Company manufacturing and exporting equipment for the oil, gas and chemical refining industries was heavily hit by the effects of strong currency. Rapid action was required to protect profitability, without jeopardising the significant market share and excellent customer service levels the company had achieved.

Within four months, the company had defined the information that mattered, collected the necessary data, and announced an immediate £0.75million improvement to the bottom line, cost reduction initiatives amounting to 20% of central overhead, the suspension of a planned £4.5million investment in what turned out to be loss-making products, and a lift in sales of profitable products.

The turning point in resolving their problems came when managers realised that despite their success so far, they were unable to answer some fundamental questions.

• Who are our most – and least – profitable customers?
• Which are our most – and least – profitable products?
• Can we be more price competitive on certain products?
• Which industries and regions should our sales force focus on?

Activity Based Costing provided the answers.

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A power generation equipment manufacturing business had ambitious plans. With production capability enhanced, it reorganised into high-tech machine cells. A number of new markets were opened up and a partnership deal with a third party seller gained access to some lucrative new business opportunities. Unfortunately its competitors proved much nimbler, and the order book became perilously weak. What had appeared sound capital investments only a few years before, now showed a poor return.

By undertaking an Activity Based Management project, within six months the company identified process improvements to increase overall capacity by 25%. By analysing product profitability, it decided to enhance its standard products resulting in fewer ‘specials’ made to customer order.

By analysing customer profitability, it was able to modify its channels to market and revise the mix of customers.

The result? A much more profitable mix of products, channels and customers, which doubled profitability. A position that delighted the parent company and shareholders alike.

The Activity Based Costing model became a key decision support tool within the business.

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A global manufacturer and supplier of orthopaedic implants and surgical instrumentation had manufacturing plants in two European countries with sales via a single European distribution centre. Their product portfolio contained over 1,300 appliances and instruments. Some product ranges were based on the latest available materials and surgical know-how, but there existed a long tail of small-batch items, mainly based on older, superseded technology.

They were anxious to improve their profitability despite the continuing erosion of gross margins in their longer established products, and their competitors’ apparent willingness to provide a superior service to their own customers at no extra cost. They needed to understand the cost implications of matching their competitors’ actions, and to find the most favourable product ranges in which to focus future development.

The first phase of an Activity Based Costing project determined the real contribution that each product made. None were negative though the activity based costs of all the mainstream products were significantly lower than previously thought, while those of the tail products were generally slightly higher. Based on the analysis the product groups were categorised into Gold (the highest contributing products that together made 70% of the total contribution), Silver (20%) or Red (the final 10%).

The second phase of the analysis determined the real contribution made by each customer. Based on contribution the customers were categorised as Green, Blue, Grey or Purple.

Because customer-driven costs were relatively low, customer profitability correlated very closely with the products that they bought. Green customers bought predominantly Gold products; Blue customers bought similar quantities of all product groups, while Grey and Purple customers bought mainly the tail of Red products.

Following the analysis the company was heartened to discover that at least 59% of the customers were profitable with the rest making a hidden loss of only £5 million.

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A manufacturer of electronic and electromechanical measuring devices that has a well earned reputation for R&D, quality and service support. Though the dominant supplier in the UK market, two years ago this position came under threat from cheaper imports. In response, it had outsourced much of the component assembly to China keeping the final kit assembly in the UK.

It had matched the competition for price, enhanced customer service levels to its larger volume customers, and commissioned a new state of the art final assembly plant in the UK.
However, the squeeze on gross margins in the UK was relentless - the board faced tough decisions but it needed sound information regarding profitability.

With each function contributing to the analysis the firm soon completed its first Activity Based Costing model. By country, it became clear the extent to which the additional revenue from overseas markets had come at a price. Only four out of fifteen had contributed any net margin. Almost all the customers that had destroyed margin were from overseas markets.

By product, the gross margin was compared with the net margin. For those destined for the overseas customers a healthy gross margin became a negative net margin under the burden of the high warranty related costs and overhead activity.

