Does your cost system need to be precise? Probably not.

Does it need to be accurate. Yes!

What’s the difference? The four pictures above begin to provide an answer.

Accurate costs are random but near the target. For example, I have a refrigerator with a thermostat that keeps it a constant 38.0F. I test it with a dollar store thermometer 10 times. The temp readings range from 37F to 39F. Therefore, my inexpensive measurement system is accurate …close to the 38.0F target … but lacks precision.

Precise costs are repeatable but not necessarily accurate. Using the refrigerator example, an expensive scientific thermometer would have decimals and register precisely the exact same temperature during each of the 10 tests. The precise measure might be 36.05F after each of the 10 measurements or it could be precisely 38.05F each time. How could an expensive measurement system be consistently different? Not calibrating the measurement system before use is commonly the root cause.

Precise implies accurate but that assumption is wrong. Precise systems are more expensive than accurate systems but often not what we need.

You may be thinking “Why should I care?”

Short answer is “To have a profitable business, you’ve got to match the accuracy of your cost system to your type of business“.

Select the situation that best describe your business:

1. Low Accuracy-Low Precision: If you’re the sole provider of a new product or service that delivers high value to customers, you don’t immediately need an accurate or precise cost system. Charge customers whatever price you want as long as net profits exceed 10%.
2. Low Accuracy-High Precision: If you have competitors with published prices, you need a precise cost system. A precise cost system, like Activity Based Costing (ABC), will consistently enable you to define, implement and measure continuous improvement to eliminate waste and compete.
3. High Accuracy-Low Precision: If you Bid & Quote for new business, you need an accurate cost system. If your bid is based on inaccurate costs, one of two things will happen; (1) your batting average on bids will be low; or, (2) you’ll win unprofitable orders you wished you hadn’t won.
4. High Accuracy-High Precision: If you compete in a market that has excess capacity, you’ll need a precise and accurate cost system. An Activity Based Cost system works well here because it measures Non-Value Added excess capacity. To take sales revenue from competition, you may want to price your product or service based on a highly accurate cost that excludes the precise expense of excess capacity.

Barometric pressure is precisely useless information. It’s precise because it has two decimal points, e.g., 28.35. But to me it’s not accurate because I don’t know what the number implies, what I should do or what I should expect.

If your choice of cost system has your head spinning like barometric pressure does to me, give me a shout. I’ll help you match your needs to the best costing method. 

The September 14, 1999 Wall Street Journal featured an article on the Six Sigma programs of AlliedSignal, General Electric, Citicorp, Johnson & Johnson, Black & Decker, Weyerhaeuser and a growing number of worldwide organizations. The primary goal of Six Sigma is to achieve no more than 3.4 defects per million products or processes.

Six Sigma is not just a “factory floor” goal, it is also an “office floor” goal. I was first introduced to Six Sigma during my mid-80’s stint as a controller with Motorola.  For example, at Motorola Six Sigma means no more than 3.4 defects per one million cell phones, no more than 3.4 defects per one million accounting system journal entries and no more than 3.4 defects per one million purchase orders.  Six Sigma applies to every product and process.

To accomplish the Six Sigma target requires many new skills and disciplines.  Jack Welch, chairman of GE, tells his young managers to “master the Six Sigma discipline that leads to black belts if they want to move up at General Electric.”  To master the Six Sigma discipline begins with business analysis and measurement sciences training.  If you apply the training effectively to improve products and processes with measurable results, you become a Green Belt.  Additional training coupled with repeated successful applications of the newfound skills qualify managers for a Black Belt.  A few select managers achieve Master Black Belt status.

What best practice method are these Six Sigma organizations using to expose the labor and overhead waste of poor quality?  What kind of cost system would mirror and measure a business process?  What measurement would be both practical and precise enough for such an important commitment as Six Sigma?

The Wall Street Journal did not name the cost measurement tool that is being used by the Six Sigma organizations to quantify the savings of Six Sigma improvement projects.  But phone calls to GE, AlliedSignal and Motorola confirmed my intuition…it’s Activity Based Cost Management (ABM).

And as Paul Harvey says, “And now you know the rest of the story.”

Send your comments to TomPryor@icms.net.

Your instinct is to select the stylist with the good-looking hair. But looks can be deceiving … the person with the messy hair cut the other stylists’ hair.

