With professor Bala Balachandran, corporations can put their money where their costs are. Vigorous proponent of activity based costing, Bala Balachandran,
distinguished professor of accounting and information systems, J L Kellog School of Management,believes that correct costing is the blueprint on which a correct reengineering exercise is based.
Professor Balachandran has a formidable array of research projects on cost management and was in Mumbai recently for a day-long seminar on Activity Based Management and Business Process Reengineering
Excerpts from the interview:
Q: What is the evidence that the fundamental concepts of management accounting have changed?
A: The real evidence in the US and even in some developed countries, according to a book Relevance Lost by Bob Kaplan, is that management accounting systems that were supposed to give information and not data ended up giving the wrong information. So managers ended up making the wrong decisions.
Take this Fortune Top 10 company. It could not have a shortage of any managerial talent. Now this company in a particular year sold more of its best-selling product (with cost to company at $ 70 and selling price $ 100). They outsourced a product on which they were losing money to the Koreans (cost to company $ 85, the Koreans said they would make it at $ 78). Therefore, they thought that by diverting capacities to a more profitable product without losing market share they would make more money.
Instead, the company lost more money. The reason was that the best-selling product was the least profitable product. Let us say the selling price was 100 and the cost according to accounting system was $ 70. Due to an activity-based system, the company discovered that the real cost was $ 110. So when the company sold more, instead of increasing the profit by $ 30, it increased the loss by $ 10. And it did not even know that.
The other side was that the worst product that was selling at $ 85 and making a loss of $5 (according to the traditional accounting system), actually cost $55 to make. So all the profits went to the Koreans. So the company was hit by a double whammy and squeezed completely. (See Inexplicable Hidden Costs).
The traditional accounting system, which was created on the basis of per unit fixed costs, was totally wrong. The variable cost was all right but
the per unit fixed cost allocation was all wrong.
Q: Why has the traditional method failed?
A: Mainly because of the manner in which fixed costs have been all-
ocated.(See Allocating Fixed Costs). It was wrong because you used the per unit fixed allocation. Assume that a company had a $ 100 revenue through a product and the cost was $ 80 ($ 20 selling expenditure). The company made 20 per cent profit. Now previously the fixed overhead was less than 10 per cent. So the maximum error in fixed cost allocation can be only ten per cent. So if the company is making 20 per cent it does not really matter because it is making money. The company is directionally correct but the magnitude may be wrong. But now with fixed overheads rising close to 60 per cent and your margin is 20 per cent then you have no clue whether you are making or losing money.
Whenever an allocated part of the cost exceeds the margin you are in trouble. That happens because in the fierce competition everybody reduced prices and the squeeze came from the top. The increased competition also forced companies to modernise and this led to increases in fixed costs. Hence the margins have become thinner.
Q: Over the years, technology has allowed better and faster processing of information, but managements have been slow to respond to this new system.
A: If the top management has the system to itself and has the benefit of using it, then they will commit to the new system. But if the top management calls this another accounting system and if they have not liked accounting from the very beginning, then they won't give a damn about the new system. So if the new system is called activity-based costing, it carries the connotation of another grandiose accounting system. May be a slightly better system but what the heck... On the other hand, if the system is called an activity-based management system that gives the top management information about where the managers are using their time and resources it becomes an all-encompassing manage-ment system. It can identify the most profitable customers, the most challenging distribution channels, the branches that are doing very well, the product line that is doing well...suddenly the CEO is excited. Then he knows that by using that decision support system he can enhance shareholder value and at the same time his bonus and incentives.
Unfortunately, some people make it out as another allocation of fixed costs which by domain and fiefdom is accounting territory. Hence the apathy. The real question is how you sell the system. The way to do it is to rest the ownership of the system with the functional manager or the line manager and not the accounts or MIS function.
The CEO now has not only the financial but the non-financial measures too instead of only one measurement: return on investment. So the measures are multiple. For example, he can track the number of transactions made to sell a product, the number of vendors supplying different components and the number of set-ups that were made in addition to volume of units that were sold. Previously there was only measure: volume of units sold.
In addition, activity-based accounting also brings out the cost of complexity of operations.
Q: How does it do that?
A: I will give you an example. In the United States in 1950s, there were only two kinds of detergents: hot-water and cold-water. By the 1980s, the number of types of detergents had gone up to 25. Unless all the 25 detergents are strategically important to a company, there is no need to have that much variety because that will lead to too many vendors, too much inventory and too many transactions.
A contrasting example is that of Southwest Airlines. Airline prices were dropping like crazy and Southwest Airlines still made tonnes of money. All the other airlines Northwest, Delta, American, United and Continental lost money. So why the hell was Southwest was making money? One reason given was that it did not have too many hubs. The other was that Southwest did not serve food only peanuts or juice. The third reason was that the guy who did
baggage handling would also check it out.
These were correct, but the most important reason was that its entire fleet of 270 planes was standardised with Boeing 737s. That means any spare part can go into any plane and any pilot can fly all the planes. Any repair crew can fix any plane. The complexity of operation is reduced and therefore the costs. Those were the cost
drivers that can be traced through an activity-based management system.
Now the question I ask is why do we need to have 25 detergents, why not seven? There is an optimal point. Procter & Gamble went down from 25 to approximately ten. Sony is another example. It has only three types of cabinets in 26-inch TVs while Zenith has 26 cabinet varieties. That means there are 26 different suppliers and 26 different inventory pairs. Once margins come under squeeze, companies start cutting costs. How do you cut costs? Not at all places but by finding out the non-value added activities and removing them.
