Beyond activity-based costing
Mariotti, John

By properly attributing costs to the places where they were incurred, activity based costing (ABC) became a valuable tool. Then came economic value added (EVA), the new way to measure whether a business is truly earning in excess of its cost of capital. EVA exposed those who would borrow against tomorrow to enhance today's results.

FOR THE LAST DECADE THE DISCIPLINE OF ACTIVITY based costing (ABC) has dominated discussions of new accounting methods, only recently yielding its buzzword crown to economic value added (EVA). Both methodologies brought important insights to the business world.

ABC helped move manufacturing operations off the old denominator measure of "direct labor," as the declining significance of labor cost made it increasingly less relevant as a metric. By properly attributing costs to the places (or activities) where they were incurred, ABC became a valuable tool. It exposed the real causes of costs. And factory management responded to this new enlightenment by attacking costs and reducing them.

Then along came EVA, the new way to measure whether a business is truly earning in excess of its cost of capital. This measurement exposed the misguided charlatans who would borrow against tomorrow to enhance today's results (and executive bonuses). It will take a few years before EVA is widely used-and eventually threatened by misguided manipulation.

So what's my point? It has to do with customer-based profitability.

ABC does a pretty respectable job of telling us which products are profitable. EVA helps us to see if we are earning returns greater than our cost of capital. But in an era of unparalleled advances in logistics, I am not so sure that ABC has really kept up with the need to understand the cost of selling to the "mega-customer."

We all read daily about mergers that create mega-companies. And when mega-customers demand special treatment in servicing their business, what is the poor supplier to do? Although suppliers are also consolidating rapidly, many are still a mere fraction of the size of the mega-customer.

This year's National Hardware Show was shaking with earthquake-size tremors triggered by Home Depot. Tens of millions of dollars of volume shifted among competitors in those few days. And manufacturers vying for the Home Depot business had to know not only what it cost to make their products, but also the cost to serve this behemoth customer after they got the business.

There is no mystery to the accumulation of costs incurred to enter, pick, pack, and ship orders. Freight rates are relatively simple to calculate. Extended-payment terms and larger inventories to cope with short delivery leadtimes can be readily computed in terms of the time value of money. However, returns caused by excessive buying, slow sales, claimed defects, or lax return policies (at the retail level) are reaching epidemic proportions in some product lines. Yet it is difficult or impossible to say "no" if you want to retain the giant retailer's business in the future.

All of these "special costs" can be quantified and evaluated by sales executives and senior management when the deal is being negotiated. But frequently they are not.

Spreadsheets and laptop computers can readily provide a means to evaluate the deal being proposed or demanded; and sophisticated companies typically do conduct such analyses. But many small and mid-size firms fail to extend their analytical rigor to a critical accounting of the "cost of the deal." Few of them calculate in advance the profitability of the large customer's volume.

Saying "yes" to the big deal at the wrong time without that knowledge can be fatal. Gitano was a well-known clothing supplier that said "yes" to Wal-Mart a few times too many during its growth period in the 1980s, only to face bankruptcy in the 1990s.

Smaller suppliers face yet another concern that is often treated as an afterthought. Landing the big customer can be like taking a drink of water from a fire hose. The volume can overextend their financial resources, swamp their production capacity, or decimate the overall profitability of their businesses. Maybe all three. "Devastating success" is my term for it. Not only can mega-deals tie up most of a manufacturer's capacity with the lowest-profit business, but they often put loyal smaller customers at a competitive disadvantage.

It's important to go beyond ABC and EVA-to customerbased profitability accounting. Suppliers need to thoroughly evaluate the cost of the deal, including the cost to serve the demanding large customer. They must consider this dimension in accounting for success before the fact-if they hope to avoid eulogies for the business afterward.