According to a recent survey, one in three adults would accept a smaller paycheck in exchange for a simpler lifestyle. It seems that Americans are increasingly asking themselves, both personally and professionally, “How much is enough?”
How much overhead cost is enough for your business? Do you have too much or not enough? It is difficult to answer that important question using a traditional accounting report. The typical P&L format shown in Table 1 causes more questions than it answers:
- Why did we fail to meet the 5.4% profit plant? Our 30% gross margin exceeded budget and we under spent overhead expenses by $10,000!
- Do I have any waste in overhead? If so, where and how much?
- How many people do I really need to run this business successfully?
- If we added overhead to the business, could it actually result in more revenue and profit?
To answer these questions and many others, home care firms are using Activity Based Management (ABM) to right-size their overhead costs.
What is ABM?
Activity Based Management is based on a simple principles … activities consume costs. Allocating overhead costs of a business to the activities that consume those resources provides valuable new facts. Facts that can be used to identify and eliminate non-value added waste.
Traditional accounting measures how much resource was consumed by a department or group of employees. ABM measures what they did with those resources.
ABM Quick Start
All it takes is approximately 90 minutes to quickly demonstrate the principles and benefits of ABM in your company. The basic building block for ABM is an activity accounting spreadsheet (Table 2). The columns are the activities; the rows are the resources. The workload of each activity is measured and costed. For example, it costs $37,700 to submit claims. Five hundred claims were filed. Therefore, on average it cost $75.40 to file a claim. This basic information can be used for improved decision-making and cost improvement.
Seven Quick Start Steps:
- Step 1 –Select a small department or group of employees for your ABM demonstration. Pick a group that is receptive to the idea.
- Step 2– Using a flip chart to visibly record their answers, ask the employees to list the 5 to 10 significant activities that consume a typical week or month. Significant is defined as more than 5% of their time. Use their estimates, not a stopwatch time study.
- Step 3– To determine Value or Non-Value, ask the employees which activities they do not enjoy … these are the non-value.
- Step 4– Define an output measure for each activity, e.g. a measure of workload. Refer to the examples shown in Table 2.
- Step 5– With their advice, allocate the group’s last three month’s overhead expenses to their activities. Note: If you don’t have a departmental cost report, estimate how much of your total company spending was related to this group of employees.
- Step 6– Gather output quantities for the past three months. Estimate if you must.
- Step 7– Divide the output quantity into the activity cost to determine the cost per output (see Table 2).
Traditional HME overhead accounting reports are two-dimensional:
- First, expenditures are classified by cost account (i.e. supplies, telephone, etc.);
2.Then, cost accounts are classified as fixed (i.e. space) or variable (i.e. supplies).
To better meet the growing needs of HME managers, an Activity Based Management system is multi-dimensional. ABM provides seven new overhead cost perspectives:
- Gross cost of each activity;
- Cost per output of each activity;
- Value versus Non-Value activities;
- Primary versus Secondary activities;
- Required versus Discretionary activities;
- Business sustaining versus revenue sensitive activities; and,
- Activities by business process (e.g. procurement process)
Variety of Activities
Activity classifications provide managers a multi-faceted tool to analyze and evaluate the business:
- Value activities, as the name implies, provide value to both the customer and the business. Submit Claims adds value. Re-Submit Claim is non-value. Typical HME’s find 25% non-value added costs at the onset of ABM. Multiply 25% times your annual overhead budget. How much waste is it? ABM can help you find it and eliminate it!
- Primary activities support the mission statement of the company. Secondary activities, as the name implies, are not directly related to the company mission. Employees will often classify activities that they feel are outside their realm of responsibility as secondary, e.g. It’s not my job to do that! HME’s frequently find 20% secondary activity cost. The benchmark is 10%.
- Required activities are performed to meet customer or external regulations. Discretionary activities add value but are candidates for elimination if profit margins fall short of budget. The HME owner or president should apply the required versus discretionary classification based on short-term financial needs. When profit margins are low or non-existent, many value activities may end up being classified as discretionary.
- Business sustaining activities, as the name implies, to not fluctuate with increases or decreases in revenue. Common examples include Do Monthly Accounting, Train Employees and File Tax Reports. While important, business sustaining activities do not create revenue. In any low margin marketplace, business sustaining activities should not exceed 20% of overhead.
- A business process is defined as a series of activities that cross-functional boundaries. Activities can be classified and flowcharted into a process. Typical HME business processes include the Procurement Process, Order Fulfillment Process and the Compliance Process. ABM business process reports are a useful tool to give employee-led process improvement teams.