When implementing Activity Based Management (ABM), looks can be deceiving. Relying on instinct has led some ABM implementers in the wrong direction. Here are three examples to consider:

• Non-value activities look like the best cost improvement opportunity.But don’t be deceived. Most organizations would gain greater benefit from a focus on value. According to Howard Hendricks in his book Color Outside the Lines, it is human nature to be negative. Mr. Hendricks says, “If you’ve received higher education, you are probably even more critical than most. Why? Because you were trained to be! You were schooled in the art of critical That’s not all bad, but it can be limiting.”People viewing ABM reports for the first time tend to focus on the non-value activities (NVA). For the most part, this is because they’ve never seen waste dollarized. Focusing on NVA, however, can be limiting. Almost every organization I’ve worked with during the past twelve years has found twice as much VA than NVA, e.g. ICMS customers average 65% value-added activity cost. Most organizations have a greater opportunity to improve profitability by focusing on the improvement of value activities than non-value. When selecting activities to improve, encourage employees to improve both a value and a non-value activity in their department.
• Products look like the best target for Activity Based Costing (ABC). But don’t be deceived.We should not mistake products for solutions when creating an ABC system. My 79-year old dad had successful triple-bypass surgery this year. Reviewing the hospital invoice I noticed that two Tylenol tablets cost $12.00! Did this productreally cost $12.00? The answer is “No”. The hospital’s antiquated cost system had allocated nursing and pharmacy overhead cost to the product instead of the activities (i.e. Fill Prescription, Deliver Prescription, etc.) performed to provide my father a solution to his illness.When defining ABC cost pools and cost drivers, make sure you’ve got the correct cost objects. I recently provided onsite ABC coaching to an industrial parts distributor. Management’s initial interest was in ABC product costing. As we prepared to construct the ABC product cost model, I realized that many of the most expensive activities had little or nothing to do with the purchase and delivery of a part. Instead, many of the activities provided customers with solutions, not products. Examples of solution-based activities were “Assess & Define Customer Needs”, “Design System” and “Troubleshoot Problems”. Including these activities in ABC product cost would have resulted in the over costing of products sold to customers who don’t consume the solution-based activities. When implementing ABC, separate product activities from solution activities.
• Rest is typically considered non-productive time. But don’t be deceived.Rest can rejuvenate profits. Counter to what the culture would have us believe, rest is productive, not waste. We live in a restless age. A 1998 Reuters report claims that the average worker gets interrupted 169 times per day. Interruptions create tension. Tension leads to poor productivity, errors, employee turnover and often illness. To reduce tension, we need rest. Even God rested … “By the seventh day God had finished the work He had been doing; so on the seventh day he rested from all His work.” (Genesis 2:2-3)In their book The Fourth Frontier …exploring the new world of work, authors Stephen Graves and Thomas Addington state, “Rest itself is an essential movement of the rhythm of life. You can’t work well without rest, and you can’t rest well without work.” When reviewing Sandoz Agro ABM reports several years ago, I recall seeing an activity called “Tinker Time”. It was the policy of Sandoz management to encourage employees to spend several minutes a day simply resting and thinking about new ideas to improve themselves, their department and the company. Tinker Time is a creative interruption whose time has come.

In his best seller Rich Dad, Poor Dad, author Robert Kiyosaki says that Poor Dads teach, “Our home is our largest investment and greatest asset.” Rich Dads teach just the opposite … “A house is a liability, not an asset.” Kiyosaki challenges the reader to not be deceived by traditional thinking. When it comes to activity accounting, Rich Dad would likely say, “It’s not the numbers, but what the numbers are telling you.” Don’t be deceived by the first glance at your activity accounting numbers. Instead, pause and pursue the story your Activity Based Management numbers are telling you.

“Good” profitable customers rarely become unprofitable. It’s more likely that they were unprofitable from the onset. Gross margin has been the traditional method of identifying “good” and “bad” customers. For example, if your overhead costs are 30% of gross revenue, a good customer is anyone with a gross margin over 30%. Conversely, bad customers have gross margins of 30% or less. This simple method has become simplistic. Customers rarely consume overhead costs equally. “Good” customers consume less activity than “bad” customers.

Activity Based Costing (ABC) has become the best method to identify profitable and unprofitable customers. ABC customer profitability analysis is based on the simple principle “customers consume activities”. It is not uncommon to find with ABC that 80% of overhead activity cost is consumed by 20% of your customers.

