Anatomy of Cost

Owens & Minor, one of the nation’s largest medical supply distributors, was in trouble: in the five years prior to 1995, the company’s sales had more than tripled to almost $3 billion, yet so-called fixed costs (selling, general and administrative expenses) had grown even faster — 325 percent and 337 percent, respectively. Though sales had tripled, gross margins had declined by one percentage point, and the company had taken its first loss in decades.

O&M had already downsized and restructured the company; it couldn’t scale back further without interrupting or sacrificing service to customers.

So the company changed gears. Instead of looking at ways to further retool internal efficiency, it examined how it change customers’ way of doing business.

It wasn’t easy. The first step required a careful examination of customer profitability. In the equivalent of a bottom-line epiphany, O&M embraced an increasingly popular cost management concept known as Activity-Based Costing and Management (ABC/M). After collecting and analyzing the appropriate customer data using ABC methodology, Owens & Minor was able to implement strategies that had an impact on the buying behavior of its customers. For instance, it provided price incentives to customers who reduced the required number of deliveries. Making fewer customer deliveries was one way O&M could reduce their own operational costs and ultimately establish profit margins that rivaled its spectacular growth over the year. Today, O&M is a flourishing $3.6 billion business with impressive year-end profitability statements.

The utility of ABC extends beyond customer service analysis. The real costs associated with products, and even vendors, can be identified. The “costs” are defined by so-called cost drivers, or “activities” — from the expense of warehousing to a vendor’s turnaround time to taking an order. ABC helps assign costs to activities, based on the resources those activities consume, such as labor, space, equipment and services. These costs can then be analyzed against specific customers, products and vendors.

ABC can produce data that leads to thoughtful cost vs. profit analysis that impacts management-level decision-making, such as how much to charge for Product A, or whether making deliveries to Customer B three times a week is feasible.

Know Your ABCs
Market competition is fierce. There is often a need to expand inventory and customers continue to demand more and better services. Standard “cost-plus,” or gross-margin pricing falls short in reflecting the complexities of the true total cost of conducting business, says James D. Tarr, a founding member of a consortium of business consultants in Southern California, The ACA Group. ABC/M’s goal is to allow distributors to analyze cost data in order to accurately measure profitability in the context of doing business with customers and vendors and the buying and selling of product.

“The acceptance rate of ABC has been one constant incline,” says Gary Cokins, an expert in ABC, author of The ABCs of Cost Management, and a strategist for The SAS Institute, an intelligence and analytic software vendor based in Cary, N.C.

“It did not accelerate like a rocket because many were skeptical of its cost and size to implement, but now organizations have learned the implementation effort is economical, and their problems with not understanding profit margins continue to grow.”

Traditional “cost-plus” or gross-margin pricing is flawed in that it applies “overhead” costs evenly, regardless of the product or customer, explains Cokins.

ABC produces the data distributors need to make better decisions. Managers, in turn, can offer customers customized services and analyze each product separately from another based on a number of variables, he says.

“The margin for error is getting slimmer as the pressure grows for better organizational performance.”

ABC helps prevent distributors from making poor business decisions, he adds. And bad decisions these days can be deadly.

ABC focuses on controlled — and highly accurate — cost allocation. Cokins offers an ABC analogy: You’re at dinner with friends. You order a sandwich, and everyone else orders prime rib. When the check comes, everyone wants to split it evenly.

“This is how many products and service lines ‘feel’ when the accountants take a large amount of indirect and support overhead expenses and allocate them as costs without any logic. There is little or no link that reflects a true relative use of the expenses by the individual products, service lines, or end users. This is unfair,” he says.

“Activity-based management (ABM) gets it right. It more fairly splits the waiter’s check,” says Cokins.

Tarr says ABC is all about allocating resources to the various products that “consume” them. “If I take all the resource costs and put them in a big bucket, then take a paintbrush and paint it equally over all these products, I’ve undercosted one product and overcosted another.”

For example, if one product is bulky and sells one at a time, and a second product is small and sells 100 at a time, what product is using more resources? he asks.

In this example, one of those “resources” is facility cost (including rent, utilities, cleaning, security, etc.). A distributor could multiply the facility cost by the square footage occupied by a certain product, then add that to the cost per order (an equation with variables such as labor, order forms, telephone and follow up). It becomes clear that the smaller product, sold 100 at a time, has a much lower per-order cost. By crunching numbers this way, distributors can easily determine what products are most profitable — and least profitable. These factors, in turn, can influence marketing, sales, purchasing and delivery choices.

Peter B.B. Turney, author of Common Cents: The ABC Performance Breakthrough, and a pioneer in ABC, defines it this way:

“A method of measuring the cost and performance of activities and cost objects. It assigns cost to activities based on their use of the resources and assigns cost to cost objects based on their use of activities. ABC recognizes the causal relationship of cost drivers to activities.”

A Work In Progress
Few jan/san companies are currently using ABC, though most are familiar with its benefits. Slow to catch on, probably because it seems too complicated, ABC is really easier to implement than many distributors realize, says Ken Rosenberg, vice president of marketing for Eastern Bag & Paper, a major regional distributor based in Milford, Conn.