Even with the most pessimistic of assumptions the revenue and profitability forecast for the customer base in the UK would far exceed the current business with the overseas markets in tow.

The analysis approach is now embedded in the business as a key planning support tool. And that means forecasting with confidence – rolling strategic planning - and being able to predict accurately the consequences of their decisions.

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A brewery had annual sales of approximately £50 million and was suffering long term decline. The company had around 1000 people in the brewery, warehouse and managed estate.
They also had tenanted pubs. Their wholesale wines and spirits division, which accounted for around £10 million of sales, operated in a highly competitive market.

The analyses in the Activity Based Costing model showed management where specific actions would lead to healthy gains in profitability in the short to medium term. Further refinement of the model then delivered many pointers to subtle changes in the business that helped it continue to build a growing and robust bottom line.

In the words of the Managing Director –

“The Develin & Partners approach made all the difference. It uncovered where profits were being made or lost. It showed the underlying reasons for losing money and what we needed to do to turn unprofitable business around. And it gave management the confidence to drop whole segments of unprofitable business when there was no hope of turning it to profit”

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A Prepared Foods manufacturer believed it was doing reasonably well with an overall 40% gross margin and profits of 10%. Not bad, considering its customers were major supermarket chains who demanded safe, fresh, consistently high-quality products delivered to extremely tight schedules day after day.

Customers also expected such services as proactive product review and innovation, sourcing of new and exotic ingredients, new ways of presenting and packaging products, 24x7 service, and so on.

Meeting its growth and margin targets meant uncovering where processes were failing, and understanding which features of the customer relationship were losing money.

The company found that, in order to meet the increasingly complex service demands from customers, internal processes had grown complex. This complexity caused additional overhead costs, eroding profitability, as was clear from the bottom line of the company accounts. What was not clear was the impact on individual product and customer profitability. So management could not see where they could improve efficiency without damaging customer service.

Salvation came in the form of a detailed Activity Based Costing model which provided a profitability analysis that showed that only 50% of the company’s 200 products made money. Simply getting the 50% that lost money to break even would add 25% to the overall profit!

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This dairy had sales of £14 million but was making a loss of 12% of sales.

The cost of milk was 72% of sales, operating costs at 40%. Breakeven could be reached by reducing the cost of milk by 30% or operating costs by 17% or by increasing prices by 12%. Each option on its own was not realistic and even a mixture was going to be unpalatable.

There was an urgent need for a proper understanding of the true costs of the 60 products and the true costs of the dairy’s relationships with its 700 customers. The Activity Based Management project became the highest priority item on the board’s agenda.

The Activity Based Costing analyses were able to show the business where it could take immediate action to reverse its fortunes. Some of the actions taken are listed below:

• Where prices were patently wrong they were adjusted where the market could absorb the increases
• Products were deleted where there was no hope of them ever making a contribution
• Better promotion of high margin products was started along with the development of new products that were likely to have the same price characteristics
• No product introductions were to be made without a business case proven using ABC costings
• No customer contracts to be entered into without proven profitability based on ABC costings
• Change service level contracts with all commercial customers to eliminate abuses
• Examine every customer relationship cost and product mix ordered in detail to uncover further opportunities to reduce margin erosion.

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A wholesale mobile phones business had done well in the early days of high demand, growing both its customer base of retail outlets and levels of service to become a large and impressive business. But with the proliferation of customer types and enhanced levels of service there came another change. On a turnover of £250m it began to make £1.5m per month losses.

As sales volumes increased so profitability plummeted. Its share price followed. A tumble to 3% of its highest level. Shareholders became highly concerned.

Eliminating the root causes of the problem became the key to turning the business round.

The project to do this had three objectives:

1. reduce the unit costs of all the processes
2. reduce the capital tied up in stock
3. eliminate any characteristics of doing business that made them a loss

As the company experienced rapid growth it started to miss deadlines, suffer re-work, lose data, and fail on promises to customers. The lack of process robustness was at the root of a growing blame culture and the source of high process costs.