Consider this ABC customer profitability example. Large retail customers typically demand low purchase prices. If you sell to someone like Wal-Mart, their gross margin percent may be several points lower than your smaller customers. ABC analysis often exposes, however, that large retailers consume less than 30% of the overhead activities. As a result, while your Wal-Mart gross margin may only be 25%, an ABC “bill of activity” may show that their pre-tax profit contribution is actually 10%, not a loss of 5% (25% – 30%). Walking away from business opportunities with large retailers is very dangerous without first performing ABC customer profitability analysis.

Hold onto your “good” customers. But what should you do with “bad” customers found out? ABC helps you convert unprofitable customers to “good”:

• Look at yourself first.Identify and begin to eliminate non-value activities. In other words, you may be the reason they’re unprofitable!
• Create cost consequences.Don’t charge every customer for the overhead cost of expediting, changing orders or past due collections. Change your pricing policy. Tell customers, “We’ll be happy to expedite your order, but there is a charge for that.” Cost consequences improve the behavior of “bad” customers.
• Share your Bill of Activity.Review your Bill of Activity with large volume, unprofitable customers. Without showing them your cost, discuss the unnecessary activities you are both performing. Use your Bill of Activity to define an improved method of doing business with them. By helping your customers improve their process, both of your P&L’s will improve.

ABC will help you identify the good, bad and ugly customers. Using ABC, ask yourself three questions:

• “Is this a profitable customer?“Yes or No
• “Is this customer strategically important?“Yes or No
• “Is this a high volume customer?“Yes or No

A customer with three Yes’s is clearly “good”. No to question #1 followed by two Yes’s is “bad”. And a customer with three No’s is “ugly”. Make 2001 a “good” year for your organization. Implement an ABC customer profitability analysis.

Does your organization need to perform an ABC Customer Profitability analysis in 2001?

If yes, ICMS can help you with planning, training, onsite coaching or software. Send an e-mail totompryor@icms.net and ask us for a free implementation plan.

Can you rank employees higher than customers and be a successful company? Southwest Airlines and Ritz-Carlton Hotels both do. If employees who work with the customer don’t feel cared for, they won’t care for the customer. Ask yourself, “Can we do that?”

Fearful times call for fearless living. If you or your organization has become a fearful recluse during the current economic downturn, break out of the doldrums. Bury your outdated practices and give birth to new processes, procedures and products.

Working hard at what does not work, doesn’t work. If this statement fits you or your organization, it’s time to bury outdated practices and give birth to creative new processes, procedures and products. Here are some ideas to consider:

• Search out and try new things
I’ve never learned anything from anyone who agreed with me. Search out and listen to new ideas, new methods and new friends. In January ’03, Bob Doig, owner of a industrial parts distribution company, decided to try ICMS’ ABC-based Gross Margin Profiling system. In less than six weeks, his company has won back a previously lost large customer, pruned unprofitable vendors from the product line and increased pre-tax profit by almost two percentage points.
• Search out and try proven things
In Failing Forward, author John Maxwell says,“Mistakes become failures when we continually respond to them incorrectly.” (1) Therefore, we should ask, “What did the winners of the 1990-91 recession do right?”If we search out and repeat what worked for the winners, we have the potential to reap the same rewards in 2003. Jane C. Linder and Brian McCarthy have published a study (2) of 1990-91 recession winners. Both winners and losers of the 1990 recession reduced costs and shopped for bargain assets. Only the winners used the principles of Activity Based Costing to: (a) cut non-value added costs and “diverted resources to activities that actually created value”; (b) “priced for profitability”, walking away from bad business while losers did not; and, (c) leveraged unique information systems to give them “the ability to manage and gain insight about their key value drivers.”

Different is not necessarily better, but better is necessarily different. I listened this morning to rock star Rod Stewart’s new CD. He sang the great old standard, The Very Thought of You. My reaction was, “This is certainly different, but not necessarily better.” To stand out and be of value in today’s marketplace, you and your organization must be different and better.

Can we do ____________? Can I do _____________? Fill in the blank for you or your organization. Think creatively, because challenging times give cause for creative responses. If you come up blank, ask people you admire for one or more ideas. Attend seminars. Read books. Spend time in prayer. Attend conferences. Take a one-day sabbatical from work to just think. Or call me. Do something! Don’t come up blank.

Today is a perfect time to begin your search and try new things to thrive through the recession. When people ask you, “Can we do that?” take it as a positive sign. It means you’re stimulating people out of their struggle with the past. Can we do that? Yes you can!

