Here are three truths and a lie about Activity Based Costing (ABC).

Which statement is a lie?

• ABC has been consistently found to be of superior quality when compared to former cost systems.
• ABC is primarily an administrative rather than technical innovation.
• ABC systems that include overhead cost in the Bill of Activity make gross margin measurements irrelevant.
• ABC software models reveal new insights into cost and profitability yet managers are reluctant to act upon the information.

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.

Distributor P&L

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:

GROSS MARGIN PROFILE

Table 1

Detailed calculations of the Gross Margin Profiles shown above:

NOTE: To receive a FREE Gross Margin Profile example and Plan, send an e-mail to tompryor@icms.net.

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:

• SET PRICES
Distributors, manufacturers, retailers and service providers can perform an annual Activity Based Costing study to calculate Gross Margin Profiles for the most common types of sales transactions. When combined with the pre-tax profit percent goal provided by senior management, Sales and Marketing can create an annual Gross Margin Pricing Profile that customer service reps can use daily to price orders. Gross Margin Profiling can also be used to determine price lists or set pricing policy.
Successful pricing requires an understanding of the products and services customers want and delivering them at a price they are willing to pay. A customer requesting delivery of a large quantity of one product to a nearby site expects a good price. A sales person with the Gross Margin Profile (table 1) in hand would know that a 10% gross margin is a fair price for both the customer and the provider. Gross Margin Profiles provide a method of matching customer wants to what the customer pays.
• BID & QUOTE
Gross Margin Profiles are a useful tool for engineers tasked with the responsibility of quoting prices on new products. Automotive and aerospace engineers estimate product cost weekly for new parts. For use as a Bid & Quote tool, the Gross Margin Profile matrix columns could be defined as types of processes, products or cost driver profiles.
• CUSTOMER PROFITABILITY ANALYSIS
Activity Based Costing is frequently used to analyze customer profitability. A full-blown implementation of ABC, however, may not be practical or affordable. Or in some cases, cost driver quantities by customer may not be readily available to create individual Bills of Activity for every customer. As an alternative, a Gross Margin Profile can be used to determine customer profitability on a customer-by-customer basis. If a customer fits a profile, it will be safe to assume their contribution to the company bottom line is also a fit (profit) or misfit (loss).

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:

• NOTHING WILL CHANGE UNTIL YOU CHANGE THE WAY YOU THINK.
• “Habitual thinking leads you to experience life in a rut. A ‘rut’ has been described as an uncovered coffin with the ends kicked out.” (1)Having only one gross margin as a reference point limits your thinking. Having multiple gross margin profiles opens the door to multiple possibilities and choices. New thinking leads to new sales and new profits.
• HAVING PRE-DEFINED GROSS MARGIN PROFILES REDUCES ANXIETY. 
“When it comes to finances, complexity kills.” (2)Even small decisions can create anxiety. Using an old, outdated method of pricing is like living a script written for you by someone else. Gross margin profiling puts the right information, with the right people at the right place at the right time. Their actions will lead to meaningful financial results.
• INSTEAD OF PROFIT STRATEGIES, YOU NEED INSTANT PRICING DECISION-MAKING.
According to author Bill Jensen, “Leadership’s view of integration is the ability to bring together all the systems, structures, processes, and people so the organization can implement the strategic plan. Workforce’s view of integration is the ability to bring together the information I need at one place at one time so I can make a decision that leads to success.” (3)Activity Based gross margin profiles empower sales and customer service reps to implement innovative pricing strategies with every customer call. Gross Margin Profiles make pricing strategically simple.
• GROSS MARGIN PROFILING DIFFERENTIATES YOUR BUSINESS FROM COMPETITION.
“A differentiating idea is a competitive mental angle. This does not necessarily mean a better product or service, but rather there must be an element of differentness.” (4)Offering different prices based on the profile of product quantity and level of service will smartly differentiate one product or service provider from another.
• GROSS MARGIN PROFILING BRINGS NEW DISCIPLINE TO PRICE NEGOTIATIONS.
Sales consultant Tom Hopkins says, “Never negotiate price. Instead, tell the customer you’ll be happy to lower price if they’ll tell you what they don’t want you to do.” Reducing cost driver quantities from a sales transaction will provide you an avenue to reduce the price without reducing your profit.
• GROSS MARGIN PROFILING PLUGS ABC “VISION LEAK”.
Implementation of ABC is often a mountain top experience for those involved. But over time, the original vision and enthusiasm for ABC leaks out, resulting in lost momentum or abandonment. Gross Margin Profiling is a tool that uses ABC information on a daily basis, thereby keeping the value and vision of ABC high.
• GROSS MARGIN PROFILING KEEPS THE MAIN THING, THE MAIN THING. 
The primary focus of any organization is to make money. With all the “noise” of e-mail, staff meetings, memos, trips, reports and projects, it’s very easy for an organization to get off message. Gross Margin Profiling makes profitability the main thing in every sales transaction.

