Discover Profits Through Activity Based Costing

10 January, 2013

As businesses grow and expand, the business owner needs to know further details about the sources of revenue, costs and profit. Many people believe the 80/20 rule can apply. For instance, 80% of their profit is coming from 20% of their products or services. That may be correct but there is a more definitive method to discover the exact source of the business profits. This method allows the business owner to identify what product and services are the true profit generators.
This method is called activity based costing or ABC.  Note: Activity Based Costing is a management reporting and decision making tool, it is not appropriate for accounting records as it allocates most of the company’s overheads, not just those overheads that are supporting the direct production or service delivery. It removes the assigning of an “overhead percentage” or overhead lump sum to the business to obtain a profit number.
Let’s take an example of a computer hardware company. This company sells computer hardware but also has a services division. The services division will host client servers as well as provide software as a service or cloud computing. Our company is a medium size business and it does not have separate management teams overlooking each area of the business. The human resources such as technicians and sales people work in both the hardware and services business.
In a standard model of accounting all revenue will be recorded and the cost of sales would be removed and we calculate a profit or loss. Revenue and product margins will be visible but some of the important costs slip into a general cost of sales account, or are hidden elsewhere within the accounting statements of the company.
It should be noted that because ABC allocates different overheads and different costs than standard accounting methods, the margins we can see from ABC are usually significantly different, and prove to be a better tool for making management decisions.
If we recast the business accounting numbers into an activity based costing report we could find deeper meaning or the “behavior of our costs” in the numbers.
.  For instance:

  • How much of our overhead costs are allocated to service the customers, whether they place an additional order or not?
    • This could be the sales force maintaining existing relationships and the cost of acquiring  new clients.
  • What are the indirect costs required to manage the production/delivery of what the customer is buying?
    • This could be the production area overheads such as supervisors, rent, and depreciation of front line equipment, delivery vehicles and so forth.
  • Are there indirect costs associated with merely receiving an order from a customer?
    • There may be a need to schedule with production to ensure the order can be satisfied, to buy any materials and supplies to satisfy the order, the production line may need to be modified to accommodate the order.

Once we understand the behaviors of the costs then the “true” overhead costs required to deliver the product or service to a customer are revealed to the business owner.
The result can be quite astonishing. Perhaps the business owner will find that the 15% product margins on the computer hardware sales are being eaten up by the free installation costs. The software as a service provides the business with 60% profit margins, 20% of the sales revenue and 80% of the overall profit. This kind of information allows the business owner to market their product differently. Emphasis on converting hardware customers to software as a service clients with 15 days free trials will allow the hardware to be a loss or break even leader into the client. The hardware business is now known to be the lead generator for the software as a service business. Or the business owner may find that the 15% margins on hardware sales are not enough to support the service and administrative costs. The owner now has information that can be used to transform the business from a hardware supplier to software provider. Another software as a service offering can be provided as the basic infrastructure is in place and the expansion of services can result is higher margins and better cash flow.
Activity Based Costing is a powerful decision making tool for the business owner. It can be the difference between the business breaking through or breaking down.
Call us at Numbers Plus today. We can show you how powerful activity based costing can be for your business and put more money in your pocket.
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