(1) Failing Forward, John C. Maxwell, Thomas Nelson Publishers, 2000
(2) “What Did the Winners of the Last Recession Do Right?”, Jane C. Linder and Brian McCarthy, www.Accenture.com, 2003

Manufacturers, distributors and retailers have used for decades a pricing method based on gross margin. Here’s how gross margin pricing works:

1. 1. Lets assume your company’s operating overhead costs are 30% of total sales revenue. Lets also assume that you desire a pre-tax profit of 5% for your company.
2. 2. Marketing proposes a new product that will cost $25.00 to manufacture or purchase.
3. 3. Using the gross margin pricing method, you would set the sales price at $38.50 to achieve a 5% pre-tax profit. The $38.50 is calculated as follows: $25.00 is divided by 65% e.g. (100% minus 30% overhead minus 5% profit = 65%).

Gross margin pricing is a simple method that has been used for decades. Yet more and more companies are switching to ABC pricing. Let me explain using the following story……

President: “I really love the new product you have proposed, but I’m afraid that we can’t add it to our product line.”

Marketing: “Why? Don’t you think our customers will buy it?”

President: “Yes, I think they would. But I don’t think they’ll pay $38.50 for it.”

Marketing: “Then why don’t we sell it for less than $38.50?”

President: “We can’t because our overhead costs are 30%. Unless we make a 35% gross margin, we’ll lose money on every one we sell.”

Is the president’s argument reasonable? To answer that question, we must review the basic set of assumptions that serve as the foundation for gross margin pricing. Gross margin pricing, as depicted in the story above, was logical and reasonable when manufacturers, distributors and retailers had (1) a small number of products; (2) a small number of customers; and, (3) overhead costs were relatively small and totally unrelated to the products sold or customers served. When these three conditions exist, gross margin pricing works well.

The basic conditions necessary for accurate gross margin pricing no longer prevail. The majority of today’s business owners (1) offer an ever increasing variety of products and services; (2) serve a larger customer base that have diverse service demands; and, (3) now have overhead costs that often exceed the cost to produce or purchase the product. The best method to define prices when these three economic factors exist is called ABC pricing.

ABC pricing disregards gross margin. Instead, ABC considers total cost, no matter where costs are currently reported on the P&L. Here’s how ABC pricing works:

1. A. A Bill of Activity is created that lists all the activity costs directly traceable or consumed by the product, service or customer.
2. B. Non-traceable business sustaining activities, such as “Do Monthly Closing”, are then allocated to the Bill of Activity.
3. C. Traceable costs + Non-traceable costs + Profit = Sales Price

An ABC Bill of Activity reflects total product cost, regardless of whether the cost is currently reported above or below the gross margin line. For example, lets assume that the new product proposed by Marketing in our story above is a purchased finished good produced by a TQM manufacturer. Non-value added activities such as “Inspect Receipt”, “Expedite Order”, and “Return Product” will not be consumed by this new product. By excluding these activity costs from the ABC price calculation, it is possible to sell the new product for less than $38.50 and still achieve the desired 5% profit. Under the old gross margin pricing methodology, these non-value overhead costs would have been assumed as being a cost of doing business for every product.

Here are a few other benefits provided by ABC Bill of Activity pricing:

1. ABC reports value versus non-value added cost. You may want to exclude non-value added costs from a bid if a plan exists to eliminate the waste.
2. ABC can report both “as is” costs as well as practical capacity “to be” costs. You may want to set pricing based on what costs can be if you win incremental new volume business.
3. ABC Bills of Activity lists the highest activity cost to the lowest. ABC serves as a terrific tool to prioritize cost improvement targets and action plans.
4. ABC Pricing financially quantifies and exposes the higher cost of purchasing low quality raw material or products e.g. low cost versus cheap.
5. ABC pricing exposes that gross margin pricing was overcosting high volume product/services/customers and undercosting low volume products/services/customers.

Should you convert to ABC pricing? The answer is most likely yes. Even if your current costing/pricing method is relatively accurate, ABC will still provide you important new decision making and profit improvement facts. While the marketplace will always influence pricing, the most successful organizations today are those that fully understand their costs. You can ill afford to overprice high volume products and underprice low volume specialty items in today’s marketplace.

