Activity-based costing
Activity-based a costing is an analytical tool that’s almost too powerful for its own good. It reaches conclusions that are unpalatable because they challenge received wisdom and therefore don’t get enacted. This tutorial will explain the power of the technique and provide practical lessons for using it.
The Economics of Efficiency
At the heart of activity-based analysis is the search for greater efficiency: the ever more efficient use of limited resources. Businesses and managers are constantly looking for ways of increasing profits by ‘doing more with less’. Activity-based costing is one of the tools at their disposal.
Most people are familiar with the Pareto Principle: the idea that 80% of the results of an activity typically come from 20% of the effort. Admittedly, if you have a pile of earth to move engineers might have difficulty with this principle, but in business, economics and statistics, the rule of thumb crops up all the time. The Pareto Principle is a feature of the law of diminishing returns which suggests there comes a point – the optimum – where getting more value from an activity isn’t worth the extra cost or effort. These concepts are fundamental to business even though we don’t talk about them in these economic terms.
The figure below illustrates the sales achieved by each member of a sales team.
In this example a large proportion of the sales team make modest or low sales compared with a small number of people who account for almost all the company’s sales. This effect is called the ‘tail’.
Cutting the Tail
When the tail is very long and narrow, as in this example, the obvious question to ask is whether the company could make more money by ‘cutting the tail’.
On the face of it, the company could sack two-thirds of its sales staff and lose only one-eighth of its income. Is this a good idea? We don’t have enough information to know but often the answer is more complex than it at first appears. For instance, if all the sales personnel are paid only by commission then even Heidi is making money. Moreover, perhaps the company as a whole is only just breaking even at this level of total sales. Cutting the tail might throw the company into a loss unless the lost sales could be replaced by existing staff or new recruits.
But consider a still more complex situation. What if the customers Ivy is bringing in are consistently the most troublesome, poor-paying, time-consuming customers of the whole company? Would her sales of £0.5m seem quite so good in these circumstances, especially if Amelia and Chloe’s customer orders sail through the company’s supply chain without a hitch?
Leaving aside the financial and HR consequences, there’s a psychological barrier that prevents people cutting the tail quite as assiduously as they might otherwise: its plain old inertia. It seems such a radical step to deliberately stop doing something that’s revenue-generating. Some people like to concentrate on core business, others like to let a thousand flowers bloom. It often seems the easiest course of action just to leave the tail as it is. High achieving businesses never do this.
Activity-Based Costing
How do you answer a questions such as ‘Should I cut the tail?’
Activity-based analysis looks beneath the financial information and asks ‘What are the things that really driving cost or value in my business?’ There’s a simple example from the HR function I came upon recently. I had assumed that the number of people that needed to be employed in HR was a function of the number of people employed in the company. If the numbers of people went down (as they had by 10% in this organisation) then I expected the workload had probably gone down by roughly the same amount. It turns out that the activity that really created work in this HR department is the number of starters and leavers. We were able to establish that although headcount had reduced the number or starters and leavers had not changed at all. This was because there were a large number of short and fixed term workers in this organisation. Their workload had not decreased much at all.
Acting on the conclusions of activity-based costing
My first job was in a teabag factory where over 90% of production was producing a single brand – Lipton’s Yellow Label – in packets of 100 teabags destined for the middle east. We also produced wide range of flavoured teas for the European market. Factory overheads were allocated by volume, meaning these flavoured teas received about 10% share of overheads. Margins were high on these brands, so favoured teas looked our most profitable lines and were promoted heavily by our marketing people.
After investigation, the following came to light:
1) The large number of different flavours meant short production runs on the same equipment so there was a lot of downtime as the loose tea of the previous run was cleaned out to avoid tainting the next run.
2) Taking this equipment down and bringing production back on line was the most time-consuming activity in the factory, involving a lot of time of maintenance engineers and operators.
3) The lines on which these flavoured teas were produced were among the oldest in the factory. They were the least efficient and took up a significant amount of time of the maintenance engineers.
4) The packaging buyer and his assistants spent almost 90% of his time on packaging orders for flavoured teas and about 10% of his time negotiating deals on the Yellow Label 100s.
