Have you ever played “Three Truths and a Lie”? It’s a great icebreaker for groups of people who don’t know each other. At the opening of a workshop I ask each participant to write three truths and one lie about themselves. Each person takes turn reading their four statements to determine if others can guess the lie. Learning new truths sparks activity and momentum.
Here are three truths and a lie about Activity Based Costing (ABC).
Which statement is a lie?
If you guessed #3 is the lie, you’re correct. The three truths were extracted from a 2001 research study titled Activity-Based Change Management: A Literature Search published by Professor Annie L. McGowan of Texas A&M University.The lie is a misunderstanding held by many non-financial managers.
Purists define an Activity Based Cost system as having two parts… a Bill of Material plus a Bill of Activity (labor and overhead). While this definition is purely correct, it is not always practical. BOM + BOA leaves no room in between for a gross margin calculation. And because gross margins are a familiar point of reference, some managers are unwilling to give up the familiarity of their current P&L format for the benefits of an ABC system.
PROFILING Gross margin percents are a form of “profiling”. Webster’s defines profile as “a side view of an object or structure”. Percentages placed next to the dollars on an income statement provide a “profitability profile”, a useful “side view” of the financial report. High gross margin percentages typically fit the profile of a profitable product, customer or sales transaction. Low gross margin percentage transactions are anticipated to have a negative impact to profit.
When done properly, profiling can be very useful. Grocery stores use shopper loyalty cards to grant discounts and profile customer consumption habits. Police use profiling to catch criminals. And insurance companies gather data to profile high-risk customers that should be charged higher rates. Gross margin can be a useful profile for pricing and profitability decisions. But to be of value, any profile must reflect reality. Traditional gross margin calculations often provide a misleading profit profile.
MISLEADING MARGIN Gross margin is used as a profiler for profit decisions. If overhead activities are not factored into the gross margin profile, inappropriate assumptions and decisions can result. For example, in the traditional P&L below, overhead expenses are 20% of gross sales. This P&L profile would lead management to believe a $10,000 sales transaction with a 25% gross margin is profitable. Conversely, a $10,000 sale with a 10% gross margin would be assumed unprofitable. This line of thinking is based on the assumption that all overhead costs below gross margin are consumed equally. Problem is, overhead costs are not consumed equally by every customer, product or sales transaction.
|– Cost of Goods||$7,500,000||(75%)|
|= Gross Margin||$2,500,000||25%|
|– Overhead Exp.||$2,000,000||(20%)|
|= Pre-Tax Profit||$500,000||5%|
An Activity Based Cost system would show that a single product, one invoice order with a 10% gross margin is profitable because it consumes only $500 overhead cost ($10,000 – 9,000 = $1,000 – 500 = $500 PTP). Conversely, ABC would show the 25% gross margin resulting from a rush order for small quantities of several products to multiple delivery sites would consume $2,500 activity costs, resulting in no profit ($10,000 – 7,500 = $2,500 – 2,500 = $0).
GROSS MARGIN PROFILING A single, averaged gross margin is not a reliable point of reference for pricing, profiling or predicting profit. Needed is an improved method that embodies the familiarity of gross margin while simultaneously incorporating the improved accuracy of Activity Based Costing. Traditionally, gross margin has been a top-down calculation… Sales minus Cost of Goods Sold equals Gross Margin. A more accurate gross margin percent for decision-making can be calculated by combining the top-down calculation with a bottoms-up ABC methodology. This meeting-in-the-middle-method of profit management is called a Gross Margin Profile.
A Gross Margin Profile is defined as “the gross margin percent required to make a sales transaction profitable”. A Gross Margin Profile is a picture of future profits. When cost of goods or services, activity cost and a pre-tax profit goal are combined, you have the ingredients for a Gross Margin Profile.
Here are the steps to create a Gross Margin Profile:
FIVE STEPS TO CREATE GROSS MARGIN PROFILES
STEP 1 Define the activity cost for every department of the company. This step can be self-implemented with an ABM Software Toolkit or provided by an ABC consultant.
STEP 2 Group activities into business process cost pools and define a cost driver for each pool. Normally there will be 5 to 10 cost pools and cost drivers.
For a distributor, the five pools might be the Procurement Pool, Order Fulfillment Pool, Delivery Pool, Expediting Pool and Business Sustaining Pool. The cost drivers might be Number of Line Items, Number of Shipments, Number of Miles, Number of Expedites and Number of Invoices.
STEP 3 Create a Gross Margin Profile matrix. The rows of the matrix will be Sales Price, Cost of Goods, ABC cost and Gross Margin Profile. The columns will a description of the items profiled. Typical items to be profiled are product lines, types of orders, job shop processes or customers.
