Business has changed. Not because of the dot.com boom, CRM or whatever, but because the world has changed. The question is whether we have changed the way in which we look at what we do.
The way we were
The cost accounting methods that we still use were designed in the Victorian and Edwardian periods and were well suited to the labour-intensive production of a few items: that’s what businesses did. The vast range of administrative processes hadn't really arrived, so overheads were fewer and lower. However, the last third of the twentieth century saw the start of the increasing rush of automation, product variety and the removal of human effort as the only significant factor in production costs.
These days, any business now does a far wider range of things and uses a far wider range of inputs, both directly for production and in the business around these. Traditional accounting allocates support resources such as marketing invoicing, customer service and all the myriad of business activities by some high-level metric, such as share of revenue. This can’t be accurate for a complex web of operations and needs to be replaced. For example, your parcel carrier might charge by weight, a simple metric, yet that doesn't reflect the cost of carriage so much as other factors like size or the number of items being collected from the customer. A kilogram difference in the weight makes little difference to a man picking them up one at a time - and now that most central sorting is done by conveyor it makes no difference at all.
The new thinking
Thus, a different method of arriving at costs is required, one that reflects the changed way in which we do things and the changed mix of inputs. One tested method is Activity Based Costing (ABC), developed by Professor Robert Kaplan of Harvard Business School. The underlying concept is not to ask what share of overall cost should we allocate to this line but rather what costs does this line generate? So we can move away from arbitrarily sharing cost to looking at inputs: from this we can start to understand what is driving our costs by understanding what alters when demand changes.
This starts to show us what each of our products and services really cost.
By looking at what happens, we can see where we are not being accurate on our costs. Say our customer orders are such that we are making one trip into the warehouse to get 50 units of one product, and another trip to get 5 units of another. The same amount of both leaves the warehouse over the month, so do they share an equal part of the warehouse's running costs? Or not?
We can also better understand unused resources. For example, under a cost-sharing system, we might say that say that if a man is idle for 15% of the time, then this should be shared out by bundling this into the cost per hour. One activity may be running at capacity, so it is inaccurate to get this activity to pick up part of the cost. We have to ask, if he wasn't idle, what activity would he be working on? Under ABC, unused resources are not part of product costs. Obviously this doesn't make these costs disappear, but does make them visible and thus manageable.
Now we are in a position to know which activities do make a true profit, which broad metrics can't do. ABC won't in itself increase your profits. While overall profit remains the same, we know where it is coming from and where it is going. We have a tool to create more profit through focussing on the profit-generating activities.
Why did it take so long?
So if it is that great, why has it taken so long? After all time and motion studies have been around for ages. It has come of age now as we have the power to cheaply do the calculations. The General Post Office used to charge postage based on distance until Charles Babbage pointed out that it cost more to calculate the cost of the postage than the postage itself. While this was an excellent early example of ABC, it also demonstrates that the cost of ABC was then too high to be worthwhile.
With modern personal computers this barrier has been removed and businesses of every size can put the benefits of truly understanding what they do straight on their profit line.
Do you know how much your activities cost, rather than how much of a share of the total you apportion to them?