You can see where this is going. We looked at each of the elements of factory overhead and asked people what are the things that cause you most hassles and take up most time. When we finished we re-profiled the brand profitability analysis using this activity-based analysis as the basis of allocating factory overheads, and guess what? The main Yellow Label brand accounted for 140% of company profits and the flavoured teas were making horrible losses. The factory manager thought I was a hero for proving to him what he knew intuitively, but I was not popular with the marketing department.
You want me to cut profitable lines?
You might think the company would mobilise quickly to stop selling flavoured teas? You’d be wrong.
People didn’t believe the analysis. Making more money by stopping selling successful lines is counter-intuitive. It was viewed initially as a weird piece of financial sophistry. I confess I hadn’t at first appreciated the hard-edge that was the logical conclusion of my own analysis: it wasn’t only a case of stopping existing product lines, big though that step would be, it was a case of sacking quite a lot of people to recalibrate overheads to fit the expected reduced workload. This turned something that at first seemed an issue for just the marketing department into an issue that affected the whole company. Even the factory manager cooled on the idea when he realised the consequences. Meanwhile the marketing people came up with several plausible reasons why exiting these markets would be a mistake.
Three Lessons for Activity-Based Costing
So the first lesson I learned was that, if it is to be truly useful, activity-based costing is more than just a book-keeping exercise. It needs to be followed through with action. And often the action has consequences that run quite deep. Cutting product lines seemed at first an action without any internal losers but this was not the case.
The second lesson is just how much people don’t like stopping doing things. It just seems wrong. Indeed it feels like the opposite of what they should be doing. It’s a bit like a bureaucracy. If you employ people intelligent, motivated people to do a thing, they’ll keep coming up with new things to do.
And this is the third, and possibly most important lesson. You need to keep cutting the tale. You can’t just cut the tail and then walk away assuming your work is done. Remember, you’ve got a lot of bright, busy people coming up with ideas. Individually, they all sound promising; collectively, Pareto’s Principle will apply. Come back to this area in a few years and you’ll find a new tail has grown. Tails regenerate!
I had exactly this experience with a client where we made reductions in overheads only to return 5 years later to find not only that the savings had been slowly reversed but that the size of the business paying these overheads had shrunk by 10% in the meantime. We had to repeat the process again.
Words of Warning
Activity-based costing is a powerful tool for one-off strategic analysis. It is considerably less valuable for routine management accounting. The trouble is that once people have the insight of a one-off piece of analysis, they want to do more with it. This is in fact just another example of the regenerating tail, this time creating more work in the finance department. In the example above, the worse thing we could have done is start routinely collecting measures of how many different SKUs the packaging buyers were buying or how long the engineers and operators would spend on changing over from one production run to another. The incremental value from the information would not have been worth the effort of collecting the information routinely and reliably enough to form a basis of allocating overheads for regular monthly reporting.
There’s an even worse abuse of activity-based costing and that’s when cost-centre managers try to use it as a basis for cross-charging their services to other departments within the company as if there was some kind of internal ‘market’. Again, it’s a classic example of ‘tail’ behaviour: it changes no one’s behaviour in the way a real market works but wastes a lot of time and energy. It is inefficient.
In my experience, the best way to handle overheads is to make no attempt to allocate them at all or, if you must, use only the simplest and easiest basis to do so quickly. Overheads should be reported at the level at which decisions about them are taken, which is typically Board level. Burdening profit centres with an allocation of overhead over which they have no direct control leads to misleading information. Don’t make the mistake of allocating overheads in the belief they will be better controlled if reported in routine management accounts. They won’t. Instead, control overheads by carrying out periodic, one-off pieces of strategic analysis, using techniques such as activity based costing.
Summary
Activity-based costing offers a technique for exploring the drivers that really create cost and value. It is however best deployed as a one-off exercise rather than a regular basis of allocating overheads or reporting KPIs. What was the outcome in the teabag example? Two years and much discussion after the initial analysis, an axe was taken to most of the flavoured tea brands, but not all. So we probably arrived at an optimum solution.