The Return on Investment from ABC
Posted on Friday, February 5th, 2010 at 10:09 am and is filed under Common Cents Blog, Highlights.There are three reasons you implement ABC—a compelling business need, recognition that ABC is superior to whatever you currently have or don’t have, and a positive return on the required investment. We could focus on any of these three, but let’s start with the return on investment (ROI). If you can’t demonstrate a positive ROI, it is unlikely management will support the initiative, and highly unlikely they will pull out the check book and fund it.
A real plus is that ABC is a natural for computing an ROI. The benefits are derived from eliminating the profit destruction associated with unprofitable products, services and customers, eliminating costs that don’t add value and other tangible and intangible factors. It is a compelling way to show that ABM is not the typical systems project that has no measurable ROI and often seems to go on forever. I can think of a customer that spent $500 million on an Enterprise Resource Planning (ERP) system. Once it was complete (after many years and the inevitable cost overruns) it was impossible to compute an ROI and no-one was using the system. Yes, the data was in good shape, but managers were still using spreadsheets and ad hoc analyses to make decisions. I am sure many of you have horror stories like this to share with us.
Each organization will have different business needs, and benefits from ABC that will vary with these needs. For example, a credit union might need to know the cost of acquiring and maintaining customers, so they could make optimal marketing decisions around profitability. If ABC reported product and customer profitability (ideally risk adjusted customer lifetime value) it would support this business need. We could develop a model of how this decision process would work, factor in the size of the marketing budget, and then make a reasonable estimate of the ROI. A government agency might want to replace equipment at the time that minimizes the total cost of ownership (maintenance plus ownership costs) over the expected lifetime of the equipment. Alternatively the agency might want to pinpoint areas of inefficiencies so resources could be migrated to fit budgetary needs. In both cases the financial impact of these decisions could be estimated and factored into an ROI computation.
I encourage you to share your thoughts on this important topic. In particular, it will be helpful to identify where you believe ABC can provide a positive ROI. It will be invaluable if any of you have specific sources of ROI you can identify from your own experience. Thoughts on overcoming difficulties computing ROI will also be very helpful. I look forward to your comments.
Dr. Peter Turney is the founder, President and Chief Executive Officer of Cost Technology, Inc. He has been an innovator and thought leader in the field of performance management and analytics for over twenty years. He has published extensively on this topic including writing the landmark book Common Cents.
My experience comes from implementing an enterprise ABC system in a manufacturing company. In hindsight the costs of implementing ABC were fairly small relative to the returns. The costs were primarily software, consulting fees and expenses associated with implementation, the cost of the server, and internal costs for a full time project manager/analyst and part time support from the information technology department. Internal costs also included training business unit staff and their time analyzing decisions using ABC information.
The financial benefits of ABC came from many sources. These included focusing on profitable products, customers and market segments, more profitable product designs, targeting of investments based on profit impact, changes in the supply chain, and reductions in cost across the board via elimination of non-value added activities. Management estimated the net benefits from ABC to be a 10% increment to the return on sales. Without wanting to diminish this success, I acknowledge that most of these benefits were quantified after the fact. It was much harder to estimate these benefits up front, and if anyone has any suggestions on how to do this it will be much appreciated.
Peter and Terry make good points. The way I look at ROI is that in some cases it may be immeasurable, but that should not stop pursuing an investment. Let’s consider how you would measure the impact of better decisions resulting from having more accurate and explanative information from an activity-based costing (ABC) system. You will eventually conclude that the many parallel improvement and change initiatives that organizations pursue (e.g., total quality management, business process engineering) are occurring simultaneously. As a result, it is nearly impossible to trace benefits, such as cost savings or future cost avoidance, directly back to any individual change program. This is like re-assembling a broken egg yoke to be whole again.
And one step removed from this ROI measurement challenge is to measure the effect that better information, such as from using an ABC methodology, serves as an enabler to turbo-charge the effect of all of these improvement programs. This further complicates quantifying the financial returns from the contribution of each change initiative program.
I am not big on making decisions based on faith, but there are some managerial concepts that just seem to be the right thing to do. And completing the full vision of the performance management framework, including ABC and BSC, is one of them. Take action or don’t take action. Both choices have an ROI; and with performance management my belief is the former is positive and the latter is negative.
