How profitable are your biggest customers? How much of your capital and operating expenditure is tied up servicing different customers or customer segments? Work it out and you may be surprised to find that your "best customers" are in fact your worst customers.

Activity Based Costing is normally accountants and finance department employees' purview and shunned by line managers as being too difficult to understand and impossibly difficult to execute.

It need not be as difficult as some people imagine and can be very useful in understanding and doing something about the cost drivers of your organisation.

In simplest terms, activity based costing operates on the following premise.

Cost objects e.g. customers, products consume activities e.g. packing, warehousing, planning or maintenance. Activities consume resources e.g. labour, electricity, (direct and indirect costs). Resource costs can be allocated to activities by a reasonable method. Activities can be allocated to cost objects by a reasonable method.

The first step in conducting an activity based costing exercise is not to determine the activities but to determine the end use of the ABC analysis.

If the exercise is to provide a clear costing analysis to evaluate slight differences in margins available in a very competitive market place, then the exercise will be lengthy and expensive and will use as much direct measurement as possible. For example, electricity consumption will need to be measured by electricity meters and labour consumption by time cards or even electronic devices.

If the exercise is to provide input into a balanced scorecard or strategy development, then the best assessment of senior and middle managers of the allocation of resources to activities and activities to objects may be enough.

Once it is clear at which level of precision data needs to be collected, the activities involved can be determined. The level of precision of data required will also influence the level of granularity required in defining activities.

There are three major ways in which activities can be determined and analysed. In decreasing order of precision, they are; direct measurement interviews, workshops, and middle and senior management determination.

Direct measurement and observations involve some physical or electronic recording of activities and their resource inputs.

Interviews/surveys can elicit the outputs and the customers of the activity, the resources consumed and the cost drivers of the activities.

Workshops can gain the same information as interviews, but will arrive at a consensus about the information rather than a collection of individual views to be analysed. Specific techniques can be used in workshops such as Ishikawa (fishbone) diagrams, brainstorming and mind-mapping.

The next step is to determine the drivers which cause an activity to be consumed by a cost object e.g. customers and the drivers which cause an activity to consume resources e.g. labour. It is important to remember again that the level of precision required in understanding the drivers depends on your end use of the activity based costing.

Once the model of activities, resource drivers and activity drivers is completed, it remains to collect data and calculate costs. A major benefit of an ABC analysis over traditional accounting methods is that it lends itself to understanding cost drivers.

Traditional accounting methods tend to focus on the profitability of a product rather than the profitability of a business or a function or a location. Product and customer profitability are calculated using a volume or hours allocation of overheads.

ABC analysis enables your organisation to understand the profitability of products or customers more accurately. It allows groups of customers who only receive telephone sales support to be allocated costs of the telephone activity and not the face to face sales activity.

The resources consumed in telephone sales e.g. the call centre labour costs are allocated only to the telephone sales activity and not the face to face activity.

In my past, ABC analysis has revealed that ten percent of our customers were making a loss for our organisation, thirty percent of our products were making a loss and our largest customers consumed a very high proportion of our resources which traditionally were thought of as our overheads.

Customers serviced by our sales people face to face were more likely to be loss making than customers serviced by telephone. We were, in fact over-servicing our customers. The more sold to a customer, the greater loss we were likely to make.

Resolving the over-servicing issue by charging people for services they wanted and offering "no frills" products to customers who did not want the extra services added 30% to the profitability of the business within six months.

©2008 Change Factory