Imagine you’re a supermarket chain presented with what seems like a no-brainer deal from your baked beans supplier. They’ll knock 10 percent off the price of each can of beans if you take delivery of a month’s worth of stock tomorrow, instead of your usual two-week‘s supply.

A bargain? Not necessarily, says Paul Kellett, director of consulting at business intelligence consultancy Fulcrum Decision.

“The supermarket industry is complex and has many associated costs above and beyond the purchase price of the product,” explains Kellett. “Supermarkets have a significant distribution problem with a wide variety of products, delivered to a large number of stores with many product-specific factors such as delivery, refrigeration, and shelf-life. They are also continuously looking to drive efficiencies into the supply chain as it is a highly competitive industry with small gross margins,” he says.

“Obtaining a true picture of profitability by individual product, store, etc is difficult without some sort of activity-based costing (ABC).” ABC is a simple concept, Kellett says.

Historically many costs within a business, such as salaries, have either been treated as indirect costs or as overheads, and either managed separately or allocated arbitrarily across the business.

But all of an organisation’s activities and resource usage have specific costs associated with them. Using an ABC solution, these costs can be allocated at a detailed level to provide a truer picture of the profitability of the business’s individual products or customers.

In the case of the baked beans deal, it’s possible an ABC analysis may have concluded that the extra costs of storing the additional product outweighed the price discount.

“The analogy I use is the welfare state versus user pays,” says Kellett.

“In the welfare state, the costs are shared across all tax payers and usage is defined by need. In user pays the particular customer pays costs linked to actual usage. Sharing costs is fine in a social environment where we wish to subsidise the more expensive customers but not in a business one.”

He says if a business has “the customer or product from hell who is the equivalent of a two packs-a-day gang member with a P problem and several large aggressive, unregistered dogs” then it is in the business’s interest to know about it.

“In these days of ‘continuous improvement’, ‘driving efficiency through the business’ and buying stronger coffee and bigger whips because of the need to be more competitive, it is surprising ABC is not implemented more frequently,” Kellett says.

Ernest Glad, CEO of consultancy Cortell Group and a published author on the subject of ABC, says activity-based costing was one of those “fads” invented about 20 years ago which most people thought would fade away within a few months.

“The reality is that activity-based costing and management has become one of those indispensable tools that support modern management,” says Glad. “In my 20 years as an ABC practitioner I have seen how ABC can change the fortunes around of many underperforming businesses.”

ABC requires an organisation to analysis its business processes, breaking them down firstly into the activities performed to deliver goods and services to customers and secondly into the activities performed to support the business, he says.

Then the “cost drivers” – the factors that cause costs to go up and down – for every activity within the business are determined and used to measure the cost of all outputs.

Activity cost can then be transferred to the organisation’s products, services or customers based on the extent to which they consume the activities.

“This provides fantastic insight into how costs react in a business and is the basis for good profitability analytics,” says Glad.

Carl Harris, Eagle Technology Group’s manager, business applications, says a number of attempts at ABC failed in the early 1990s because projects were seen as requiring too much timeconsuming extraction of information at a granular level.

That had now changed with technology advances making data extraction much simpler. “ABC is coming back around,” says Harris.

“We all know that the market is more competitive this year than it was last year, and it will be more competitive again next year. There’s only so much information and analysis you can squeeze out of your existing data warehouse and the technologies around that.”

This means businesses are having to look at other ways they can make cost savings or profit improvements which in turn means they need to know what they’re going to measure, he says.

“Profitability in terms of identifying profitable product lines, or identifying profitable customer sectors in the retail sector is extremely important. Your manufacturing process can only make so many cost savings. You then have to look outside the pure development of the product to the distribution models, to how you are positioned in the retail market and what costs are associated with that.”

Vendors have told iStart that clients, both large and small, have benefited from ABC-type deployments.

“One customer has been able to determine which contracts they’re going to accept and what product mix they’re going to do by using a costing process that more accurately reflects their costs,” says Tim Turner of Jetreports, which offers a reporting solution in the familiar Excel environment.

Sometimes return on investment can be rapid, says Raul Schleier of Visual Intelligence, which sells analysis and reporting solution QlikView.

“I’ve had a client where we’ve installed QlikView and the first day we discovered that they hadn’t invoiced a particular product for 11 months,” says Schleier.

“There was something wrong with their system that wasn’t picked up internally. As soon as we hooked up QlikView on top of this we could see that they were sitting on 11 months of uninvoiced sales for that particular product.”

Cortell Group’s Glad says ABC has proven useful to organisations both at an operational and a strategic level.

“Operationally it is used as a cost control tool to measure waste, to benchmark costs of activities and processes, and to understand and control the cost drivers that cause costs to increase disproportional to outputs,” he says.

“Strategically it is used to determine which products, business units, distribution channels and customers add or destroy value. An organisation can then change its manufacturing, marketing or distribution strategies and fundamentally re-engineer business to achieve higher growth, return on capital and other measures of corporate performance.”

Eagle Technology Group’s Harris says while New Zealand corporates have been slower to pick up on ABC than their overseas counterparts, that may not be a bad thing.

“When something’s been around for 15-plus years [as ABC has] and it’s not made the inroads you’d expect of something like this then there are probably very good reasons for that,” he says.

“It’s worth waiting and making sure that the techniques, the technology, the methodologies around it are sound and do actually deliver business value. I think we’re now at the point where there’s demonstrable value in proceeding down an ABC route and a performance management route. New Zealand’s played it pretty cautiously and wisely so.”

Further Reading

• Business Intelligence Buyer's Guide

For more information, vendors, resources and case studies visit the Business Intelligence Research Pavilion

July 2007

By Simon Hendery