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Activity-based costing: Accounting for Profitability
By Karen Titus
Contributing Editor
This article appeared in Modern Metals December 1999 issue
In an increasingly competitive market, it's essential to know which jobs are profitable and which aren't. ABC is one way for service centers to determine the true cost of filling orders.
For years, David N. Deinzer has been telling his colleagues at Denman & Davis, "We're not going to ship steel out the door with dollar bills wrapped around it."
It seems obvious: Why would any service center knowingly do jobs at a loss? Less obvious, however, is determining which jobs are profitable and which ones are not.
For Deinzer, president and chief executive officer of the Clifton, New Jersey-based firm, the answers have come through a process long familiar to other businesses, but relatively new to the steel industry: Activity-based costing, or ABC. This accounting method allows users to track the costs of every activity involved in processing a job, from the time the telephone is picked up to receive an order to when the product is delivered and paid for.
In short, says Deinzer, "we can measure the net profitability of every customer. We know who the winners are and who the losers are." And armed with that information, Denman & Davis has been able to fine-tune its operations, turning unprofitable clients into profitable ones, improving production efficiencies and, in some cases, learning when it may pay to part ways with a customer.
That's no small matter in today's competitive environment, says Ron Dye, the Leonard Spacek Professor of Accounting and Information Systems at Northwestern University's Kellogg Graduate School of Management. As a field becomes more competitive, it's more important to have accurate information about your costs of doing business. Accurate pricing in competitive businesses is crucial. What's at stake is nothing less than your survival."
How does it work?
Activity-based costing is powered by raw data. To determine how long a job takes to complete, and its ultimate cost, users need to capture information about every step of the manufacturing process. That can be as hard as it sounds. "A lot of it is literally standing on the shop floor with a stopwatch," says Christopher Siebert, manager at Ernst & Young LLP, "timing things and counting things. It's really basic."
"If you do it manually, it's a real pain in the neck," Deinzer agrees.
At Denman & Davis, which has been using ABC for some two years, initial time studies were done manually—for as long as three months in the burning operation—to gather the base data for various tasks. In the future, however, the company plans to collect data via a bar-coding system.
"You could have a bar code on a particular machine, on an employee's badge, or on your work order," Deinzer explains. "So ultimately what we'd like to do is shoot the order, shoot the machine, shoot the badge, and that would tell us exactly how long each step takes. And that should allow us to track that information automatically, on a regular basis." The company recalculates its costs every quarter.
Using what senior vice president Rick Haeberle calls "simple formulas," the company turns this collected data into more useful information. Much of ABC is actually based on well-grounded estimates and averages, he notes, since it is not practical to time every task manually.
"You have to make certain assumptions on time," he says. "We're not timing every job for every customer and actually assigning the real activity cost to them. We're making some assumptions about how long something takes, then allocating costs based on those assumptions.
"You don't have to get it down to the tiniest, perfect detail," agrees Siebert. "You don't need to know if some thing costs you 0.0258 cents per unit or 0.0257 cents a unit. Who cares? Just know that it's about 0.02 cents per unit and you're OK."
Costs such as heat, light and power are allocated to customers using a formula based on the facility's square footage, which is then broken down as a percentage of how much business a particular customer gives the company in a given quarter, based on the total weight of steel they purchased. Trucking costs are determined using a formula based on mileage to the customer and delivery weight.
Customer payments are tracked as well. "We have a charge based on the cost of money to us," Deinzer explains. "If the customer pays within terms, there is no charge. If he doesn't pay within terms, his average days outstanding are calculated, and we put in a finance charge and a cost against that account. So if we're borrowing money from the bank, all those interest charges are, in turn, allocated based on the customers who aren't covering their payment terms."
Revealing results
ABC findings have been somewhat surprising, Deinzer reports. We found that some of the prices that we thought we'd have to meet to stay competitive were way off target," he says. "There were cases where the gross margins was wonderful, but when you looked at all the activity that was involved in processing the order, the gross margin no longer meant anything.
"For instance, we might have two 1000 lb. orders, he continues. "One might be one item weighing 1000 lbs., while the other one involves 500 pieces at 2 lbs. each. The activity involved in the latter case is incredible, but traditional cost measurements in our industry never picked up on that."