Seven Discontinuous Decisions
Activity Based Management is a powerful new technology, but only when it is used. To be of value, ABM must be applied, not simply analyzed. After you’ve created your ABM Quick Start spreadsheet, find a quiet place and ponder these seven overhead changing decisions:
- DROP… Are there any activities in the department that should be eliminated or minimized? Frequently these will be non-value added or time consuming secondary activities. As an example, we recently installed e-commerce on our web site. During a quarterly review of our office activities I noticed that we will still performing old paperwork activities with the new web-based technology. We dropped the old activities and improved the cost, cycle time and quality of the order fulfillment process.
- DEFER … Are there any activities that you should defer to a later time? When profits are lacking, discretionary activities should be deferred to the next quarter or year. I would like to “Train Employees”, but it may make better sense to defer this activity to a later time. I’ll do it. But not now.
- DELEGATE … Are there any activities that should be performed by someone else? ABM frequently exposes activities that could or should be performed by lower cost employees or outsourced. One of our administrative activities is “Shred Confidential Files”. It was more cost effective to buy this activity from an outside company and re-deploy my staff’s time to creating revenue.
- DOMINATE … Are there any activities that we are really good at? If yes, are we promoting them properly to the customer? Someone once asked Walt Disney his secret of success. Disney’s response was “Do something so well that the customer will pay to see you do it again.” Do you have any dominant activities? If not, why not?
- DEPLOY … Is there an activity that should have its time and resources re-deployed to another use? A time management expert once told me that the average person, because they’re unorganized, spends one hour per day searching for what they need to do their job. One hour per day equals six weeks! Redeploy searching time into getting better organized.
- DARE … Select one activity for improvement. Dare your employees to submit a plan to you tomorrow for approval. Challenge them with a 10% productivity improvement goal. Share the savings with them.
- DEFINE … Define an activity that the department should be doing but they’re not. Maybe it should be a customer service activity. In her popular book Customer Loyalty fattens the Bottom Line, Sharon Sullivan says “A company can increase profitability by as much as 125% if it boosts retention of its current customer base as little as 5%. Replacing customers is 5 to 6 times more costly than retaining current customers.” Don’t relegate yourself to doing the same activities day end and day out. Be creative. Define something new!
Action or Procrastination … which are you going to choose?
Most home care owners see the need for overhead cost reduction on their monthly accounting reports. Reimbursement reductions coupled with rising overheads result in shrinking profit margins. And even though most managers have heard of the benefits of using ABM to reduce overhead and ABC to improve decision-making, they put off implementation. The systematic and habitual putting off of important activities can usually be attributed to one or more root causes. The causes may differ but the effect is the same. You fail to accomplish something you want and need to do.
Why do HME managers procrastinate?
- Fear of method… Home care managers incorrectly assume that ABM/ABC is a new, untested method. While ABM may be new to you, it is in fact a sixteen-year-old, proven methodology.
- Fear of failure … This actually is the fear of failing to meet your own, possibly unrealistically high expectations. Even when implemented in its simplest form, ABM always provides valuable new cost management insight.
- Fear of implementation… Many managers are afraid of ABM’s implementation costs. Facts are just the opposite. Several low cost implementation options exist. Several reasonably priced, home care savvy consultants exist. Or you may want to consider using an ABM-educated college student with spreadsheet software. Or another low cost option is to purchase a self-implementation toolkit that includes ABM software, Activity Dictionary, Case Study and step-by-step implementation instructions.
- Fear of success … Some managers avoid success in order to maintain the status quo, e.g. “If ABM exposes 30% non-value added overhead cost, then I’ll be forced to make some changes to the business.” The first step towards improving your P&L is admitting that you need to improve it.
- Fear of surrendering control… Every deadline missed is a battle won in the war to maintain absolute control of your business. Continually postponing an analysis of your overhead cost (ABM) and product line profitability (ABC) is a subtle way of saying, “See, I’m really in control.” Are you afraid that ABM/ABC may show you’re favorite product, service or customer is a big loser?
In his number one best seller, Who Moved My Cheese?, author Spencer Johnson M.D. reminds us all that “the quicker you let go of old cheese, the sooner you find new cheese.” Are you praying for new and improved profits while still holding on to your old accounting reports? The quicker you let go of the old and move to the new principles of Activity Based Management, the more likely you’ll enjoy the benefits. ABM brings new clarity and creativity to the old topic of overhead.
How much overhead cost is enough for your business? Only you can effectively answer that question. But with ABM to clarify the decision, I am confident that your results will be much closer to your financial goals.