Q: For long accountants have used value-added as an analysis tool. How is it different from value-chain analysis?
A: It is not different. I use value chain analysis as a part of the input. I look at the value-chain and then create a cross-functional team. The value chain starts from marketing, which understands customer needs and tells the company what products to produce. Then purchasing procures the products, then it is produced and from there is sold and distributed. So if I have a value chain each for pre-manufacturing, manufacturing and post manufacturing stage I can identify ways to improve costs.
Now, instead of pre-manufacturing, we split into 15-16 major activities. Then for each activity, it is possible to determine the value-added and non-value added costs. Value-added is that activity that is perceived as value to the customer and for which he is willing to pay. I mean if it is garbage that is being produced (that is, no value to the customer) then there is no point producing it better.
So a company should ask itself whether it is doing things right or doing the right things. If a
company can identify the symptoms, it can then get to the root causes. That is the management activity available in activity-based costing.
Q: In your opinion how do cost systems in Indian companies stack up against those prevalent in the rest of the world? Among the Indian companies that you have worked with what have been the concerns and the level of interest exhibited by the top management?
A: I think some Indian companies have a decent system. Not the best, but a decent system. And that goes for even a progressive company like Telco or Sanmar group's Chemplast or Lupin Labs for whom I have done some activity-based costing. Compared to the average global standards, they are as good or as bad anybody else in the world. But compared to a tremendously advanced system in the West, they do not stack up.
Now the question is where they are okay and where they are not okay. In terms of identifying material costs, like some direct labour costs, they are comparable to the best in the world. But in terms of identifying fixed costs, even its measurement, they fall short. Because of chartered and cost accountants, they take what is called the peanut butter approach. They take the total fixed costs and divide it by the total number of units produced and come up with a per unit fixed cost. In my opinion, per unit fixed costs is the wrong unit. If it is a fixed cost then by definition it is not volume dependent. Unfortunately, the system is like that. But people in the US and other industrialised nations realised that this was all right 15 years ago when the margins were much higher. But with low margins and higher fixed costs now it is not all right. Chrysler realised it (their every system is activity-based costing), and so did
Pennsylvania Blueshield in health care.
In India, the awareness is slowly coming. But while CEOs also agree that a new system is needed, they may not mean that. That is primarily because it is still being confused as another accounting system. But once CEOs realise that this a management system and that it helps them take optimal product mix decisions they start feeling the need for it.
Q: Indian corporations are facing increased competition from global players and suddenly everybody wants to cut costs. What are the dangers of cutting costs without linking it to the firm's strategy?
A: Suppose I want to reduce my weight. I can do it through continuous improvement. I avoid fat-rich foods and calories. I do not drink much and I exercise. Maybe two pounds a month is what I can lose through this method. Good or not? Good. At least I am in the right direction.
Now, say I want to reduce 20 pounds in one day. No problems. Chop one leg off. The leg weighs 30 pounds there will be a lot of bleeding, but then God has given us two legs so one is redundant. Unfortunately, there are some people who are doing cost cutting like this using business process reeingineering amongst other things. They take what has been designed to need two legs. I call it reengineering or cost cutting wrongly done.
What is cost-cutting or reengineering rightly done? I may go in for liposuction, identify exactly where the fat is and take only the fat out. Then I may improve the weight by seven pounds. Now seven is better than two and it is not the lousy 30.
So in my opinion cost-cutting can be done only in areas in which the company knows there is fat. But if it is well known that is a functional product or part and you need faster running capability, how can you chop a leg?
In the United States companies went in for cutting costs and downsizing. There was a lot of bleeding, lots of people were laid off and things got tough. People grew nervous, productivity and market share went down.
The better quality people switched to other organisations. Only three people were doing what ten people did before, although five were actually needed.
So in the first year these corporations may have shown a gain but in subsequent years they showed a loss. For example, IBM laid off many people but lost market share as well. Why do you think Microsoft remained strong? While they may not have done the right things, other people were doing the wrong things.
Instead of listing improvement of productivity or quality as the key strategic objectives, cost-cutting became the key strategic objective. The key is to look beyond the first year of operation. If you are making a loss in the second year onwards, you are doing a lousy cost-cutting. The crucial question is whether a company has eliminated work or did it eliminate workers?n
Executive Kit
Commodity trap.
Service brands have been hard-pressed to find adequate differentiators. Most telcos have attempted to widen their product bundles and ended up losing their branded identities. It is increasingly becoming clear that buying more commodity services from the same carrier does not build switching costs. Indeed, it may add to a telcos vulnerability.
Recent research done by The Boston Consulting Groups suggests ways to avoid the traps of legacy.
Trap 1: Defining customer care too narrowly. Customers must not only be recognised, they must be offered a consistent experience, irrespective of the channel they use to interact with the company.
Trap 2: Managing customer care for cost reduction instead of new revenue generation. Instead look for opportunities to enhance customer care through cross-selling, increased retention, and faster time-to-market of new offers.
Trap 3: Pursuing marketing strategies that dont tier or segment customer care offers. Some customers are more profitable than others. Yet very often service delivery is not aligned to customer value. The key is segmenting services in ways that provide more value.