A warehouse full of phones gave an ability to meet demands from stock. However, stock older than 2 months couldn’t even be sold for the price paid to its suppliers. Phones aged rapidly!

A few customers ordered high quantities; around 2,000 products at a time.  Most didn’t. About 50% of the customers ordered 4 or less units per order. These orders only added the last 5% of sales value and gross margin. But will the last 5% of gross margin be sufficient to cover the cost of processing the orders?

One particular segment, small High Street Dealers, mostly ordered small quantities of phones with an average order gross margin of only £15. For the company as a whole the analysis had shown that the average cost to process an order was around £50 which meant that for the High Street Dealer segment, on average each order lost the company £35. This segment placed 87% of the orders accounting for over 50% of sales value! Volume growth had all been in the segment that rocketed up their total costs.

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The merchanting division sold and distributed to its customers via a regional warehouse network.

In common with many businesses of this type, the merchanting division had built up a solid customer base offering a standard next-day delivery service to everyone. Although the gross margins from all customers were positive, the sector was experiencing pressures from its customers to further reduce prices and improve levels of customer service. Management realised that existing management information offered limited support to the urgent commercial decisions they now faced.

However, under competitive pressure it needed to get an accurate understanding of:

• The relationship between Gross Profit and Trading Profit, where trading profit equals gross profit less selling, warehouse, distribution and stock carrying costs.
• Volumes sold, stock policies and customer service levels.

A traditional Activity Based Costing and Profitability analysis was undertaken but the results had a strange trend in them. The high gross margin sales also attracted disproportionably high warehouse and logistics costs which had grown over the years, despite constant management attention to keep the trend in check. Finally, the root cause was uncovered. Traditionally, the sales force had been paid a bonus based on gross profit. As a result, adding additional lines to stock, or incurring extra costs for small orders or tortuous and expensive special deliveries, had no impact on their bonus.

On the contrary, they would do many things, at any expense, to achieve a high gross profit. The ABC analysis had been fundamental at uncovering the major issue; that of bonuses to the sale force.

A change to paying bonuses based on Trading Profit had an overnight impact on the sale force’s behaviour and a change to all customers becoming positive in terms of Trading Profit. The refined analysis of Trading Profit re-segmented the customers into the Gold, Silver and Bronze categories.

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A specialist distributor’s new owners provided a tough challenge to the management team – improve return on capital from a meagre 6% to 18 %, equivalent to a tripling of profits!

Further challenges included: retailers seeking bigger discounts, better stock availability and more technical support; robust competition forcing the business to work hard just to hold on to their retail channels; suppliers insisting the business stocked and distributed a very broad product range from items costing a few pence to thousands of pounds.

The turnaround came when an Activity Based Costing analysis revealed the true cost of balancing inventory around the warehouses. For every £1 the company spent on the activities of purchasing, paying suppliers, receiving and storing incoming goods, it spent a further 41p on moving stock from warehouse to warehouse.

Despite the balancing process, it was still frequently necessary to express goods to customers at the other end of the country, at further cost.

Within three months, the company had plans in place to carry all their stock in a single warehouse. This, plus other improvements, allowed the business to reduce overheads by over a third, while actually improving availability and speed of delivery to customers.

Above all, the study showed that players in the middle of a supply chain do not have to regard themselves as squeezed from both sides – they just have more parties with whom to negotiate. Success in this field depends critically on being well-informed.

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A supermarket chain had a number of Regional Distribution Centres serving several hundred branches.

Although the gross and net margins of both the overall business and of the individual stores were acceptable, the business wanted information that couldn’t be derived from the conventional accounts or any other available management data:

• More refined distribution costs so it could negotiate more vigorously with its 3rd party distributor, who handled around 40% of the volume.
• A model of the ‘selling operation’ in order to determine the net profit at category level in the stores (160 categories).
• The ability to simulate different distribution and selling configurations so it could evaluate their relative benefits

The Distribution division had worked on a simple cost-per-case measure for each of the major types of goods (ambient; chilled; frozen). The first stage of the ABM project used the Activity Based Costing model to refine this figure by considering the actual packaging and handling characteristics of every product in the distribution part of the supply chain. The model of the Distribution division provided an accurate cost of getting products to the stores.