The big question then becomes, What should be done with this information? "You have to find a way to relay your performance metrics back to your activities," says Haeberle.
In some cases, the customer has proven to be the source of unprofitability. Deinzer points to one customer who ordered more than 2400 process-burned plate items a year, each with its own drawing that had to be transferred to Denman & Davis' CAD system. "Once or twice a week we'd get a package of drawings that we then had to CAD ourselves for the burning machine to be able to duplicate the part they wanted," he says. With ABC, a cost-per-CADing fee was built into the system. Rather than charging this particular customer considerably higher rates, however, "We were able to go to them and say, 'Look, this is going to cost you a lot more money to continue this way.' So now, we directly download the drawings from their computers to our CAD system. By working with them, we were able to take most of that cost out, saving both of us money," Deinzer says.
"We're not going to ship steel out the door with dollar bills wrapped around it."
—David N. Deinzer, Denman & Davis
In another case, improvements were wrought by increasing order requirements. One Denman & Davis client, Atlantis Equipment Corp., Stephentown, New York, had a customer who was ordering heavy welded frames that required extensive plate burn-outs— "basically one or two at a time, whenever they got an order," says Richard Keeler, vice president and co owner of Atlantis Equipment.
The costliness of this haphazard approach, identified through activity-based costing, led Denman & Davis to approach Atlantis about improving efficiencies. "So I went back to my customer and worked out a program where they increased the quantity they ordered, which meant I could then boost my order size to Denman & Davis," Keeler says. "I was also able to warehouse a couple of finished units for my customer. My customer was able to hold his prices, have a couple of finished units in inventory that he had agreed to buy, and Denman & Davis could process metal at a more efficient quantity. It was a win-win situation."
Identifying opportunities to reduce costs is only one application of activity-based costing, notes Siebert. "It also allows you to price better. It allows you to challenge what are often preconceived notions about how things are priced."
At times, the information can be tough for companies to swallow, he says. "Traditionally, the idea has been that the customer is always right, give the customer what they want, and so on. But what you may find out with activity-based costing is that doing so can cost you a bloody fortune."
While there may be times when it makes sense to take a loss on an item, "Activity-based costing can at least tell you what you need to make up for," Siebert adds. "You don't want to just blindly say, 'We need to make this to keep the customer.' Before long, you'll find that this customer comes to you only for that one product, because they know they can get it from you and that no one else is dumb enough to make it."
While the goal of activity-based costing has never been to eliminate unprofitable customers—"We'd rather look at ways to make them profitable," Deinzer says—in some cases ABC has led to significant price adjustments that have caused customers to look elsewhere. And that's just fine by Deinzer. "We know what our costs are, and we know we're cost-effective and efficient benchmarked against our competition. So if our customer can find a competitor of mine who's willing to take that work for less money, let them go ahead. Let them paralyze the competition with all that unprofitable work. We have a profitability advantage, and we know when to walk away from something. We no longer sell losing accounts."
Conversely, Haeberle notes, activity-based costing also has kept Denman & Davis from dropping clients mistakenly assumed to be unprofitable. "We were clearly able to see the benefits to keeping them, which we otherwise would have overlooked. "
Making it work
While activity-based costing is a fairly straightforward proposition, its successful implementation re quires no small effort. "This is a mission," says Haeberle with a laugh. "You don't do it once and say, 'I'm done.'"
And it may not be appropriate for every company. According to Kellogg's Dye, "You need to have substantial diversity, either in your range of products or the complexity associated with the production process. If you're basically making the same product, with similar production methods, lot sizes, etc., then there usually are not terribly large benefits associated with going to an ABC system."
For those who do decide to implement activity-based costing, Siebert points to four groups that need to buy into the concept: Top-level management, which has the power to invest—or withhold—resources from the project; manufacturing/production, which will be measuring performance; the information technology department, which will process the data; and the sales and marketing staff. "That last group is especially important," he says. If they quote a bad price or ignore your calculations, it doesn't matter how well manufacturing or IT do their jobs."
But when all parties do their jobs well, the benefits can be considerable.
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