Life, business, commerce, and government are a continuous process of making choices. Strategy execution, which I believe is of paramount importance, is all about making choices. When making choices and decisions, conflicts are naturally competing, and they are weighed among options when the final decision is made. Computers, data management, quantitative analysis, and analytical theory have made huge strides that facilitate making performance management, including ABC, pay off. Performance management provides managers and employees clear direction and the computational horsepower to measure and weigh the trade-off decisions to always point to the highest value creation.
Gary Cokins, SAS
I am the project manager for ABC and SPM (Strategic Performance Management) for South Dakota Department of Transportation. Our implementation took 4 years but the return has been well worth it.
We use ABC to compare activities throughout the state. We can then determine best practices and implement them in other areas when it is financially beneficial.
Another issue that we have is many proponents of outsourcing activities. Another benefit of ABC is that we have fully loaded costs that show the DOT can do those activities for less money than a private company. We have been able to gain FTE from the legislature because we would save the state money by insourcing the activity.
Our ROI continues to grow with every year that we use the system.
In ‘Sanskrit’ (an old Indian language), we used to have small riddles. In this, there used to be three riddles in first three lines and the fourth line used to be the answer of those three riddles. The amazing part was the amswer used to be in ’single word’. This single word had three different meanings, which used to be the answers to of the riddles.
I want extend the same idea here. Peter has mentioned three reasons for implemeting ABC, viz. a compelling business need, recognition that ABC is superior to whatever you currently have or don’t have, and a positive return on the required investment. I would say whatever is the reason for implementing, the results give you ‘INSIGHT’. you use this insight to find answers to different questions.
If we now focus on the ‘ROI’ part, for along time experts have mentioned that the ROI comes from either improving costs or profitability. The percentage would very from organization to organization. It is dependent on how good and how bad you are. Actually it would ‘how bad’ and ‘how good’ you are, if we want to look at it sequentially.
The ‘how bad’ part of the organization tells us the ‘potential to improve’. This is dependent on how badly you are performing your processes now. ABC helps to identify this and further analysis tells you the possible reasons. Once you have done this the next part depends on ‘how good’ you are. This is, how good you are in implementing the action plans. This is ‘potential to change’. Potential to improve is the total opportunity and potential to change is what you can actually achieve.
I disagree and agree to some extent. I don’t think the cost of ABC could ever be justified using ROI or some other discrete measure. Many companies only look at the cost of implementation and labor associated with maintaining it. The benefits obtained from using ABC are not really quantifiable: more accurate product costing, better comprehension of where your costs are and to what products they flow. These are things that all companies should know, but are probably disguised in a myriad of other overheads. If a company places a value on knowing what these intangibles are, than they do, if they only look at the cost of implementation – which frequently happens and is why ABC has never really gained widespread acceptance, then the costs do not justify the means.
Mike makes some excellent points regarding the challenges and limits of measuring the ROI from ABC. I agree that some benefits—such as having more understandable cost information—are intangibles and not possible to quantify. It is also true that some benefits are difficult to quantify. However, I don’t think difficulty quantifying benefits justifies not quantifying the benefits. For example, Mike mentions more accurate product costs as difficult to quantify. More accurate product costs will lead to better decisions such as pricing, promotion, up-sell, design etc. These decisions have financial consequences. While it may be difficult to track all of these decisions, typically 80% of the financial return comes from 20% of the decisions. Track these big decisions and you will have most of the ROI captured. There are other areas where the financial impact is easy to quantify including cost savings that result from insights derived from ABC information. Johna Leidholt’s comment relates directly to this. So, while acknowledging the difficulties in measuring ROI, I believe it is possible to measure, and also important to measure from an initiative acceptance and validation basis.
Peter,(and other “commenters”).
If you twist my arm, I accept that one could develop sufficient equations for the Pareto 80% explanation to generate compelling ROI math supporting ABC information.
My feeling though is a rational manager will consider the adverse opportunity cost of making less effective decisions (i.e., poor decisions) using flawed and misleading managerial accounting information from traditional costing.
There is an opinion: It is better to have no cost information the bad cost information.
Gary
Gary Cokins, SAS.