The calculation of net margin at the cash tills was full of surprises. Although gross margins were fairly similar and positive for all categories, around 25% of categories were actually losing money.

More disturbing the value for net margin bore no correlation with gross margin. The latter never predicted the former.

The data in the model armed managers with the reasons for poor net margin performance so they could look at ways to improve things. In some cases, working processes were altered, in others pricing was changed.

In some instances, where a category was making a large loss from low sales, the space was used for other products and categories. However, these actions always had to be tempered by considering a typical ‘basket’ of products purchased by customers, because loss making products may be offset by very high net margin products regularly purchased in combination.

The result of all management’s plans and actions that came from the Activity Based Costing analyses was a dramatic increase in overall net margins. In a large retail business this is many £Ms.

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A UK energy supplier was under severe pressure to improve its profitability, as well as increase the customer base.

The directors had already considered a percentage reduction in staff across all parts of the business but the risk of arbitrarily reducing service levels was not one they wished to contemplate when there was already a net outflow of customers.

Two ways forward presented themselves: improving processes to reduce waste and duplication, and looking very carefully at unprofitable domestic customers.

An Activity Based Management (ABM) study was launched with these objectives.

That some domestic customers were unprofitable was no surprise. The actual number was a big surprise! Five per cent was anticipated, but the ABM model found the real number to be over 15 per cent, reducing the profitability of the business by £10m a year (25%). And worryingly, what if the most profitable 40% of customers were attracted to competitors? 

This raised a number of fundamental questions which ABM answered:

• Which domestic customers should they focus on retaining?
• Could previously unprofitable customers be restored to profit?
• If customers could not be made profitable, could they be helped to join competitors?
• On which groups should customer acquisition be focused?

The business was then able to put plans in place that satisfied their major shareholder’s expectations. More importantly, in terms of the proposals planned and managers’ enthusiasm for embedding the use of ABM techniques, the business made great strides in providing excellent customer service at the lowest cost.

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A Utility Company talked of strategic initiatives but they depended for success on doing the basics well. Responsibility for delivery lay at the door of the operations managers in the Distribution Division.

Operations Managers running the installation, maintenance and repair teams typically had a good idea what was happening on the ground. They had to. But they didn’t have time for painstaking fact-finding and analysis, so they didn’t have valid, up to-the-minute information on performance. Their ability to spot emerging problems, and then get to the heart of the problem quickly, was often restricted.

Equally, because they hadn’t got the full costs of doing jobs, they often had to rely on intuition and gut feel to choose the least expensive way. But the hidden costs of planning, inspection, possession, diversions, reinstatement or overtime often broke the budget or made the difference between profit and loss.

The need was for an information tool that pulled together relevant data from disparate systems, and from distant parts of the same system, to provide a clear picture of the operation. Using simple technology, managers had to be able to compare variables that affected cost or performance, such as different teams, regions or assets, different types of labour or plant, or different periods, and be able to delve into the detail where the devil was often hiding.

The tool was simply and affectionately dubbed ‘Ops-Coster’. It was a combination of data, lots of it, from a current system – job recording – and the analysis of costs, particularly overheads, using an Activity Based Costing model.

The beauty of the tool was its ability to slice and dice data and then let managers delve deeper into specific areas of interest or concern.  The true value came from being able to answer questions that were completely relevant to the Operations Managers rather than those questions that the standard systems could answer that were mostly designed for the finance department.

In addition, the tool improved the accuracy of costings by attributing indirect resources – such as Planners, Schedulers and Management – on the basis of actual usage, rather than through distorting averages. It also had to show whether the Division was achieving its goals within budget and be able to predict the resources required to meet forecast changes in business volumes. Additionally, it also reported the true contribution that contracts made to non-operational overheads.

