We are going to relate the case of a company that produces power generators, which in the mid-1990s launched ambitious growth plans. Production, which was stagnant, was reorganized into highly sophisticated technological units. New markets were opened and alliances with third parties facilitated new opportunities and new businesses.
Unfortunately, as the global recession began, its competitors turned out to be much more nimble and its order list weakened dangerously. What seemed to be a solid capital investment until just a few years ago turned into a poor return.
The company decided that its response would be to "double the business" within the next two years. However, the new General Manager took an uncompromising stance that the business should be profitable and that this would be accomplished without increasing operating costs and production times.
Within the following six months, the company identified improvements in internal processes that allowed it to increase its total capacity by 25%.
Analyzing the profitability of the product, it was decided to expand the range of "Standard" products, which meant the decrease of "special" products, made to order. Analyzing the profitability of customers, it was possible to modify their market channels and review the customer mix. Results? A much more profitable mix of products, channels and clients that doubled profits and improved the position of the company and its shareholders and employees.
Problems arising in this company are common in many engineering companies.
- Lack of information on which products and customers are really profitable - only a suspicion that some were marginally beneficial. Production costs calculated using an estimate that 10% was directly for labor. This was the source of a major distortion in the analysis (many industrial companies still use this method, even though their overhead costs account for a large portion of total costs).
In the case that we describe, the company only obtained 1 out of 10 tenders in which it was presented and this occurred due to the lack of knowledge about the most convenient objective where to concentrate resources. (When the “weak” times come, it is difficult to get customers, so make the mistake of offering a lot in the product or service without knowing if the price you get pays for it).
Almost all orders became "special", although the company had designed a "Standard" line of products. Consequently, the engineering department was involved in each order, with repeated delays in delivery dates (a key issue emerged: the long period between the closing of the business and the delivery of the product resulting from the requirement of numerous changes in specifications of the client before specifying it).
The company made all kinds of efforts to adapt to customer demands, maintaining the original price for fear of losing the order at the last moment. Thus, the following errors were made:
- Lack of information for outsourcing decision making. Consequently, a large part of its own facilities were idle while there was a high level of subcontracting. (The system of including all overheads for the calculation of the cost of production time provided an erroneous basis for comparing with the prices of subcontractors) Frequent program changes due to shortages. Attempts to insert orders into the regular production schedule caused a disruption to the resource planning system. Out-of-program demand created shortcomings that led to further scheduling changes by installing system-wide uncertainty. High levels of inventory and obsolete stock. Changes in the schedule generated a superfluous stock, created by external orders.Production turned the raw material into useless pieces given the need to reduce overhead. Pieces were produced by "if certain orders were agreed" that ultimately did not materialize. High level of waste and disposable material arising from failed processes. Each month in progress gave the impression of being chaotic at work, even though the subsequent months promised to be stable. As the delivery dates approached, the pressure to deliver equipment to issue invoices increased. The custom of “assembling the equipment” at the client's premises was adopted, but that caused exorbitant additional costs and lost many tax incentives that counted the own plant.Pieces were produced by "if certain orders were agreed" that ultimately did not materialize. High level of waste and disposable material arising from failed processes. Each month in progress gave the impression of being chaotic at work, even though the subsequent months promised to be stable. As the delivery dates approached, the pressure to deliver equipment to issue invoices increased. The custom of “assembling the equipment” at the client's premises was adopted, but that caused exorbitant additional costs and lost many tax incentives that counted the own plant.Pieces were produced by "if certain orders were agreed" that ultimately did not materialize. High level of waste and disposable material arising from failed processes. Each month in progress gave the impression of being chaotic at work, even though the subsequent months promised to be stable. As the delivery dates approached, the pressure to deliver equipment to issue invoices increased. The custom of “assembling the equipment” at the client's premises was adopted, but that caused exorbitant additional costs and lost many tax incentives that counted the own plant.Each month in progress gave the impression of being chaotic at work, even though the subsequent months promised to be stable. As the delivery dates approached, the pressure to deliver equipment to issue invoices increased. The custom of “assembling the equipment” at the client's premises was adopted, but that caused exorbitant additional costs and lost many tax incentives that counted the own plant.Each month in progress gave the impression of being chaotic at work, even though the subsequent months promised to be stable. As the delivery dates approached, the pressure to deliver equipment to issue invoices increased. The custom of “assembling the equipment” at the client's premises was adopted, but that caused exorbitant additional costs and lost many tax incentives that counted the own plant.
