Consider this scenario: "An airline has an empty seat on a flight that leaves in an hour." Isn't it appropriate to use the “marginal contribution approach” (covering variable costs and thus 'contributing' to pay fixed costs) to put a price on this seat? ” Professor of accounting at Dartmouth University, Shank sees it this way:
“I understand that it is said that this seat is lost and that any income is good. But what I also say is that the proposal to sell that seat at a reduced price (say $ 50) just because it would be vacated is a concept that destroys companies. Believing that this policy helps cover costs is a serious mistake. ”Let's see why:“ The airline sells that seat for $ 50 and the lucky passenger sits next to you. The promotional price of $ 50 comes out as a topic of conversation; you paid $ 300. The next time you travel you will expect to pay $ 50. You will comment it to another passenger and so on. It is only a matter of time for everyone to want to pay $ 50 and only the fools pay the full price. ” This is one of the consequences of fixed cost / variable cost thinking.It has been disastrous for sectors such as air transport, the paper industry, land transport, among others. The same could happen to your company.
It is time to abandon the fixed / variable cost model to make decisions about your sales and distribution system. Why continue to use this way of solving distribution problems that only leads to ineffective decisions? Robert Kaplan and Robin Cooper recommend in several articles and books to use the concept they call “Rule of One”: “A cost is fixed only if the Department or Area in which it occurs has a single person or a single machine”. In all other circumstances, costs must be considered as variables. The basis of this reasoning is that costs are determined by customers.
Customer-determined costs
In Distribution businesses, costs are more induced by customer demand than by volume of delivery. For example, the pre-sale costs to obtain an order are determined by the preparation of the seller, his visits, demonstrations, proposals, appointments, follow-up, trips, telephone calls, etc. - which are requirements imposed by customers. Plant storage and movement expenses are determined by the size and type of order, automation, product characteristics, packaging, inventories, etc.- that must be adapted to the customer's behavior. Delivery costs are determined by geography, distance, traffic congestion, equipment, etc. - which are customer requirements. And that's not all: after-sales costs are determined by returns, training,guarantees, repairs, etc. all of them, customer requirements as well.
Instead of thinking of costs as fixed / variable, you have to think of them associated with the Activities you do for clients.
Take delivery for example. In fixed / variable terms the transport rent is fixed, the driver's salary is fixed, the maintenance is fixed, taxes and licenses are fixed, etc. In this way you would have to give, free of charge, a paper box for $ 10 to a new client who lives in front of an old client. The $ 2 gross profit contributes to your fixed costs; that good!!
But what would happen in this same situation, if the delivery work was outsourced? You would not have to think in terms of fixed / variable costs but only out of pocket costs. If you are charged $ 10 for delivery, you would not accept a $ 2 gross profit order without the delivery charge.
ABCosting: a different approach
ABCosting approaches the problem of cost accounting from a totally different perspective than the fixed / variable cost classification scheme. ABCosting provides a clear picture of the costs of distribution by first identifying the Activities of your business and the Resource costs associated with them, and second by assigning those Activities to objects such as Customer, Products or Processes.
Examples of "Activities" in distribution businesses are: issuing sales orders, receiving products, selling products, taking orders and delivering products. They are Resources: the people involved, technology, equipment, services, capital and the costs related to them. Customers, Products and Processes consume these Resources.
ABCosting assigns the costs to these objects based on the rate of consumption activities. ABCosting allows to observe the accumulation of costs by Processes. For example, the processes of selling products and services, taking orders and their fulfillment, obtaining products, and controlling inventories and deliveries. All of these processes demand Activities within the company, often in different departments. With ABCosting you can analyze and rebuild the Process to reduce costs by eliminating unnecessary tasks, irrational operations and eliminating inefficient activities. Take for example delivery to destination.
ABCosting identifies all Resources and their associated costs that go into the Delivery Activity. It doesn't matter if a cost is fixed (truck rental, for example) or if they are variable (fuel); it is assigned to a common fund of delivery costs. If the warehouse supervisor spends 20% of his time scheduling deliveries, 20% of his compensation is allocated to the delivery cost fund. After adding up the costs associated with an Activity, they are assigned to Customers, Products or Processes, based on a "unit of activity". An activity unit, sometimes called an activity driver, is generally what triggers the consumption of Activities. For example, delivery to destination is a typical trigger for Distribution Activities.Each customer is assigned a cost based on how many Activity inducer units they consume.
The following graphic shows the elements of an ABCosting system:
ABCosting identifies and allocates costs based, not on the perceived behaviors (fixed / variable), but what Activities originate them and who consumes them.
ABCosting recognizes that as distributors we do what we do to meet customer demands. We provide value-added services that require value-added activities and these activities consume costly resources. Therefore, it is only a matter of assigning costs to Clients if we are engaged in profitability analysis, to sellers if we are doing profitability analysis of the Product line, or to the Process if we are rebuilding the costs of our business or to the entire distribution channel.
Conclusion As distributors we need cost information to make strategic decisions, pricing decisions, provide value added services, calculate profitability per customer, profitability per seller and process automation. If we approach these decisions from the fixed / variable costs perspective we are going to make the same mistakes as airlines. ABCosting offers a new way of approaching the process that begins with customer demands and ends with meeting those needs. Adopt ABCosting as the ideal tool for Management and decision-making strategies.
