Beyond Activity Based Costing
The Profitability of Customers is key to EVA
If you don't know where you are making (or losing) money, you are probably on the verge of trouble. The Enterprise Group can help you understand the profitability of your business better than ever before.
For the past decade the discipline of Activity Based Costing (ABC) has dominated the field of new accounting methods, yielding its buzzword crown only lately to Economic Value Added (EVA). Both of these brought important insights to the business world.
The former (ABC) helped move manufacturing operations off the old denominator measure of "direct labor" as its declining size made it no longer the proper metric. By properly attributing costs to the places where they were incurred or caused, activity based accounting became a valuable tool for operations. Factory management responded to this new enlightenment, attacking the real cause of costs and reducing them. Over the decades, operations managers have proven their ability to fix the problems if they could see them clearly.
Activity Based Costing effectively exposed the real causes of costs for attack and reduction. Then came EVA, the new measure of whether the business was truly earning in excess of their cost of capital. This measure exposed those misguided charlatans who would borrow on tomorrow for today's results (and executive bonuses). It will take a few years before the measure of EVA is widely used and threatened by misguided manipulation without really creating more value (creating value is, of course, the goal of businesses).
With all that introduction, what is my issue? Customer profitability, that's what! ABC does a pretty respectable job of telling us which products are profitable. EVA helps us see if we are earning returns greater than our cost of capital. In an era of unparalleled advances in logistics, I am not so sure that ABC is really keeping up with understanding the cost of selling the "mega-customer." We all read daily about merger after merger creating these "mega-companies." Wal-Mart and Home Depot cast huge shadows in retailing. Lockheed Martin now dominates the military-defense field. Microsoft is buying up the competition daily. Boeing dominates in commercial aircraft. GE is "king" in several fields, and Disney dominates the entertainment field. Procter & Gamble is a long time behemoth in packaged goods. The old saw that 1/2 of the Fortune 100 of ten years ago is gone, is true--they were largely acquired by the other half!
When these mega-customers demand a special treatment in servicing their business, what is the poor supplier to do. While suppliers are also consolidating rapidly as well, many are still a fraction of the size of the mega-customer. I spent much of my career selling large retailers, and most of my consulting clients do too. This past year's National Hardware Show was shaking with earthquake size tremors triggered by Home Depot. Tens of millions of dollars of volume changed hands among competitors in those few days. Such large business deals are not usually done at or during trade shows. Most are made privately, beforehand. Whether Home Depot chose this venue or the calendar just fell that way is not the point.
What is the point is that manufacturers who were vying for this business had better know what it cost not only to make the product, but also to serve this behemoth customer once they got the business. There is no mystery to the accumulation of costs incurred to enter, pick, pack and ship orders. Freight rates are relatively simple to calculate. Extended payment terms and larger inventories to cope with the short delivery times can be readily computed in terms of the time value of money. Returns due to either excessive buying, slow sales, or claimed defective products (or a lax return policy to gain favor from retail consumers) are reaching epidemic proportions in some product lines. To say "No" is difficult to impossible if retaining the business in the future is the goal.
Yet all of these "special costs" can be quantified and evaluated by the sales executives and senior management when the deal is being negotiated. But frequently they are not! Spreadsheets and laptop computers can readily provide a fully developed means to evaluate the deal being proposed or demanded. The more sophisticated companies do it. Many of the small and midsize companies fail to extend their analytical rigor to this critical accounting of the "cost of the deal?' Few of them thoroughly calculate how profitable that large customer's volume will be in advance. And saying "yes" to the big deal at the wrong time without that knowledge can be fatal. Gitano was a well known clothing supplier who said yes a few times too many to Wal*Mart during it growth in the 1980's, only to face bankruptcy in the 1990's.
The smaller supplier has another concern that is often an after-thought. Gaining the big customer may be like taking a drink of water from a fire hose. The volume can either overextend their financial resources, swamp their production plants, and decimate the overall profitability of their business, and maybe all three. Devastating success is the term I use for it. Not only can these mega-deals consume most of their capacity with the lowest profit business, but they put the loyal smaller customers at a competitive disadvantage, and their suppliers out of business, without even knowing they are doing it!
Go beyond ABC and EVA, to Customer Profitability accounting. Take the time to really evaluate the cost of the deal, the cost to serve the demanding large customer. Then make this added dimension the final piece in accounting for success before the fact, and not the eulogy of the business afterward.
