Beneath The Surface

Entrepreneur, Oct, 1999 by Mark Henricks

Suspicious not all areas of your company are bringing in a profit? Break it down with activity-based costing.

Among the 1,500 plant varieties Bluemount Nurseries Inc. stocked, Nick Pindale suspected that some yielded profits and some only losses. Unfortunately, Pindale, the CFO and grandson-in-law of the founder of Monkton, Maryland-based Bluemount wasn't sure which was which.

Pindale sought answers from an accounting technique called activity-based costing, or ABC. Dividing nursery tasks into categories such as potting and planting, he assigned costs to each. Then he determined which ones Bluemount performed cost-effectively and which would be better outsourced, trimmed or omitted. The information identified the most profitable plants and even helped provide documentation for a bank loan needed to boost production of moneymaking lines.

Bluemount bloomed with ABC. "Five years later, not one of our original greenhouses is still standing," says Pindale of the 65-person nursery. "We've added state-of-the-art machinery in our potting line. And we've doubled in size."

By focusing on such activities as "processing invoices" instead of departments such as "payables," ABC differs from traditional cost accounting. Advocates say it's an improvement, providing information of far more use than customary ledger reports. Its ability to help companies find and trim money-losing products, customers and processes, as well as identify those with profit potential, has led to its adoption by well-known companies, including Mobil, Fidelity Investments and Coca-Cola.

"Within 10 to 20 years, everyone will have some form of ABC," predicts Gary Cokins, author of Activity-Based Cost Management: Making It Work (McGraw-Hill) and director of industry relations for ABC Technologies Inc., a leading ABC software and services firm in Beaverton, Oregon. "It's a matter of when, not if."

LEARN YOUR ABCS

Activity-based costing showed up on the business scene in the early 1980s, largely through the writing of Harvard Business School professor Robert S. Kaplan. Driving the interest in ABC was the growing proliferation of products and segmentation of customers and markets, along with generally tougher competition, says Cokins.

"Kaplan realized that accountants were using a single factor to assign cost to products," Cokins says. "It was usually labor hours, or sometimes gallons or pounds. When product diversity increased, this became nonsensical. Some things inevitably got over-costed, and others got under-costed relative to their true consumption of costs."

Today, ABC is considered particularly useful to companies with diverse products, many types of customers and tough competition. Firms in industries experiencing rapid price reductions are also prime candidates.

The first step in applying ABC is to define cost categories. These may include salaries, materials, utilities and the like.

Next, identify primary processes and key activities for each category. For instance, the process of addressing customer help requests involves activities such as answering the phone and researching questions.

Then calculate the costs of each activity by, for example, dividing the number of help requests processed into the combined salaries and benefits of your help-desk workers. Finally, you assign each activity's costs to the appropriate category.

Done right, the ABC exercise accurately assigns the costs of activities done for specific customers, products and services. That can point to activities that waste time. It can also highlight the customers, products and services that are actually keeping you afloat. It's not unusual, say advocates, for ABC to reveal that most of a firm's customers or products are actually losing money.

DETAILS, DETAILS

One ABC risk is getting bogged down in excessive detail. There's no end to the minute activities that can be identified in the process of conducting business, notes Cokins. The trick is to keep the level of detail manageable, collecting and analyzing useful information without expending too much time and energy.

ABC uses data from several sources. Some firms engage in time-motion studies to analyze complex activities. Others interview workers about what they do in their jobs. Most use information from existing accounting systems. Key data commonly includes figures such as the number of customer orders processed, total purchases and the number of new accounts opened, says Cokins.

Most ABC practitioners find that special-purpose ABC software is required to make the task manageable. At $6,000 and up for one package sold by ABC Technologies, software can add significantly to outlays for this type of accounting technique. There are, however, some pilot packages available for $500.

ABC produces bottom-line results only after practice. Although some companies see results almost instantly, it typically takes three months or so for most businesses to experience the benefits of ABC. And, depending on your product or business cycle, it could take much longer.