The Return on Investment from ABC
Posted on Friday, February 5th, 2010 at 10:09 am and is filed under Common Cents Blog.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.
I agree with the idea that you should quantify ROI even when it is hard to do so. This provides an ongoing rationale for the continued use of ABC. Every decision made based on ABC/M data helps to ensure continued investment in the tools and information and reminds business decision makers why they are spending money on it. In this economic environment that reminder is important.
I believe the challenge is with respect to the initial investment, since you can’t get that sort of analytics without the toolset in place. At the beginning I think it is necessary to prove that you are providing the information as cost effectively as possible, and as Gary points out, have business decision makers who see the potential business benefit and are ready to make decisions on that basis.
It is my opinion that fundamentally, simplifying the business process is a desirable goal in its own right, and ABC helps us to achieve this. There may be no “compelling reason” for this and it may make precious little difference to ROI in itself. If we can achieve the same output for less effort then great, but I wouldn’t expect ROI to automatically zoom up.
It is what we do with the increased capacity that counts. If we do nothing then results will be pretty much the same. If we have a strategy for utilising the resources we have freed up, then results will improve.
For me one of the major benefits of ABC is actually analysing what it is we do. From there it’s a small step to ask why do we do it? And could we do it better? Do we need to do it?
Once people start thinking about the processes they are involved in then great things can happen.
Mike makes great points here.
I believe one of the problems that the Theory of Constraints (Eli Goldratt and the book “The Goal”) have with ABC is their assumption is “We own the capacity which is fixed (unadjustable), so let’s fill it.” Hence their simplified fixation with “Any product cost is meaningless, and there is no calculated product cost. Only purchased material expenses are variable.”
That resource capacity is adjustable (temps vs. full-time employees, lease vs. buy) is a separate discussion for another time.
What I like about Mike’s point is the focus on filling freed up and available capacity that results from productivity improvements. This begs the question, “Who owns idle capacity? Operations or Sales?” I believe it is the latter. Operations’ goal is create more with improvements. The basic options are either fill unused capacity with sales (to make more money) or remove it (layoffs?). The Sales function should be involved and understand unused capacity management.
As far as TOC is concerned, I must admit that it has really made me think about the relevance of attempting to identify unit costs. For one they are often misunderstood and lead to sub optimal decisions being taken. At this point I should say that in my opinion that is our fault, because if we don’t explain the limitations of the unit cost how can we expect non financial staff to make good decisions?
Despite his seeming downer on management accounting (after all Goldratt’s throughput accounting is not very different to marginal or relevant costing) he is right about the arbitrary allocations to arrive at unit cost.
Consider two plants making the same item, material cost per unit is £100, conversion costs for the period are £1000.
Plant A produces 1 unit Plant B produces an infinite number of units.
Costs per unit will be:
Plant 1 Material cost + conversion cost/unit = £1100
Plant 2 Material cost + conversion cost/unit = £100
I think that for processed items FG Stock should be the sum of material costs per unit x number of units plus conversion costs for the period (identified seperately).
Attempting to compute total costs per unit has no value as far as I can see, but it could lead to invalid pricing decisions (especially where cost + pricing is used) or invalid make/buy decisions.
To take this a step further one might argue that variable costs at least should be included in the cost/unit, not so. Let us consider direct labour, this should be fairly straightforward to assign to products. Total direct labour/total output = direct labour cost per unit. But:
What happens if I improve the efficiency of my workforce? Perhaps we have a culture of continuous improvement, then over time the labour required to manufacture x number of items decreases. This then is not a fundamental property of the product, “direct” labour is a property of the process, and once you make that leap of faith you realise that there are no truly variable costs because everything can change irrespective of the product or quantity being manufactured.
I have been watching that new Sunday program “Undercover Boss” where the CEO or COO take a week off and take entry level positions within their own company’s and learn what is actually happening.
After doing several ABC Studies or Processes based cost studies I was amazed at how many CEO’s and C level executives did not know what was going on within these activities or processes to get their products to the final consumer. These studies where the pre-driver styles in order to get to the drivers of the cost (cause and effect style). They seem to rely on spreadsheets, graphs and ROI presentations. Yet, when faced with possible OSHA violations within the processes, no one wanted to change and look at what was going on.
Maybe with the show (Undercover Boss) more Chief Executives will get the message that it is not ROI but the knowledge of what it actually cost to get that product (or service) to the final consumer.
Mike,
Sorry. I am not buying into your logic. You will not get me take “the leap of faith” you reference. Labor payroll expenses and their capacity may “belong” to operations to “supply” to work, but it is product demand and mix that causes and consumes that capacity.
Resource capacity is adjustable, especially different types of skill sets. Longer-term product mix demand changes can mean you may need more of some and less of another. TOC is OK for short-term prodction mix optimization, but beyond that needs marginal expense analysis, etc.
Also, Goldratt’s TOC “throughput accounting” the way he defined it requires the very special condition of a physical bottleneck 24 x7 x 365 days. Without that in place, then good old marginal / incremental expense analysis applies. (But few organizations do that well.)
Hey Gary, thanks. I appreciate the feedback on my hypothesis.
I think Goldratt is being unfair in his criticism of management accounting and, to me, as I said throughput accounting seems very much like marginal costing. I think the waters become muddied at the point where short term becomes long term, and all costs become variable.
My argument is that yes the product demand consumes the resource of, in this case, direct labour but given the contradictions highlighted in my hypothesis isn’t it, at best, misleading to attempt an allocation of costs per unit? Wouldn’t those costs be more appropriately entered into FG stock as period conversion costs?
Mike, Gary, I’ve really enjoyed reading your exchange… I hope you are able to continue online once Gary works out how to get his connection from the Aussie beaches!
Shouldn’t we be recognising that the composition of a unit price is not just Fixed + Variable…. and that there can sometimes be a large grey patch in between. “Variable” is not always (rarely) straight-line, and “Fixed” can be a function of time (we can’t get rid of the “fixed” costs immediately, but can reduce it over time… ) ?
I think the ’cause and effect’ relationship is more relavent. The ‘fixity’ or ‘variability’ of costs can be debated. The ’short run’ or ‘long run’ relavance can also be debated. But if the products/services or customers have consumed the resources (through) activities, it has be considered relavent to that.
When discussing cause / effect models perhaps a good starting point would be Kim Warren’s work ‘Strategic Management Dynamics’. It is basically a resource based view of strategy borrowing also from stock and flow models and systems dynamics concepts.
I have done some testing on the method and it reveals some interesting results. There is also no need to distinguish between resources, drivers, activities etc. as the relationships are mathematically constructed.
There seems to be a trend – converging of various disciplines from Management Accounting, Econometrics, Business Intelligence, Predictive Analytics towards real life predictive cause-effect models.
Gary did predict this with his concept of a Chief Performance Officer.