Does ABC pricing really work? For an answer just ask Tom Sherry, VP of Sales & Marketing for Owens & Minor, one of America’s largest medical products distributors. He stated at a 1996 health industry executive conference “We have successfully demonstrated the benefits of ABC. We are replacing gross margin pricing with ABC.” If you recently said “I can’t believe our competition is selling at that price!”, it may be because your competition has switched to ABC pricing. Your competition may be setting prices based on total costs, not just gross margin costs.

Don’t take our word for it. Try a simple test. Take a cross section of your current products, services, or customers and compare their ABC Bill of Activity costs to your existing pricing method. You’ll be pleasantly surprised at the insight and improved accuracy provided by ABC.some Bill of Activity examples, simply give me a call at 817-475-2945. It may be the most important call you make this year.

For a free Gross Margin Profiling template, e-mail Tom Pryor at: tompryor@icms.net.

I recently used some of my 3 million air miles to upgrade to first class. As we approached cruising altitude the flight attendant handed me a menu. It listed two salad dressings and three entree offerings. I noted that the alternatives were the same as all my previous non-menu flights. I also noticed that by the time the flight attendant got to the back row, only one entrée option remained…. chicken. The menu results in more customer dis-satisfaction than pleasure.

By my estimates, it costs $50 to put a menu in my hands. Looks can be deceiving. One would not think that a single piece of paper would cost $50. But when you add up all the activities it takes to get a menu in my hands on an airplane, $50 may be a conservative estimate e.g. Design Menu, Meet on Menu, Request Printing Proposals, Select a Supplier, Issue Purchase Order, Print Menu, Receive Menu, Inspect Menu, Pay for Menu, Store Menu, Schedule Menu Picks, Pick Menu from Warehouse, Package Menu for Meal Cart, and Handout Menu.

Do you have any $50 menus in your organization?   Things that at first glance appear to be inexpensive but are in fact just the opposite. Activity Based Cost (ABC) systems often expose expensive activities, services and outputs that are overlooked by managers and traditional cost systems. For example, many of the organizations that have implemented ABC have found the following activities to be very expensive:

• Issue Monthly Closing Report… This report is not just an activity, it’s an entire business process in most companies. ABC often shows that this report cost thousands of dollars to prepare. Many managers question whether they get value equal to the report cost.
• Attend Meetings… It is not uncommon to find that the cumulative cost of this activity across all departments makes it one of the Top 10 most expensive activities in many organizations. Is there any output from your meetings?
• Wait… Inactivity consumes as much cost as activity. Idle people and machines are wasted resources and represent excess capacity. Excess capacity is the largest non-value added cost in most organizations. What would your product or service cost if you minimized excess capacity? ABC can answer that question.

What activities, products or services should you unplug this year?   Everyone has limited time and resources.  Curtailing or reducing specific activities will free up valuable time and budget that can be used in three ways:

• Give some. Re-deploy the time and budget for activities, products or services that have been begging for more resources.
• Keep some. Let the savings fall to the bottom line as increased profit.
• Save some. We all can use more financial and time margin in our lives. Margin = Your Limit (-) Your Load. Keep some of the time and money from the unplugged activities to move your margin from a negative to a positive.

Epilogue: On a flight last night, I was offered the same entrees with no menu. When I asked the flight attendant “Has the company gotten smart and eliminated the menus again?” her response was “No, catering did not give me enough menus for every person, so I threw them all away.” Add another non-value activity to the list: “Fill Out Missing Menu Report”!

If you do business with First Union Bank in Charlotte, North Carolina, the customer service department knows you by name, account number and by color … red, yellow or green.  When it comes to answering yes or no to a customer’s request for a lower credit card interest rate or to escape the bank’s $28 bounced-check fee, the First Union customer service rep’s answer will be determined by the color of a tiny square that pops up next to your name on the rep’s computer screen.

For customers with red squares the answer will likely be “No”.  Their accounts are not profitable for the bank.  Green means the customers generate hefty profits for First Union and should be granted waivers.  Yellow is for in-between customers.  The rep may negotiate with you.

First Union’s computer system is called Einstein. It takes just 15 seconds to pull up the customer profitability analysis. “ Everyone isn’t all the same anymore,” says Steven G. Boehm, general manager of First Union’s customer information center in a Wall Street Journal cover story January 7, 1999.  First Union estimates that the Einstein customer profitability analysis system added $100 million annual revenue from extra fees paid by unprofitable customers plus income generated from holding on to preferred customers who might have otherwise left the bank if not for the extra “yes’s”.

