it depends on the possibility to get further data and on the costs of this information.
The purpose of this article, just as it happens for all the dissertations of the page Topics, is to highlight the strategic side of the subjects and if you want to go deeper, you can resort to page Contacts.
Kick off
One more point at issue is the reference of the calculation of the theoretical time, the basis for determining the Idle Capacity.
Let’s guess that you have only two machines, A operating 8,760 hours a year, B operating 7,000 hours (suppose that it is on lease and the contract don’t provide for further time extensions).
At the same time, suppose the time needed to work each product unit passing there is for both of the machines one hr, so that if you operate the machine A all the time, you will get 1760 units waiting to be worked at the machine 2.
The result is that you have created Inventory with its management costs and nonproductive time (storage, handling…..).
YOU SHOULD LOOK AT THE BOTTLENECK AND DEFINE YOUR THERETICAL TIME (7,000 HOURS).
It’s also clear how the bottlecks also define the pace of the entire system.
The meaning of what I am writing is that you cannot neglect the identification of the bottlenecks for creating the cost estimates used in CCM systems.
In addition to that, the bottleneck is useful in this context for turning attention to the point in the process where improvements will yield increases in goods units (service units) and potential profitability.
What does this mean?
In the previous example, I outlined how nonproductive time is created in the process when the capacity of the machines is not balanced around the bottleneck and excess waste (waiting time, storage, handling) comes up.
You know that these categories of activities (falling in nonproductive capacity categories)are not valued by the customers when falling into normal limits, let alone when they are generated in excess.
Yet, they take resources and time out of the other activities that instead are assessed by the customers in order to make the purchase of products and services.
These activities are the manifacturing (execution in case of services) and developmental ones because they yield ouput and as a result a potential increase in profitability.
Moreover, it's easy to see how the ABC approach can be advantageous in the mapping of the activities concerned within the CCM system, but that's not the core of this dissertation.
Before to move on to the metrics you can use for assessing incremental business or outsourcing opportunities, I would like to highlight another point.
Nonproductive Capacity is caused by variability of the process.
If you look at some of its forms (for instance scheduled downtime, unscheduled downtime, maintenance, rework…), you can gather how this capacity kind comes up because of the variations needed to pass from one job to another, to keep the machines going efficiently and so on.
All of these are “breaks” that should be minimized by adopting the appropriate measures that reduce the variation probability and trying to enhance the quality of process and components that reduce the nonproductive time.
Here is an example of a manifacturing firm.
If the quality/kind of the raw materials/components is uniform, the number of set-up operations (like the changeover for istance) will be reduced.
Let’s make the example of a service business
A telemarketing business whose employees call and call always the same persons to market a product or service, receiving very often at the end negative responses.
If the calls were addressed to a specific kind of people/target (probably the most "fruitful"), without variation of target management approach and “Persuasion process” with different info and product/services to be advertised), the repetive useless calls (rework) would be avoided and the time gained would be focused on productive time and as a result more profitable.
The uniformity of the process shoud be successfully targeted not only within the value chain of each company but as well with reference to its supply chain to make it as profitable as possible.
Some of these issues have been dealt with in the article n .36, “Only Just In Time?” I refer you to.
Another use of the CCM reporting is its usefulness as a means of monitoring the continuous improvement.
As a matter of fact it allows also to compare the Managed Capacity and related costs period after period and analyzing if some progress is being made.
For instance if you look at the Managed Cost per Hour trend and notice a decrease highlighted by the CCM reports, it means that an increase in the efficiency has been achieved in the deployment of the resources.
Let’s guess, moreover, that your company invested into new techmologies by purchasing new equipment.
The natural result of it should be the increase, in the period concerned, in the Committed Cost per Hour compared to the previous period.
At the same time the Managed Cost per Hour has been lowered.
What does it means?
Look at the numbers.
Table 1 – Continuous Improvement Monitoring
Year |
Committed Cost/HR |
Percent variation |
Managed Cost/HR |
Percent variation |
2018 |
$ 2,800 |
|
$ 4,800 |
|
2019 |
$ 3,400 |
+ 21.21% |
$ 4,200 |
- 12.5% |
It means theat the investment policy of the company for increasing the efficiency of the processes is going the right direction.
What about the metrics to make the right incremental business and outsourcing decisions?
A simple way to calculate both the Productive Capacity and its costs has been shown in the article 31.