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A private, multi-business-unit Financial Services company was strong and profitable. It employed over 850 specialist personnel at its corporate headquarters and in its offices in seven other countries. However success, evident from rapid and continuing growth, was bringing its own problems.

The central shared functions that served all the business units had grown complex and, in the view of some within the business units, expensive. The company needed to know more about its costs in both its shared service areas and in its business units.

Because conventional accounting and management reporting of costs could not provide the information, the company implemented an Activity Based Management approach.

Once the Activity Based Costing model had been built a number of immediate benefits were apparent:

• In the central shared functions, the unit costs of each of the services provided to business units created an accurate internal charging mechanism based on actual cost driver volumes.
• The unit costs coupled with rolling forecasting of the demand volumes allowed the costs of future demands to be calculated and levels of future resources adjusted accordingly.
• The unit costs were used by the managers in the shared services to focus on process improvements.
• In the Business Units the accurate services costs allowed the BUs to model the profitability of providing products and services to end customer. This information was then used to adjust product portfolios, service levels and prices.

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A multi-national company had a large IT Services function and over a five year period the organisation had achieved major cost reduction and customer service improvements, in which IT played a significant part. Yet in this period, IT Services’ reputation for timely and fit-for-purpose service delivery sank to an all-time low. The costs of IT support and operations were rising inexorably. Users were questioning what they were getting for their money and how they were charged.

The management accounts were strikingly uninformative. They showed the cost of IT resources – staff costs, travel and so on – but very little about what those resources were doing or what they delivered to the business.

To get real transparency of costs the IT Director decided to commission an Activity Based Costing model of IT Services.

After applying activity-based costing to IT Services it had:

• Clear definition of services, their costs and the activities involved in their delivery
• Information on areas of potential cost saving, improvements to services and value for money to users
• The basis for an equitable charging structure based on resource consumption: recharge costs based on the true drivers of cost
• A means of assessing the benefits of outsourcing and supporting benchmarking
• Metrics to improve cost management with well-informed strategic and resource planning: eg reschedule the replacement of legacy systems, improving cash flow over three years by £400,000 a year
• Reduction in the overall cost of IT Services: eg eliminate 40% of Help Desk queries, saving £100,000 a year.

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The relationship between the supplier of IT services to a major UK Utility was becoming more and more fraught. IT managers' time was increasingly dominated by negotiations over budgets for IT staff and estimates of time for additional work.

Both parties approached negotiations believing the other to be at fault. The IT managers suspected their opposite numbers were out to build reputations as tough negotiators by paring IT budgets to the bone regardless of the effects on service quality. Client managers, on the other hand, suspected their IT counterparts were retaining too many staff, all of whom had to be charged to the client by fair means or foul.

Within 4 months both sides had a clear understanding of the costs of the activities that made up each of the key services. Negotiations were positive, brief, and focused upon predictions for the root causes of activities. Client managers were able to finely tune their spend by minimising the root causes within their control. IT managers were able to help them to minimise their spend further by reducing the costs of activities over time.

As a result:

• Overall spend declined for the first time since IT was outsourced - a saving of £1m over three years without any drop in service quality
• Far less time was spent on budgeting
• A stronger partnership between client and provider - allowing them to deliver new services to the end customer more quickly.

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In the Republic of Ireland, Health Service Executives (HSEs) combine many Health and Social Services. The scope had an area roughly 150 miles by 100 miles, and spent €850 million per annum. It needed to know if it was spending the money well, and what drove expenditure, by being able to answer such questions as “How will changes in the population put demands on our health services?”, Can we influence future demands on social services through health education and preventive care?”, Are there better, more cost effective ways of providing our full range of services?”. From the government’s perspective the project had to meet a number of key objectives:

• Achieve transparency of costs
• Better understand value for money
• Link demographic changes to resources
• Link Government policy to resources
• Enable better planning of services provision

The Activity Based Costing approach was chosen as an ABC analysis was able to throw more light on why costs exist and how they vary. Instead of starting with how much was spent last year compared to budget, ABC concentrates on what the money is being spent on, and why it is spent. For example, how much does a Home Help really cost, and how many people will need such help next year? Will an ageing population influence the number of people needing community facilities? What is the trend in drug abuse, and therefore how much do we need to budget to deal with it? Can we influence demand for services through health promotion?