What secret formula is the basis for this powerful

Einstein system you may ask?  

What kind of cost system could report with any degree of accuracy the profitability of a specific customer? What cost system could be so simple that non-financial employees in a bank could use it? What cost accounting method could actually help add revenue and profits to the top line and bottom line of the P&L?

The Wall Street Journal does not mention the name of the method that First Union used to achieve their tremendous achievement.  But as soon as I read the story I knew the answer.  A phone call to First Union confirmed my guess.  It is called Activity Based Costing (ABC).  Yes, it’s the same ABC method that ICMS makes available today to every manufacturing, distribution, governmental and service organization worldwide. First Union Corporation not only implemented ABC, they use it and sustain it.

As Paul Harvey says “And now you know the rest of the story.”

Epilogue

Does your organization need to improve decision making like First Union Corp?  Do you need to know where you are making money and losing money?  ICMS has the books, training and software tool kits to help you do ABC profitability analysis and ABM cost improvement.  Call us today at 1-817-475-2945.  Or send an e-mail to Tom Pryor at tompryor@icms.net.

That is an astounding number of books. I read a book a week, but at this rate I’ll never catch up. Why are there so many new business books? Here are my thoughts…

Top 10 Reasons for 10,000 Business Books

• The need for new and improved business practices is growing exponentially.
• Managers have developed an insatiable appetite for the combination of lattes and books.
• Publishers believe, “If we publish them, they will come.”
• Layoffs of older, wiser managers leave remaining employees one resource for common sense… the bookstore.
• Today’s managers prefer gathering ideas than implementing ideas.
• Increased amounts of flight delays are causing travelers to purchase books to pass the time.
• com made it easier to buy books.
• Global competition has stretched the capabilities of companies, creating knowledge voids.
• Managers “change” books instead of “changing” their organizations.
• Dummy books have doubled book volume, e.g. “Six Sigma” followed by “Six Sigma for Dummies”.

Consumer Reports for consultants
Until recently, there’s been no Consumer Reports for the tools and techniques recommended by business books, workshop facilitators and consultants. To address this need, Bain & Company, a global consulting firm, surveyed 5,600 senior executives asking their usage and satisfaction with 25 tools. While the average company used 10 of the 25 in 2000, 81% felt that most management tools promised more than they could deliver. The Wall Street Journal reported greatest dissatisfaction with Corporate Venturing, e.g. growing a mature company by funding new, autonomous businesses and technologies. On the other end of the scale, executives rated Strategic Planning as the most valuable tool.

The rest of the story…
Not reported in the paper, but found on Bain & Company’s web site, is the high acceptance and rating of Activity Based Management (ABM). Of the 5,600 executives surveyed, most reported using ABM during the past eight years. And more importantly, the executive’s satisfaction ranking of ABM was a mere 10% lower than the highest rated of all tools, Strategic Planning. The primary uses of ABM were reported to be re-pricing products, optimizing new product designs, reducing costs, operational planning and strategic planning.

According to survey respondents, the success of any tool is determined by its repeatability. Was ABM/ABC a one-time pilot project in your organization or is it an ongoing process that continues to contribute to your improvement? To transition from a project to a process of improvement, the surveyed executives offered three recommendations:

• Recognize that every tool has strengths and weaknesses.
Tom Akright, leader of ABM at Ralston Purina, has always spent time educating management of what ABM does and does not do. Tom stresses that an ABM system does not think for you, perform work for you or fix problems by itself. ABM still requires knowledgeable, talented people to read, interpret and use the information from an ABM system to make decisions and implement improvements.
• Learn to apply the right tool to the right problems in the right way.
ABM does not solve every business problem. Six Sigma may be the right tool if your processes are consistently producing poor quality products or services. Or Business Process Re-engineering (BPR) may be the right tool if your organization takes too long to respond to the customer. ABM complements and enhances these tools, but ABM does not replace them. Senior management have responsibility for defining the “right problem”, middle managers have responsibility for defining the “right tools” and employees should be taught how to use the tools in the “right way”.
• Use proven tools prudently rather than trendy tools hastily.
ABM is 15 years old. Therefore, it is inappropriate to call ABM a “trendy tool”. ABM has proven itself over and over to be the best practice cost management tool for all types and sizes of organizations. Nonetheless, I have seen well-intentioned people implement ABM hastily, e.g. done too quickly to be accurate or wise. My grandfather wisely taught me to measure twice, cut once. The most successful organizations measure their needs, measure ABM’s relation to that need and then cut waste using ABM/ABC.

