At the outset I want to shatter some of the myths that all of us have been groomed in and which have been fed to us over the years. Take a simple myth. If you are a multi-product, multi-function company, the marketing department in (say) Chandigarh is spending rupees 75 lakh and you ask the accountant how does he allocate the 75 lakhs. He would most probably say it is proportionate to turnover. A say 7 product turnover was given marketing expenses 75 lakhs proportional to products; this is true. Now when I picked up the phone and talked to the branch marketing head, he said, “You people are mad. Most of the time I am not selling or marketing because I get repeat orders on the phone for whatever I sell. But you are allocating my cost, proportional to the business I am getting for that product. In fact most of the time, most of my overheads, most of my energy, most of my infrastructure is being spent on products which I do not want. 70% of my energy goes into products which I have to try and sell because you have made them. But there are few winning, moving products on which I spend just rupees 7 to 8 lakhs. Remaining expenses are on non-moving products.

Four people go to a restaurant. One of them does not want to eat, he orders soda. The others order drinks, a full meal and dessert. The total bill comes to Rs. 4000/-; are you going to divide this bill by four? This is the surest way to lose friends. In a sense, activity based costing is like this. You have to put the resources in the right activity, right pocket.

ABC is not Software Intensive

Another myth is that ABC is software intensive. It is not so – Software only does the donkey work. If you are oracle based, or unix system, you have a back end collecting data, it can be merged on to a excel format. You do not require a massive software gadgetry to implement activity based costing.

Lets take another quick example. It will show the intensity with which we do ABC. In Garware Nylons when I ran the plant, we made polyester and nylon. One of the process was compressed and intensive. The other process was not compressed and intensive which means we did not require any fancy stuff to make it. But as far as the accountant was concerned, four crores spent on steam and compressed air were allocated to the product, proportionate to the turnover. This increases the cost of the product unnecessarily which affects its pricing and so the sales. This is allocating the compressed air cost to all products when it is solely applicable to only one. Engineers should be in the business of allocation of cost, not the accountant. When I took charge as controller for Atlas Copco, their advertisement said “Engineer to Head Finance”. Basically I was judged by the time I spent outside my department, making sure the department heads polarize with the trial balance.

ABC need not be software intensive, at least to get 80% of the value in a short time. If you want to go 100% in one stroke, then the effort is disproportionate, yes, that is when you require an enormous amount of investment in data processing. Let us assume that you have a traditional budget. In a traditional budget you have got things that you identify with. So you identify with salary, wages, cost, interest, depreciation, communication expenses, etc. In an activity based budget you convert the whole thing from overheads to activities department-wise. For example, if a Company has overheads of say rupees 70 crores, and you got say 24 departments, and have allocated rupees 3 crores for each department, This 3 crores has to be broken down into the specific activities and amounts for which it is allocated.

You have to take a customer-oriented approach. You have a design department which says I spent rupees 45 lakhs on design, you ask 3 or 4 end users (internal customers) within the company, does this mean anything to you and the internal customers disown this activity. Chances are the external customer will also disown the activity. Probably nobody will pay for it. It is fine if you have activities which somebody is paying for, but it hits the bottomline. Also we should not rob Peter to subsidize Paul for life. Otherwise you don’t know which product to kill. In our consultancies we are asked often – what do you kill ? We have got 18 products. Well, do you even know the bottom line of every product. Do you know how to allocate marketing expenses? So when everything is wrong, chances are that you would take a wrong decision, it will be more emotion-based, because the project is somebody’s personal pet, its because the product is championed by the designer who is more vocal than the others.

So you require data gathering, data collection, data understanding, data interpretation; we are not talking about costing at the moment but just activity based management. The next step is a sensitivity analysis, where you worry about your own volumes. For example if I make 100 meters, is it sustainable? Depending on sensitivity analysis, the winner may become a loser or a loser becomes the winner. When you talk about sensitivity, the engineer should worry about the volumes at which the unabsorbed cost actually becomes absorbed cost.

Side by side you also set some yard stick for yourself about when exactly you subcontract. This is a most misunderstood subject. Deployment, re-deployment, re-training, re-skilling, all this is fine. It’s also an investment, but it may not be feasible each time. Therefore you need some fundamental numerical, easy to understand norms about when to subcontract. Activity based costing addresses all these things.

Goal Setting

Then you come to goal setting. Very few people give you a numerical value. If somebody says I am going to get down the demurrage to the company from rupees 2.3 millions to 1.2 millions, that is a goal, which is addressed by activity based approach. For example the material department of one of my clients was incurring something like rupees 3 million every year in demurrage. The problem had nothing to do with the company; it had nothing to do with the suppliers. It was due to lack of communication from the finance department, which involved just telling the Materials Manager if money is available or not. The Materials Manager didn’t have the energy to trace 17 consignments almost every day and go to the finance department, asking whether for this consignment we have got the money. As a result, these consignments were delayed in the docks for a period ranging form 7 days to one month. And rupees 3 million was the cash outflow. When we shifted to activity base, we found in other departments, a lot of people who said they did not have 8 hours of work. The telephone operator said I can track 17 consignments for you. So she was given this humble assignment. Everyday for about half an hour she communicated with 17 overseas vendors, she was quick getting those calls, she understood the bill of lading, she was groomed in the working of purchase order and delivery schedules, her job was just to tell the vendor when to dispatch, that’s all. She said please don’t dispatch on Monday but dispatch on Friday. She did this four times a day. The company brought the demurrage down, which was a consequence of communication gap. In the activity base of the Materials Managers routine, nowhere was it practiced to communicate with the foreign principals and say please don’t dispatch. When the consignment came, finance would be told and if there was no money, demurrage was incurred.