Some resources are required, Rosenberg says, but it’s really a commitment to sitting down and crunching the numbers. His company takes the information from its distribution software, daly.commerce, and downloads it into Microsoft Excel spreadsheets. Initially, the company relied on help from its IT department to compile the data.

The company’s CFO designed the approach, analysis and reporting.

Eastern Bag has used these resources, developed during 2000-2001, to segment its customers. If it’s apparent that a customer isn’t profitable, the company makes decisions on how to address the matter.

“We’re looking to classify our customers using two variables: sales volume and return on sales,” Rosenberg explains. “We segment them into A, B, C and D. Then we look at the services we give these classes of customers. We want to give the most services to the biggest, most profitable customers.”

ABC has helped Eastern Bag & Paper determine who those customers are, and the results weren’t necessarily what the company expected.

“What blew me away, after we did this costing analysis and looked at our return on sales, was our most profitable customers. There were five or six surprises in our 10 most profitable customers,” he continues.

On the other end of the spectrum, Rosenberg is looking at ways to increase the profitability of its C and D customers. After the company began analyzing numbers with ABC, Rosenberg says he was most astonished at the true cost of each stop its delivery trucks made. So if a customer requires three or four deliveries a week, it is likely taking a bite out of that customer’s profitability.

“When you look at ABC, not everything is related to pricing. There’s the transactional costs,” he says. “If you analyze the numbers, the biggest transactional cost is delivery.”

With the help of the ABC data, Eastern Bag & Paper realized it had to do something about its least profitable customers. No distributor wants to have to give up business, so it changed its service strategy instead.

“We have a program where our sales managers are keying in on customers who have a poor return on sales and are finding ways to improve the profitability of those customers. In some cases, it’s the frequency of delivery or order size. In others it’s the gross margin or number of line items they purchase from us,” he explains.

United Stationers has an effective ABC program in place. As the parent company of Lagasse Inc., it has passed some of its capabilities and knowledge on to the large industry wholesaler, which has adopted a sort of hybrid system, says Steve Schultz, president of New Orleans-based Lagasse.

In 2000, Lagasse started construction on a data “warehouse” that allowed it to capture all the transactional data generated by its 1.3 million annual transactions with 14,000 customers.

“There was a wealth of data to be extracted with which to make strong business decisions,” Schultz explains. “As early as late 2001, we began to implement and execute strategies and make business decisions based on data that’s generated from our internal ABC system. Since 2001, we’ve dramatically changed the decision-making capacity of our management team,” he continues. “There’s hard evidence of the benefits of the decisions that we’ve made based on the knowledge and information that we’ve generated.”

While many ABC users tout the efficiencies they’ve achieved on the customer end, Schultz says his company has achieved the most impressive gains within its vendor relationships.

Based on ABC data, Lagasse designed a “balanced score card” benchmark tool for its vendors, which lists on-time delivery rates, order accuracy, dock time and load time, damages to products, and back orders, to name a few. These measurements lead to a GMROI (gross margin return on investment) number for each.

“What we have produced has all of our metrics on it,” he says, “and it’s communicated to our top 40 suppliers.” For 18 months, Lagasse has been using this measurement to work with its vendors in finding ways to impact the gross margin return. It’s not about haggling over prices or rebates anymore, Schultz explains. “We could wring more cost out of our business this way.”

Lagasse also shored up ordering efficiency with its customers after analyzing ABC data. While the company would ultimately like to make profitability-enhancing changes that are entirely seamless to customers, one recent update was not-so-subtle: a new policy that instituted a $5 charge to be added to every order under $40.

“The reality is that a $40 order under a fully allocated cost model doesn’t generate enough gross profit to meet our targets.”

Not to say it wouldn’t meet other distributors’ targets, but that’s the purpose of ABC, Schultz continues. It provides the knowledge necessary to make intelligent, educated decisions.

Lagasse has had such success with its first stab at ABC that it is in the process of seeking new technology to add to its capabilities.

“We’re looking at third-party provider systems to ultimately maximize the feedback,” he says.

Roadblocks to Adoption
Is implementing ABC an intimidating process? It doesn’t have to be.

“You don’t need to create a huge complex system to do this,” says Tarr. “You can build these kinds of models in Excel or Access.” The quantity and variety of software on the market have increased, too. There are options that are relatively affordable and functional for distributors of all sizes and sophistication levels.

“Many people think — and the software vendors will tell you — that you need to build a big, complex model,” says Tarr. “You may want to, but you don’t have to. You have to take all those costs in the overhead pool and find a better way to assign those costs to a product.”

“Technology is continuing to evolve to be more affordable, more widely available and easier to implement,” says Jack Shaw, president of eBusiness Strategies, Marietta, Ga. “For small distributors: be aware of ABC and start thinking about your business in these terms.”

Aside from cost, there are also cultural barriers for some companies.

“The major obstacle is the mentality of the accountant,” Cokins says. “The accountants have done more damage than good when it comes to implementing ABC/M. They typically over-design and over-engineer the ABC/M system,” Cokins explains. “They fall back on their instincts of precision and detail — whereas costing is modeling, and simpler models produce high accuracy.”