“Ideas, not gold, govern the world. Machines do much of the world’s work, but machines are born of ideas. A human worker without ideas is only a machine.” These words of wisdom are from “Onward to Fame and Fortune” by William Thayer, a best seller in 1897! Both old and new books can be resources for good ideas. Bain & Company’s survey is a new reminder of an old method to sort through those 10,000 books… the right tool applied in the right way to the right problem will consistently produce the right results.

Send your comments to Tom Pryor via e-mail: TomPryor@icms.net.

Does your organization need to perform an ABC Customer Profitability analysis in 2001?

If yes, ICMS can help you with planning, training, onsite coaching or software. Send an e-mail totompryor@icms.net and ask us for a free implementation plan.

Yes, you read it right. This statement from the Jewish Talmud is different from American criminal law. While both Jewish and American law desire the same outcome…truth… the methods used to ensure a criminal defendant is accorded due process are quite different.

To achieve the best results with an Activity Based Cost (ABC) customer profitability analysis, a combination of American and Jewish criminal law practices works best. American law requires consensus … a unanimous vote of the jury … while the Talmud calls for conflict. “After the deliberations of the court, and before any judgment was reached” says Jewish law expert Aaron Schreiber, “the judges were required to spend the night together in pairs, searching for a possible defense for the criminal defendant.” [2]

When implementing an Activity-Based customer profitability analysis, combine both legal practices:

• First, you need a unanimous vote by your management teamthat
(a) gross margin is no longer a reliable predictor of profitability;
(b) profit or loss by customer would be valuable information; and,
(c) ABC is the best practice method to trace overhead costs to each customer.
• Second,you need someone on the management team to side with unprofitable customers.
ABC analysis commonly finds 20% of wholesaler, distributor, service, banking or manufacturing customers provide 80% of the organization’s pre-tax profit. One or more members of your management team should be asked to pose a possible defense for the 80% of customers who are found unprofitable.

In a recent Activity-Based customer profitability analysis, ICMS consultants found 884 of 3,319 customers of a distributor were unprofitable. We advised the client, “Don’t rush to judgment”. Before we convict and cut those 884 customers, let’s consider the Three P Defense for Convicted Customers:

• Policy… Setting a minimum order quantity for each sale’s transaction can transform a small, unprofitable customer from the red (loss) to the black (profit). Knowing transactional breakeven costs and enforcing a minimum order quantity can reduce order fulfillment costs for both you and your customer. For example, the owner of an industrial parts distributor was surprised to learn from Activity Based Costing that his breakeven was $283.00 per order. Leaping from “no minimum” to $283.00 was more than his customer base could absorb overnight. Instead, he trained customer service reps to gradually increase the minimum over a year’s time, asking the customer “Is there anything else you need that we can add to this order?” The result? Many small, unprofitable customers became profitable in a matter of a few weeks.
• Price…“Everyday low Prices” works great for Wal-Mart, but this pricing model may not be a good choice for your company. Instead, a “fair but not equal” pricing method might work better. For example, medical products distributor Owens & Minor successfully and profitably separated the price of their products from the price of their services (activities). This menu-based pricing model ensures each customer pays for the overhead activities they consume.
• Process…Requiring every customer order to flow through the same fulfillment process can result in overhead costs that exceed the product revenue. An alternative process for small, simple orders can ensure they are profitable. For example, instead of delivering every order with the company vehicle, a growing number of home healthcare providers are using United Parcel Service (UPS) to deliver simple, low-price products like walkers, canes and toilet seats. UPS delivery costs per transaction are often lower than deliveries performed by a healthcare professional.

The objective of Activity Based Cost (ABC) customer profitability analysis is to acquit the profitable and convict the unprofitable. If you are using ABC in your company, select someone to play the Henry Fonda role in Twelve Angry Men… a dissenting murder trial juror that slowly convinces others that the case is not as clear as it seemed in court.Don’t convict and cut customers until they’ve received their full day in Activity-Based Court.

[1] Why Not? Barry Nalebuff & Ian Ayres, Harvard Business School Press, 2003

[2] Jewish Law and Decision-Making: A Decision through Time, Aaron Schreiber, Temple University Press, 1979