If you divide the total Productive Capacity Cost to the number of goods units (service units), you’ll achieve the Competitive Cost per Unit.
Productive Capacity Cost/Number of Good Units (Service Units) = Competitive Cost per Unit.
This ratio is very useful to assess some decisions beyond the short term (we know when the short term is concerned with that some traditional measures are used, first of all the Contribution Margin and the Throughput Margin).
As a matter of fact, it takes into account the “true costs” linked to the capacity utilization in a decision-making process and the comparison of the present Competitive Cost per Unit with the Cost of a potential Incremental business per unit (cycle time X Available Cost per Hour) will yield a logical result.
Furthermore, other kind of strategic reasonings are possible about the acceptance decision of the Incremental Business by the firm (page Contacts).
At the same time if the Outsourcing option cost per unit is less than the Competitive Cost per Unit of the business, it means that is an advantageous decision.
Further considerations can be made about the Capacity Cost Management approach and the literature is rich both in operational and strategic sides but thestrategiccontroller.com has highlighted what it considers some of the main strategic characteristics.
If you wish to go deeper, the page Contacts of this website is always available
39. Which is the Most Profitable Customer?
Table 1 - Alpha Ltd Income Statement | |||
1st quarter 2019 | Johnson Ltd | Frank Group | Total |
Net Sales 1 | 2,000,000 | 1,780,000 | 3,780,000 |
Var. Ind. Costs 2
|
740,000 | 800,000 | 1,540,000 |
Ind. Contr Marg 3 |
1,260,000 | 980,000 | 2,240,000 |
Industrial Overh. 4 | 760,000 | 600,000 | 1,360,000 |
CGS (2+4) 5 | 1,500,000 | 1,400,000 | 2,900,000 |
Indust Profit (1-5) 6 |
500,000 | 380,000 | 880,000 |
Adm/S&M/R&D 7 |
520,000 | ||
Gross Income (6-7) 8 |
360,000 |
That's one of the possible Internal Income Statements we use to make the right analysis by customer (similar for market and distribution channel) and to start reasoning on what a right a profitable action could be.
It's a simple example where the customers of Alpha Ltd are onyl two, but I prefer malking this way in order to reach the goal of this article.
You'll notice that we stop at the industrial expense level but all of us are aware that a customer absorbs a lot of resources by other dpts.
Some of these costs and related activities are considered even value-added ones, that is they are functional to some of the attributes the customers see as important reasons for "striking the bargain" (getting the purchase process done).
Without making a breakdown analysis of these activity categories according to their value creation potential, I kick off to descant on this real consumption of resources and the costs incurred.
Some of these customer resource-consuming activities are hidden into the Adm, Sales & Mkt dpt and in some cases also into the R&D when a long-term supply contract is in place at particular terms on the features of the products.
Many of these activities bring about the top side of each Income Statement (the industrial expense level), that is the manufacturing/delivery activities and linked costs arise because the "lower" side of the Income Statement (other dpt expenses) has been effective.
In making the short-term decisions we rely on the variable costs but when a wider lapse is helpful we cannot stop either at the Contribution Margin or at Throughput Margin and we make our reasoning on the full cost.
Nothing new about that.
Where does the strategic side lie?
In assessing the customer profitability as well as the channel distribution channel one (for instance) many management accountants consider only the respective Industrial Profit calculated by multiplying the Product Unit Industrial Cost by the number of products sold to each customer.
In other terms they ignore the costs to serve customers that include all the costs related to the activities that help the business "strike the bargain" (sell the products/services) and match the requests from customers.
Example of these are Advertising, Service calls, Collection, Billing, Travel and so on.
As you may understand, these activities are not the same for all the customers and you can evaluate it if you spot the right drivers that is the factors that explain the resource consumption and the related costs of a particular activity.
In other words when the drivers vary, the costs for those activities vary as well.
If you make the right driver analysis, you make the right Customer Profitability Analysis, achieving as a result further benefits such as:
- Giving the decision-making basis for marketing new services and products.
- Choosing the best product/service mix to realize.
- Discouraging the most unprofitable services and products.
- Identifying the best distribution channels.
.........
Let's make a step back.
If we make use of the traditional volume-based cost allocation techniques we cannot avoid to hide the real consumption of resources and the subject dissertation doesn't make sense.
