How to build a culture of cost management (by Sudhakar Balachandran, August 17 2005, Financial Times) Five

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How to build a culture of cost management (by Sudhakar Balachandran, August 17 2005, Financial Times)

Five years into the new Millennium, the forces of technology and globalization are transforming markets worldwide. Technology has brought once-distant markets closer, creating opportunities and challenges. Among other things, these trends have led to tangible changes in operating costs at multinational companies. First, globalization makes operations more complex: the variety within any product or service market can be staggering, with specifications about product requirements, sizing, packaging, labelling, distribution, sales force and logistics. A global market offers potential for higher revenues, but complexity also brings higher costs. Second, a global trend towards deregulation has opened many markets to foreign competition, putting pressure on prices. The combination of cost and price pressures, if left unmanaged, squeezes profit margins. Any response to these challenges requires a sophisticated cost-accounting system to provide vital information for decision-making. Such systems are the means of gathering and distributing information about costs that the business uses to plan and to manage operations.

In the early 1990s Robert Kaplan and Robin Cooper developed activity-based costing (ABC), an insightful way for companies to think about the costs of doing business. Kaplan and Cooper argued that a well-designed cost-accounting system needs to reflect the activities in which the business engages, and the relationships between the resources consumed by those activities and the products and services the business provides. Today, ABC is used by many successful companies. Managers distinguish first between activities that add value and those that do not; then they seek to maximise the former and to minimise the latter. To begin with, a business must answer two questions: 1) Does my customer want this activity? 2) Is my customer paying for this activity? Value- added activities are those that the customer wants and is willing to pay for. Doing more of them increases revenue. All other activities are non-value added. Doing fewer of them reduces costs. In their efforts to develop more useful approaches to cost management, and to better manage value- added and non-value added activities companies have modified the focus of their cost accounting in several important ways.

Evolution of cost accounting beyond manufacturing. The roots of cost accounting and cost management lie in manufacturing, but during the 1990s cost-management practices began to be used in the non-manufacturing operations of manufacturing companies and eventually in service businesses. Several factors have contributed to this shift. In the first place, the distinction between a product business and a service business has blurred. Is McDonald’s, for example, a product or service company? One could argue that it has elements of both. Second, service businesses have multiplied, and product businesses have expanded their service-based elements. Costs of services have also increased. In response, cost accountants have developed techniques to deal with this new complexity. Third, the rise of enterprise resource systems, such as SAP, which provide a richer view of costs, has raised the profile of cost accounting within many companies. Today cost management is practised on the factory floor, but also in organisations as diverse as banks, consulting firms, advertising agencies and not-for-profit organisations.

A shift from product profitability to customer profitability. Companies have developed models to assess the profitability of their customers, market segments and other aspects of the business. From the early 1990s, companies realised that a lot of their costs were not directly related to the products they sold, but to selling and to general administrative costs. Many of these resulted from services they provided for customers in support of products sold, such as the services offered to mobile phone buyers or credit card users. It became much more important for these businesses to measure customer profitability rather than product profitability. Consider the example of a credit- card company. When a customer makes a purchase little incremental cost is required to process the transaction. But if he is late in repaying the credit card company and asks it to waive the late fees, the company could incur significant costs. In telecommunications, the product is often difficult to define and changes rapidly. Formerly, customers often paid for voice services by the minute. Nowadays, however, many providers offer “unlimited plans” for flat monthly fees. In instances where the product is difficult to define, it is useful to focus on customer profitability since revenues and expenses can often be traced more easily to the individual customer. A move from current - profitability to profitability over a lifetime. Companies have begun to develop systems to track the “lifetime value” of a customer. This is particularly important for businesses such as insurance where the costs of acquiring a customer are relatively high, and businesses in which the customers of one service are likely to opt for related services, such as in banking. These types of businesses have focused on developing customer relationship management systems based on data warehousing techniques. Retail banks, for example, track the behavior of their customers in many ways: which products they use; how often they visit the cash dispenser and how many of the bank’s products they use (such as cheques, credit cards, savings accounts and so on). The data helps banks maximize the value of the relationship and the lifetime profitability of the customer. Attention turns from the income statement to the balance sheet. In the past, cost accounting has focused on expenses such as maintenance costs or set-up costs – in other words, those that appear on the income statement [UK: profit and loss statement]. Today companies realize that some of their resources do not appear as expenses on their income statement, but rather as assets on the balance sheet. Further, the cost of these assets is often not reflected in the numbers used to assess profitability. For example, in an effort to increase sales, a salesperson may offer longer credit terms to a customer. Offering longer credit terms boosts accounts receivable relievable (trade debtors), an asset on the balance sheet. Similarly, a company could stock large amounts of inventory to make sure it does not lose sales because a customer’s order is “out of stock”. To communicate the simple notion that “assets cost money”, companies have begun to look for ways to hold their operations accountable for both the cost of resources traditionally considered as expenses, as well as the costs of assets. Distribution businesses, for example, might measure return on assets (ROA) by customer. Customer ROA is the ratio of a customer’s profitability to the assets specifically committed to that customer. If a distributor holds inventory for a customer or extends credit terms to a customer, the level of assets in the denominator of ROA increases. However, ROA will not increase unless there is a corresponding increase in customer profitability.

A shift towards systems that improve utilization of resources. In many businesses, a service is analogous to a product with no shelf life. If, for instance, a room in a hotel goes vacant overnight, that revenue-generating capacity can never be recovered. In a consulting firm, if a consultant is idle for an hour, the firm typically incurs a cost (in salary, overheads and benefits) but that hour of revenue-generating capacity (the product) has disappeared. The need to measure and make the most of such usage is not new. But technological change (such as the last-minute internet discount) and business practices (such as contract consultants) offer service businesses more choices. Success in service businesses requires not only an accurate measurement of how resources are used, but also a reliable estimate of the opportunity cost of idle capacity. In Built to Last, Jim Collins and Jerry Porras characterized traditional corporate strategy as an “either/or” proposition: managers could choose to pursue either low costs or high quality, for instance. Cost-management practices are similar: have been no different; companies either try to enhance revenues or to reduce costs – to maximize value-added activities or to minimize non-value added activities. As globalization intensifies, they need to do both. Companies that are skilled in identifying, measuring and classifying the value of their activities will be in a stronger position to respond to those pressures. The smart ones will be able to build a cost-management culture that helps them to generate sustainable growth, and ultimately, to build shareholder value.

Given the paper above, explain how modern financial institutions can benefit from the implementation of Activity Based Costing for their businesses using appropriate references. . Give examples of activities in a bank where Activity Based Costing would offer an improved costing analysis for the business.