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

If the spotlight was pointed at you, what would you do in the following situation?

You’re a college graduate, passed the CPA exam and have a new job in the accounting department of a well known, publicly traded manufacturing company.

After a few months on the job you suspect that the legacy cost accounting system is significantly overcosting high volume products and undercosting low volume products. You’re tipped off to this issue when you analyze cost trends of the past ten years in preparation for the upcoming budget. You have found that:

• Overhead costs have been growing for the past five years at a rate twice that of material or labor;
• 80% of the products represent 20% of the sales;
• Accounting policy and practice for the past twenty years has been to allocate overhead to products based on direct labor content, even though labor is now only 5% of product cost.
• The overhead rate (overhead divided by direct labor) is 1000%, e.g. $10 of overhead for $1 of labor.
• Overhead expenses below gross margin, most of which is not included in product cost, have grown at a rate of 10% per year for the past five years.

You are not totally sure of the full implications of your findings. You pull out your cost accounting textbook. The authors list inventory valuation, pricing, strategic planning, budgets, make/buy decisions, marketing plans, compliance reporting and sales commissions as some of the compliance and cost management issues impacted by the product cost system. You become concerned that your employer’s legacy costing method may be misleading management and stockholders.

Your concerns move from the potential P&L impact of inaccurate costing to the balance sheet. The majority of finished goods inventory is comprised of high volume products. If those products are in fact overcosted by the legacy cost system, assets on the balance sheet are significantly overstated.

Your favorite professor told you, “Never bring your boss a problem without also offering a potential solution.” Therefore, after additional reading, calls to friends and much thought, you come to the conclusion that Activity Based Costing (ABC) would be a logical method to improve the legacy cost system. You feel ABC would address your concerns. Feeling confident and prepared, you bring your findings, concerns and recommendation to the attention of your boss.

“You may be right, but rule number one of accounting is consistency is more important that accuracy”, replies your boss. “That rule has served me well during the past fifteen years. Senior management expects our accounting department to be consistent and conservative but not change agents. If we admit we’ve been doing something wrong, we’re likely to get our heads cut-off. But if we consistently do something wrong, we won’t be severely scolded by the auditors or senior management.”

You are surprised and confused by your boss’s response, but thank them for their time. Returning to your desk, you ponder the following questions:

• The manager did not disavow my findings. Therefore, am I confronted with a potential legal issue, management issue, ethical issue or no issue at all?
• If an ethical issue exists, where should I go for guidance?
• Am I an accomplice in a crime if the cost system is inaccurate but goes unchanged?
• Are their other implications if I stay and the product cost system goes unchanged?
• What is it “costing” the business not to change the cost management system?
• How could I build a business case to improve the cost system, possibly using the principles of Activity Based Costing (ABC)?
• What could I do to encourage change? If my boss is not inclined to change, should I go around them and look for support from auditors, top management or possibly the internal customers of cost accounting, i.e. Marketing, Sales, Design Engineering, Bid & Quote, Purchasing and Manufacturing?

One of the activities my wife and I used to raise our daughter was periodically ask questions like, “If you have a flat tire, what will you do?” Or, “If you’re at a party where kids begin smoking dope, what would you do?” We wanted Valerie to know what to do before something unexpected happened. It appears to me that Enron vice president Sherron Watkins was prepared for the unexpected. She boldly sent a letter to Chairman Ken Lay questioning the company’s accounting practices and recommending change.