For example, the columns for a distributor might be High Volume-Short Delivery, High Volume-Long Delivery, Low Volume-Short-Expedited Delivery, Low Volume-Long Delivery, etc.
STEP 4 Determine the cost driver quantity consumed by each column of the matrix.
For example, if a short delivery is 20 miles @ 10 cents per mile, $2.00 of mileage cost would be added to the High Volume-Short Delivery column of the matrix.
STEP 5 Calculate the Gross Margin Profile for each column of the matrix. The Gross Margin Profile chart below shows the gross margin required to achieve a 5% pre-tax profit on each type of order. The formula to calculate a Gross Margin Profile is:
|1 – COGS||/ COGS+ABC||= Profile %|
|1 – .05|
GROSS MARGIN PROFILE
|Single item, large quantity, single site, short delivery||Several items, small quantity, expedited to multiple site, long delivery|
|– Cost of Goods||$9,000||$7,500|
|– Procurement Pool||$48||$750|
|– Order Fulfillment Pool||$150||$500|
|– Delivery Pool||$2||$100|
|– Expedite Pool||$0||$500|
|– Business Sustaining Pool||$300||$650|
|= Total ABC Cost||$500||$2,500|
|Gross Margin Profile||10%||29%|
Detailed calculations of the Gross Margin Profiles shown above:
|1 – $9,000||/$9,000 + $500||= 10%|
|1 – .05|
|1 – $7,500||/$7,500 + $2,500||= 29%|
|1 – .05|
NOTE: To receive a FREE Gross Margin Profile example and Plan, send an e-mail to email@example.com.
USES OF GROSS MARGIN PROFILING How can a customer service rep quickly quote a price that’s fair for both the seller and buyer? How can a job shop engineer confidently bid a job at a profitable price? How can a sales manager determine if specific customers are profitable? How can managers empower employees to make profitable pricing decisions? These important questions and many others can be answered by creating a Gross Margin Profile.
There are many uses for a Gross Margin Profile. The columns and rows of the matrix can reflect the specific needs of most every type of company and decision-making situation. Three common uses of a Gross Margin Profile are:
ADVANTAGES OF GROSS MARGIN PROFILING The formula for value is: Value = Benefit (-) Cost.
The benefits of a Gross Margin Profiling system exceed its cost, resulting in significant value. Here are seven benefits to expect from Gross Margin Profiling:
NEEDED: ABM COST REDUCTION AND ABC COST ALLOCATION Since most organizations have already trimmed costs, a recent report in The Wall Street Journal indicates many companies are now changing pricing methods to increase profits. If a customer is not willing to pay the profile price for the product and services requested, it’s a lost sale but not a lost profit. “Jergens Inc., a Cleveland industrial parts maker, has started charging big premiums for small orders of fasteners that it used to price like larger orders. Union Pacific Corp. has started charging its rail-freight customers as much as 40% extra for faster delivery.” (5)
Companies are dropping customers who aren’t willing to pay for the activities they’re consuming. “If the less profitable customers dropped out, it wasn’t a great loss. Instead, it freed up capacity for customers at the higher end of the pricing ladder, who wanted more space on trains,” (4) says Martin Coalson, assistant VP of product development and yield management for Union Pacific.
CONCLUSION Truth is, one gross margin is simple. But for most organizations, one margin is simplistic. Managers with broad product lines and diverse customer profiles are living a lie to think one gross margin fits all. An averaged gross margin results in below average profits. “The Profit Zone is the arena of a company’s economic activity where high profit happens — not average profit, not cyclically inflated profit, not short-term profit. The Profit Zone is where sustained, superior profitability creates enormous value for a company.” (6)
Gross Margin Profiling, based on financial facts from ABC software, can move a company from the “oh-no zone” to the profit zone. Profiling matches customer priorities with provider’s profits. Cast a brighter, new vision for your organization. Implement Gross Margin Profiling. In the process, you will learn new truths that will spark activity and momentum. That’s the truth, not a lie.
(1) The Spirituality of Success, Vincent Roazzi, Brown Books, 2002
(2) Courageous Leadership, Bill Hybels, Zondervan, 2002
(3) Simplicity, Bill Jensen, Perseus Books, 2000
(4) The Power of Simplicity, Jack Trout, McGraw-Hill, 1999
(5) “After Cost Cutting, Companies Turn Toward Price Rises”, Timothy Aeppel, The Wall Street Journal, September 18, 2002
(6) The Profit Zone, Adrian Slywotzky and David Morrison, Random House, 1997