I was recently delighted, but surprised, to be booked to do a workshop at a fall 2008, distribution association convention on the topic of "Activity Based Costing" (ABC). ABC is a cost modeling methodology for getting a better sense of the true profits from - customers, services/products, suppliers and other business decisions - that was first "productized" in 1987. Back then, it got a lot of "this-will-revolutionize-business" hype, but the adoption rate has generally been slow across all industries. Some industries - banks, casinos, large logistics firms - are heavy users but activity within independent distribution channels is about 10% or less.

Although I have been personally involved in some terrific, distribution-company turnarounds that were both guided and energized by ABC ranking reports (starting in 1976) for profitability of - customers, suppliers, branches and employees - most distributors have not tapped the full potential of ABC analysis or even philosophical thinking which raises at least these questions:

Why the low, slow adoption rate for ABC by distributors over the past 21 years? [1]

Why the weak follow through at firms that do get first- or second-hand ABC insights?

How can we make ABC a more user-friendly and less threatening tool with simple starts?

What would be the first, easiest distribution-specific ABC applications to try?

Is my recent booking a sign of broader interest within distribution channels?

And, from the non-user crowd: "First, what exactly is ABC anyway?"

ABC, simply put, is an accounting method (not software, although there are ABC software tools available) for assigning a firm's "resource costs" for all activities that go into producing products and/or services by a more detailed splitting up of and reassignment of indirect or overhead costs.[2] (Readers can google "activity based costing" + "six steps" and find all that you need.)

By simple example, if two customers of a distributor each bought $1,000 of goods with $200 of margin dollars in the order, how much profit did each order put to the bottom line? It depends, of course, on the number and degree of service cost activities. What if one order involved every (extra) service cost imaginable while the second was generated by a non-commissioned, house account which was ordered electronically for standard, in-stock, fast-turning goods and then picked up by the customer who paid in cash? We know intuitively that the second order is more profitable, and we are grateful to have it to cross-subsidize some of the losing orders that we know we have everyday. Our financial reporting systems have been shaped to pay our taxes on time and do asset-backed borrowing from banks; they don't tell us which suppliers, products and customer combinations make us the most money, which really defines our competitive strategy.

To extend the two order problem to customer profitability analysis for an entire year's worth of business, it is not uncommon for an ABC analysis to rank customers from the most profitable to the biggest losers to reveal the following magnitudes:

The top 10% of the most profitable customers yield 90-100% of company profits (The top 5 accounts are sensationally profitable; should we do anything extra not to lose them? Or, to sell even more to the core more effectively?)

The top 40% cumulatively yield 140-150%, which, let's say, is the break-even point for the ranked customers.

The bottom 60% starts as negligible losers to finish with a few shockingly-big losers at the bottom. The cumulative losses on the bottom 60% offset the extra profits from the top 40%, so that 100% of the accounts do total to 100% of the profit before interest and tax (PBIT).

But, the bottom 1-2% of the customers will, notably and amazingly, lose as much as 20% of PBIT (Should we try to turn these "lead" accounts into profitable "gold" accounts? How?)

Visit merrifield.com to read the rest of this article and learn more about how to experiment with ABC profit reports.

D. Bruce Merrifield, Jr.
©Merrifield Consulting Group, Inc., Article 2.27
merrifield.com

[1] Or, 29 years since the publishing of the Harvard Business School case entitled: "Paper Distributors, Inc. (E): The Small Order Problem." The case was on one of my turnarounds and is now out of print.

[2] Acorn Systems (acornsys.com) is the #1 ABC software company. They have a number of very large distribution firm clients ($200MM and up). They hope to repackage their "distributor best practices" into a more affordable solution for smaller firms in the near future. I have helped a number of distribution software firms install a simple "customer profitability ranking report" option.