I believe the product cost scenario bears some similarity to the story at Enron … the legacy cost system may be legal but it’s not accurate. Do you agree? Are you in that situation? Are you prepared? I look forward to your thoughts and opinions.

This headline caught my eye on a recent trip to Austin, Texas. Apparently a 1985 BMW 7 series sedan has been parked in the same space at Austin International Airport since September 2000. At this point, the owner who picks it up will owe $6,480. That’s $18 a
day for 360 days. Among Austin’s frequent fliers, the vehicle has become a celebrity of sorts.

How could this happen? How could something of value be abandoned, forgotten or overlooked by someone? The more I thought about it, I realized that many of us have less obvious “abandoned BMW’s” in our personal or professional lives and organizations. How about you?
What have you abandoned? Here’s a list to contemplate.

• We’ve abandoned our cash cows. 
During both economic surges and slumps, sales and marketing people often tell customers, “Sure we can do that.” While meeting a customer’s needs is the right thing to do, left unchecked, it can result in unnecessary product line complexity, profit-draining activities, resource-draining customers and non-value added inventory. A rapidly growing real estate company, for example, expanded their services and overhead in recent years to include lots, farms, condos and commercial business. Activity Based Costing (ABC) quickly reminded the management team that residential sales is the cash cow, e.g. 93% of profit. What is your organization’s cash cow? Is that product, service or customer being milked or left out in the pasture?
• We’ve abandoned the activity of thinking.
Managers, especially during an economic downturn, do not spend enough quiet time thinking. It is very easy for a manager to get caught up working “in their business” instead of working “on their business”. If we abandon thinking, we abandon the opportunity to adapt strategies to the changing business landscape or defining
• B-Hags…Big Hairy Audacious Goals. Wal-Mart, as discussed in the best-selling book “Built to Last”, has survived over multiple generations because they have a B-HAG. When your vision becomes smaller than your opposition, you set yourself up for failure. Does your company have a B-HAG?
• We’ve abandoned talking and listening. 
American fathers spoke with their children 45 minutes a day on average in the 1960’s. Today that “quality time” has shrunk to about six minutes. In “The Effective Executive”, Peter Drucker says we simply have no idea where our time goes. He recommends “activity accounting”… deliberately log the specifics of our actual behavior in quarter-hour blocks and compare it to your goals. As those of you who have implemented activity accounting can attest, the findings can be enlightening, humbling and sometimes embarrassing.The log will document what we “are doing” as well as what we “no longer do”.
• We’ve abandoned the basic principles that made our nation and organizations great. 
Principles based on honesty, respect and trust. My pastor often says, “Americans have become so open minded, their brains are falling out.” What is the “line in the sand” for you and your organization? Has it been rubbed out in recent years? In their new book “The Myth of Excellence”, authors Fred Crawford and Ryan Mathews state, “people are so hungry for basic human values, values they’re not experiencing in their day-to-day lives, that they will flock to a company that provides them.” The authors were shocked to learn in their research that lowest price is not the customer’s primary measure of excellence. 
• We’ve abandoned our mission.
When I ask clients during workshops to recite their company mission statement from memory, over 90% fail. If you can’t remember it, you’ve abandoned it. Don’t abandon your organization’s mission statement… its statement of principles, priorities and values. If employees can’t recite it, simplify. Then filter your budget through the mission. Is management’s allocation of resources in sync with the mission? Or are there inconsistencies that need correction before starting the New Year? In Al Ries’ book, “Focus”, the introduction begins with these lines: “The sun is a powerful source of energy. Every hour the sun washes the earth with billions of kilowatts of energy. Yet with a hat and some sunscreen, you can bathe in the light of the sun for hours at a time with few ill effects. A laser is a weak source of energy. A laser takes a few watts of energy and focuses them in a coherent stream of light. But with a laser, you can drill a hole in a diamond or wipe out a cancer.” Don’t abandon your mission. Focus your mission.

The cost of abandonment can be significant. According to the Austin American-Statesman’s newspaper report, the airport BMW is worth less than its parking fee… $4,000 sales value versus the parking fee of $6,480! Have you or your organization abandoned something of value? If so, don’t let the value of whatever you’ve “parked” exceed its worth.