So there is goal setting after goal setting. You do a BPR, you get demurrage down from rupees 3 million to 1.5 million, you need another BPR for 1.5 million to go to 0.5 million. And thereafter it should go to 0. Now, the mechanics and the energy levels of bringing it down from rupees 3 million to 2 million are simple, the telephone operator was no problem. The mechanics of bringing it down from 2 million to 1 million are different. As most Materials Managers realize, if you want to go from 80% to 90% the efforts are disproportionate, and at some point you switch BPR to other activities, which are more meaningful to the bottomline. Every department head should look at one thing – how do I become a profit center. It’s a motivating numerical tool for a MD to accept it.

ABC is not a formal accounting system. Nothing has to tally with anything. If you want to control material cost, ABC is not the best tool. In any case ABC is not the solution for everything. But ABC gives you a corporate plot of what is happening and what the customer is not paying for in your company. In other words, it tells you what is eating away your profits. And it tells who works and who does not.

ABC in Action

Now, lets see ABC in action. We did an exercise in our company once. I asked the secretarial staff, what is your ABC plot? So they came up with something like I do so much of PC work and so many hours of dictation and typing. And we figured it out, a secretary was sitting in front of a manager for four hours, neither taking dictation, nor typing. Because the manager constantly attending to calls, he had interruptions, his mind was not composed. With the result, the perception in the activity based analysis of that secretarial assistance was four hours of dictation and typing, but the actual act of delivery, the deliverable time was 25 minutes of typing. So three and a half hours were being wasted, which means if that secretary’s salary is 10000 rupees a month, 50% of time was wasted. No customer pays for waste. But internal customers tolerate it. Activity based analysis highlights that internal customers are tolerating so much of nonsense but the external customers are not paying for it. And that becomes a very focused action plan of business process improvement and reengineering.

I asked the Marketing man in Delhi what do you think is your highest expense. And he said manpower, foreign travel and meeting customers etc. added up to rupees 17 lakh for the Delhi branch. The interest on receivables was rupees 1 crore. Because he was getting cheap orders, the company was busy delivering and he was very popular. But his cheap orders were dear to the company. Because from up country, we never got payments for upto 180 days. We were delivering rupees 4 crores material per month to him and his highest cost was interest and not manpower.

What happens when ABC is done is that the department head also has an option to voluntarily surrender assets to improve his bottomline. I have space I do not need, please use it for some other activity. I have people I do not need so take them away. I am having machines, I am not likely to use most of the time, its inherited, take them away. Activity base plugs all this.

Nowadays we have moved from product-centric to customer-centric. You talk about, after sales service and escalations; customer values in managerial decisions. Lets look at what it means. Usually if there is a repeat order, the customer is expected to go through the entire process again. If he is an irate customer; he is not going to like you. You are in no position to reduce cost for the customer. He does not want to go through your front line salesman again, he does not want to go to your purchase again, your production planning again. He says I want another like the one I bought some time back and he expects you to it deliver to him. So the response time to the customer, the way you deal with some of the repeat customers has to be different. The setup to address this issue has to be a priority. It’s very difficult but important for industries today that all functions within the industry and all activities within the functions present a unified front to the customer.

Looking for Substitutes

It is important to apply the concept of leverage to departments. If I do X, he will get 4X is the concept of leverage. You leverage anything with anything. You leverage relationships at home. If I want to communicate with my son and I realize that he is nauseated by the amount of inputs he gets from me I would rather ask my friend to communicate the same thing to him. Sometimes in organizations what a consultant says has more credibility than what the managers say. The inputs are the same but the delivery could be different. With the amount of data mechanization, you will use it to leverage inventory valuation, product costing; you will use it for performance measurement, incentives and bonus, and cost and management control. Today the percentage metrics of data processing is moving from something like 10% to 15% of decision making. Something that is identifiable as the product cost can be segregated from something that is not identifiable as its product cost. This is reason why activity is important. If the man in Delhi screams sufficiently loudly that 30% of his overheads are going into a product that is not selling, you will kill the product first. The unproductive stuff can be anywhere between 30 to 50% in the life of the marketing. In production also it is a similar proportion. I have situations where we spent something like rupees 45 lakhs on the finance department alone. And the whole thing could be done for rupees 3 lakhs by a dedicated CA. In small scale companies also, why spend a huge amount on accounts department that is neither communicating nor has any value addition, nor are suppliers happy with it. I can fix it with a much smaller package administered by an external consultant. I am not advocating consultancy. But the fact of life is rupees 5 lakh substitutes can do rupees 25 lakh functions. The bottomline is better. So you have to broaden your horizons for substitutes. Of course there are the links, the cross department interdependence; when you do activity based costing you always come across this situation. If you say rupees 45 lakhs have to be reduced, then the links will come that if he can do this, I can reduce this, and so on. That secretary sitting in front of the manager hardly taking continuous dictation, Rs. 6000 is the extra cost of sitting this way. So once you do this for every department, every noticeable overhead, things will change. If you see the case of substitute in banking, it is electronic payments which cost 2 paisa per transaction. It’s swift and smart, it’s extremely customer centric without seeing the suctomer in the bank. You stay at home and we look after your transactions. I have got extremely great personal relationship at a cost of 2 paise but don’t come to the bank. Because here you will have a tea or coke with me, my time is spent on manual processing and it all comes to Rs. 83 per transaction! Activity base has converted a deliverable to the bottom line. If deliverables go to bottom line, which is the least incidence of cost. I will maximize those transactions with least incidence of costs. I know where to focus. If I know I have to focus on electronic payments, I am going to increase activity where electronics and data process are involved, I have to go for software. I wont want a clerk, I want a system administrator. Important thing is to focus on what is deliverable and what the customer is paying for so high. This is activity based unit essence.