ABC analysed the whole cost of providing treatments and services – not just the direct clinical and service costs, but other support costs such as accommodation, equipment, management, administration and information technology. Armed with the ABC information, future submissions to the Department of Health and Children are now based on proven costs of activities and their cost drivers, which will ensure that adequate and realistic budgets are put in place.

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A UK private hospital group assessed that the healthcare market would be undergoing rapid and radical change. Over the next four years, it predicted the following trends:

• Downward pressure on prices as the NHS imposing HRG tariffs, with the insured market following suit
• Lower margins
• Increased capacity as new entrants from abroad appear – often cherry-picking profitable business
• Changes in clinical practice and technology that lead to shorter lengths of stay in acute settings, and more day-case, ambulatory and mobile treatments
• Shrinkage in the private healthcare market as the NHS waiting times reduce
• A shift in ‘buying power’ away from consultants towards commissioners – insurers, corporate customers, NHS trusts, GPs and patients themselves.

The group had positioned itself strategically to develop its business with both the NHS and private patients. This meant not only a change to the mix of products, services and customers, but also changes to corporate culture and the complex web of relationships which had evolved in the healthcare market over many years – between the NHS and the private sector, between hospitals and consultants, and between patients and their healthcare providers.

The Activity Based Costing model of net product, service and customer profitability  had a material impact on the group’s ability to:

• develop appropriate pricing strategies for the different markets in which it operates;
• evaluate financial risk when bidding for contracts;
• negotiate profitable contracts with current and potential customers, including insurers, corporate clients, self-pay consumers, and the NHS in all its forms;
• inform ad hoc pricing decisions;
• compete successfully with other providers;
• understand its operational costs, and thereby to control them better and to reduce them;
• benchmark costs and profitability internally and to identify opportunities for operational improvement, within the bounds of best clinical practice;
• optimise the operating margin, by modelling the cost implications and the profitability of different case mixes and volumes of business;
• plan and manage capacity by identifying bottlenecks, and separately to evaluate the costs of usable spare capacity;

The Activity Based Costing initiative was designed to deliver the costs and profitability of:

• service elements (‘components’ of care, such as imaging, physiotherapy, theatre time, accommodation, and drugs);
• episodes of care, patient pathways (by OPCS codes and for HRGs);
• individual customers and different customer groupings;
• different payment agreements within customer groupings;
• consultants;
• care settings – in-patient, out-patient, day-care.

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A ‘new’ university prides itself in offering a wide and flexible choice of course with a variety of modes of study catering for a diverse student population. It focuses on providing for the needs of the local region and has a high proportion of mature and part time students.

The university had suffered from reducing student numbers as a result of changes in the market place. Competition for students had become increasingly fierce and other universities were rapidly catching up as the sector became more commercial in its approach.
Following a review that identified many opportunities to reduce costs, a key requirement was:

1. A need to refine the university’s offer (its courses) and to whom it made the offer (its students).
2. Greater transparency of where costs actually went and,
3. How much the courses made from various types of students

The university decided to create an Activity Based Costing model of the whole organisation.

Total costs of the university were £70 million of which £40m went on modules (£35m) and students (£5m). The total number of students was 13,000 along with 630 academic staff and 690 support staff. There were 2000 modules which went into 1000 courses. Students could have 3500 degree combinations.

Combining module and student cost data provided many insights into the university’s costs and profitability. The Activity Based Costing model provided essential management information on processes, resources, ‘products’ and ‘customers’.

In particular it was then able:

• To support requests to fund providers
• To adjust the mix of modules to improve profitability
• To improve the mix of students to improve profitability
• To provide a focus on process improvements
• To guide decisions on the best use of the budget
• To apply scenario planning

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