Send your comments on this article to Tom Pryor at TomPryor@icms.net. Call 817-475-2945 to talk to an ABM expert about your ABM needs.

While there is no single root cause for Ford’s staggering 3rd quarter ’06 $5.8 billion loss, I believe product line complexity is a major contributing factor. Assuming an assembly line speed of 55 vehicles per hour, it would take Ford 131,888,129 years, Honda 28 years and Kia only 20 hours to make one of each combination of product offered in sales brochures.

With smaller, less complex product offerings, Honda and Kia are profitable while Ford is not. Complexity can be a killer. In the case of Ford, their expansive product offering results in more raw material part numbers, more suppliers, more inventory, more bills of material, more scheduling headaches, more accounting, and more overhead costs but not more profit.

Success is not logical. More is not always better. “Small is the new big because big has gone from a huge advantage to a liability. The ability to change fast is the single best asset for any person or organization.” (1)

To remain big, Ford needs to make its sales catalog of models, colors and options smaller. Here are seven, small action items that will have a big, positive impact for both Ford and your own organization:

Ask Sales & Marketing to create a year-to-date, high-to-low sales dollar listing of all products & services. Call a meeting and announce “Here’s a list of the 80% of our products & services that produced less than 20% of our revenue this year. We’re not leaving this room until we eliminate 50% of the 80%!” Eliminating unnecessary products & services reduces inventory, paperwork, errors, cycle time, changeovers and overhead costs.

Ask your CFO or Controller to do a Customer-ABC report. Subtracting activity costs from Gross Margin, calculate the year-to-date pre-tax profit (PTP) or loss of every customer. (2) “A” customers are the top 10% that result in 100% of PTP. B’s are the 20-40% who results in 150% of PTP. C’s are the balance of customers who destroy 20-40% of PTP. Call a meeting and announce “Here’s a list of our C customers that have no pre-tax profit. We’re not leaving this room until we define process changes that will make them profitable for us next year.”

Ask customers, suppliers and employees “What’s the most complex thing you’ve experienced in our business?” Compile the responses and define action plans to make things simpler for everyone. Complexity kills innovation. “There’s more innovation coming from today’s virus writers than from the big software companies whose core goals are to progress and innovate.” (3)

Ask Human Resources to count the number of layers of management in the company’s organizational chart. If it’s more than three (3) layers, ask HR to work with the CFO or Controller to calculate the impact and financial savings of transitioning to no more than three layers during the next year.

Clean up the general ledger chart of accounts. Adding cost centers and expense codes are misguided attempts to control costs. Call a meeting of each accounting manager and announce “We’re not leaving this room until we reduce the number of balance sheet, cost center and expense codes by 20%.” Eliminating unnecessary account codes reduces errors, account reconciliations, accounts payable coding and simplifies budgeting.

Mandate senior management meet with ten customers and ask “What do you like or dislike about our pricing policy?” Write-up the findings and use it to make ordering processes simpler. I live in Texas, home of the highest electric rates in America. My electric provider has eight different pricing plans for homeowners. Why do I need eight pricing plans for one source of electricity? I don’t!

Ask people you work with “What impact do I have on you and your job?” Are their responses negative, positive or a neutral shrug. In Cure for the Common Life author Max Lucado says, “In a desire to be great, one might cease being any good.(4)” If people’s responses are not positive, take a humble, “small” approach and end every meeting with the question “How can I help?”

Why does Mary Kay Cosmetics give top sales reps each year a pink Cadillac but never a pink Accord, Camry or Amanti? I believe the managment of Honda, Toyota and Kia know something that their counterparts at Ford, GM and Chrysler have ignored for decades… making a pink car results in sales but no profit. Complexity is costly. Complexity kills. Don’t let it kill you and your organization.

(1) Small is the New Big, Seth Godin, Penguin Group, 2006

(2) Most commonly done using Activity Based Costing. Email TomPryor@icms.net for an example.

(3) Complexity Kills Innovations, Kelly Martin, Symantec, March 2005

(4) Cure for the Common Life, Max Lucado, Thomas Nelson Publishing, 2005