We should resort to the activity approaches that highlight the real cost drivers that show how and why the resource consumption happens in all the activities that help the business acquire the customers, make the deal and satisfy their after-sales needs.
Here the steps of the ABC/M methods are not shown because the literature is rich in these topics, but we will limit to show the last part of the process, functional to the purpose of the dissertation.
According to the results of table 1 the most profitable customer, by limiting the analysis to the Industrial Profit, is Johnson Ltd and on this basis the business, we call Alpha Ltd, makes its decisions.
We can see at the same time there are Adm, Sales & Mkt, R&D expenses not allocated to each customer and we put at issue whether a Customer Cost Analysis can shift the decision basis.
Let's guess all of the related costs are previously allocated, on the basis of activity drivers, to the activity and now the last step to take is tracing the activity costs back to the customers.
How can we do this?
In this regard a preliminary Cost Classification is important.
Customer Unit-Level Costs: these costs increase as soon as a product/service unit is sold or delivered to the customers. A good example is the Shipping costs when their amount depends on the number of units shipped.
Customer Batch-Level Costs: the cost variation materializes when a customer transaction is done and may include more than one unit of product/service.
The invoicing costs could be a good example as well as in most cases the delivery ones.
Individual Customer Costs: the resources in these case are consummed depending on the activities made with reference to a specific customer.
This is the case of the R&D costs when a customer asks for some new product features for the future supplies or of the travel expenses incurred to "pay visit" to the customer.
When the analysis shifts its focus to the Distribution Channel or Structural Business costs, other two categories come up:
Distribution Channel Costs: they vary according to the number of these channel because the firm pays for operating, running each of them.
For instance, if the company uses great warehouses for distributing its products to smaller sales points, all the related costs come into this category.
Structural Sales Costs: these expenses are related to those activities that aren't traceable to the previous categories because concern the "basic" existence of the Sales dpt, such as the compensation of the Sales Top Management and the costs of commercial cental offices.
Having said that and turning our attention to table 1, let's guess to be able, based on the available data, to spot 8 kinds of "activities" to serve customers that are traced to 3 of the above mentioned categories, with the respective costs, their drivers for allocating them to the customers ($ 460,000 out of $ 520,000 of Adm., Sales & Mkt expenses)
$ 60,000 are not allocated to any customer for any operating and appropriate reason.
Table 2 - Costs to serve customer breakdown by Activity of Alpha Ltd (the numbers are not taken by any real business case)
Activity Amount Categ. Cost Driver (CD) CD Numb CD cost CD Numb for Johnson $ for Johnson CD Numb for Frank $ for Frank
Delivery 120,000 Batch-Level Miles 5,000 24 3,000 72,000 2,000 48,000
Cust. Visits 70,000 Indiv. Cust. Visits 30 2,333 22 51,333 8 18,667
Order Processing 25,000 Batch-Level Orders 300 83.33 180 15,000 120 10,000
Invoicing 20,000 Batch-Level Invoices 240 83,33 160 13,333 80 6,667
Sales Return 15,000 Unit-Level Units 500 30 300 9,000 200 6,000
R&D 60,000 Indiv. Cust. Techn. Requests 8 7,500 6 45,000 2 15,000
Restocking 20,000 Unit-Level Units 250 80 190 15,200 60 4,800
Shipping 130,000 Unit-Level Units 2,800 46,43 1800 83,571 1000 46,429
TOTAL 460,000 304,437 155,563
In consideration of the results of this Cost Analysis the real Customer Profitabilty table is the following:
Table 3 - Customer Profitability Breakdown
1st quarter 2019 | Johnson Ltd | Frank Group | Total |
Indust Profit |
500,000 | 380,000 | 880,000 |
Adm., Sales & Mark. |
304,437 | 155,563 | 460,000 |
Customer Profit | 195,563 | 224,437 | 420,000 |
Adm., Sales & Mkt not allocated | 60,000 | ||
Gross Income |
360,000 |
The basis for any kind od decision concerning the customers has now changed: the most profitable Customer is Frank Group and not Johnson as resulted instead from table 1.
Of course the importance of this Activity Analysis goes at the same pace as the degree of the customer orientation of the business.
The higher the importance the firm puts on the customer satisfaction the higher the costs to serve customer and the higher the usefulness of this cost management technique
Other issue is the profitability by Customer in the "remote" future.
There another kind of analysis that should be done and any request may be asked on page Contacts