Traditional accounting — variable vs. fixed costs — can be ineffective in today’s economy, where the majority of business costs are not fixed.
Another strategy, called Activity-Based Costing — or ABC — helps businesses pinpoint the true drivers of cost by measuring process-related activities. Specifically, it separates value-added activities — those that are essential to the delivery of the product or service — from nonvalue-added activities — those that aren’t essential and may be consuming resources needed in the essential areas.
Applying the principles of ABC enables management to more accurately identify unprofitable areas and correct previously unrecognized problems, improving overall profits.
ABC also offers a less obvious benefit: increased employee satisfaction. A department’s profitability often determines the amount of salaries, bonuses and other perks. Have you ever heard an employee complain that his or her bonus was comparable to one a less productive employee received? Since ABC measures activities, it helps establish a fairer compensation policy.
Here’s how it works.
The traditional method
On the traditional cost-allocated profitability chart, income figures are based on actual income earned by each department, but administrative salaries and other costs are allocated equally to each department. Besides violating the basic accounting principle of matching expenses to income, this just does not make good sense. Yet this is how some companies report net income on a monthly statement.
To show you how ABC corrects this situation, let’s use the example of an auto dealership. According to the traditional profitability chart below, this dealer should eliminate the body shop, service department and new car inventory. The dealer would be more profitable if he or she just sold used cars and parts.
But is that the best course of action? Of course not.
Traditional Method
New Cars Used Cars Parts Service Body Shop Totals
Sales/Income 220,000 380,000 310,000 145,000 145,000 1,200,000
Sales Costs 68,600 68,600 68,600 68,600 68,600 343,000
Other Costs 151,400 151,400 151,400 151,400 151,400 757,000
Total Costs 220,000 220,000 220,000 220,000 220,000 1,100,000
PROFIT 0 160,000 90,000 -75,000 -75,000 100,000
Let’s look at some of these cost centers in more detail and apply some practical methods of tracking actual costs to each department. You’ll see some shifts in profitability when we reallocate the expenses to the actual areas where they occur.
The ABCs of payroll
There are 200 employees at our sample dealership: 25 in new car sales, 25 in used car sales, 20 in the administrative office (including three finance and insurance employees), 60 in parts, 40 in service (including three rental/leasing employees) and 30 in the body shop. These numbers reflect part- and full-time employees, so taking the total salaries, dividing by 200, and multiplying by the number of employees in the department would not give you an accurate cost picture.
Most payroll systems list employees in cost center groups. Using our example, new car salespeople might have a cost code of 100, used car salespeople 200, etc. Likewise, employee benefits, payroll taxes, pension and similar expenses tied to individual employees can be derived easily through these cost centers.
Also, be aware of the percentage of work your administrative personnel do for various departments. For example, a tag/title clerk might spend half of the time working for new car sales and half for used car sales. Therefore, none of the labor should be charged to parts, service or the body shop.
To ensure accuracy, consider having your administrative staff complete a short survey indicating how much time they think they spend doing work for different departments. This can be an eye-opening experience in many companies.
The ABCs of expenses
Rent expense or fair market value of property can be easily allocated by the amount of square footage each area uses to produce income. If the body shop uses 15 percent of the total dealership area, multiply total rent expense by 15 percent and allocate it to that department. New and used cars will probably take the largest share of this expense.
Examine each of the categories listed on a monthly expense statement: telephone, utilities, insurance, office supplies, professional and service fees, data processing, bad debts, contributions, interest, depreciation on equipment, equipment maintenance, travel and entertainment, and miscellaneous. Then ask the accounts payable person and other staff directly involved with these expenses for suggestions on how to properly allocate or reduce them. This doesn’t take long, and other people’s perspectives can bring some interesting ideas to the forefront.
Be open to suggestions from everyone, not just top management.
The ABC method
Now, let’s fill out our income statement again, this time allocating expenses to the departments that actually incur them.
ABC Method
New Cars Used Cars Parts Service Body Shop Totals
Sales/Income 220,000 380,000 310,000 145,000 145,000 1,200,000
Sales Costs 90,000 80,000 70,000 60,000 43,000 343,000
Other Costs 150,000 164,500 247,250 85,000 110,250 757,000
Total Costs 240,000 244,500 317,250 145,000 153,250 1,100,000
PROFIT -20,000 135,500 -7,250 0 -8,250 100,000
This should provide a more realistic picture of what’s going on at our dealership. ABC shows the only star in this line-up is used cars, although the service department and body shop could probably be profitable with a little tweaking.
But what’s with new cars? Certainly something has to be done to change that $20,000 loss. Maybe some salespeople just aren’t pulling their weight. It might be time to trim, train or replace some of the sales force.
Parts is also not as profitable as the first analysis indicated. Are the salespeople not selling up to their potential? Could some serious transgressions be taking place?
In addition to trimming departmental costs, ABC can help you further minimize overhead by providing a ratio of productive to nonproductive people in your company. By having a clearer picture of employees’ actual activities, not just titles or positions, you can ensure that the majority of your staff is people who are on billable time and generating revenue, not just increasing your payroll expenses.
In our example, the dealer might want to examine the specific activities by the staff in the parts department. Is everyone generating revenue or could some positions be eliminated?
Benefits of ABC
Using this less traditional, but more accurate, method of measuring costs can:
- Permit pinpointing of business cost elements to allow effective and targeted cost reduction.
- Give an understanding of business processes, not just costs, for better decision-making.
- Be more flexible and comprehensive than traditional methods.
- Differentiate value-added, essential activities from nonvalue-added, unnecessary activities that drain valuable resources.
Try ABC allocation in your company. By doing so, you can reward employees who really deserve it and work on getting the best out of those who are not achieving their full potential. F. Jeffrey Kovacs ([email protected]) is a shareholder with Schneider Downs & Co. Inc. in Columbus.