The big revelation was discovering that misinformation about costs was the root cause of the company's most serious problems. As in many manufacturing industries, outdated accounting systems caused chaos in the strategic organization of production. In order to understand the fallacies of its procedures and achieve strong control of production costs, the company embarked on an ABC / ABM (Activity Based Cost / Activity Based Management) project.
Using ABC / ABM to determine actual costs
Through a cross-functional team, data on each department was selected and categorized according to core activities, those that somehow add value - and diversified activities, those that only consume value.
Understanding the true costs and their magnitude was a vital starting point for process improvement. By achieving the ABC / ABM model implementation, accurate knowledge of costs finally offered solutions to the problems.
For example, with ABC / ABM it was determined that the policy of attending to the special requirements of customers made only 70 of the 300 orders received profitable.
The cost data provided by ABC / ABM was presented in such a simple way that it was possible to use it as a system for setting prices. This not only saved budget study time, but allowed to respond only to those requests with the highest probability of profitability. The cost estimate for each hour worked began to include all overhead overhead. Since the incidence of labor was only 10% of the total cost, this calculation formula had caused a serious distortion of reality. In a particular case, values of $ 37 had been managed for a Standard hour, while that the actual cost was $ 28 for production time and $ 281 for set-up time. From this new information,Due attention was begun to be paid to the relationship between general production costs, their causes and the products associated with these types of expenses. Discovering the actual costs in the production process was itself a revelation, but the biggest surprise was knowing that the basic cost per hour could be reduced.
The distortion in costing had also eroded planning capacity. Previous studies indicated that a high percentage of production had to be carried out by subcontractors at very high prices while in the production areas there were inactive people. The ABC / ABM results proved something that the unions had been denouncing for a long time: the company was exporting jobs to other companies.
When analyzing the profitability of each client, it was determined that many of them meant a poor level of profit for the company. Some of them were discarded, while others were managed through less expensive channels.
The lump sum of profits became healthier when almost $ 1 million of customer related costs were eliminated.
However, the biggest jump in profitability occurred when the causes of various activities were identified and improvements in the processes were implemented. The resulting additional capacity allowed an increase in the volumes of profitable activities, sold to profitable customers and produced at a lower cost.
In the first year, the drop in costs obtained by reducing the extra payments to subcontractors and their handling was an additional $ 1.5 million.
The analysis carried out by ABC / ABM allowed the definition of new strategies that allowed to increase the company's participation in the market and create a negative impact on the competition. Indeed, while the previous strategies aimed to increase the volume of sales for all types customer, that is, consider only the volume. In light of the explanation of costs obtained by ABC / ABM, the company understood the cases of clients or products with which it was not convenient to do business.
At the same time, by entering a competitive position and dropping prices, the company knew exactly when to allow the competition to win the losing contracts that actually only added more to the losses than the profits. If the company had refrained from participating in the tender, the competitor would have been the only opponent and would have sold at a high price.
Benefits demonstrated by this study:
- The exact calculation of costs per customer and product gave insight into the deep root of the problems and how to improve processes. The possibility of reducing the employment of subcontractors and replacing them with own resources Accuracy in the study of costs and profitability, which led to an improvement in the product mix. The ability to direct scarce sales resources towards the most profitable opportunities. Accuracy in the study of clients with which it was possible to aim to better serve truly profitable clients. Strategies for growth in the market at the cost of yielding unprofitable contracts to the competition.
