EENIE, MEENIE

Eeenie, Meenie

By Paul Winters

Decisions! Decisions! Decisions!

A big part of a manager's job is to make decisions. The ultimate objective of most of those decisions is to make the organization more profitable. Decision making is basically composed of three fundamental elements: problem definition, information gathering, and evaluation.

If the first two elements are performed completely and correctly, the decision reached in the evaluation stage should be obvious. Unfortunately, most decisions are made with inadequate or misleading information.

Few decisions have a 100% degree of certainty. Good managers balance the risks associated with making an incorrect decision with the cost of delaying that decision in an attempt to increase the confidence level.

Decisions made during a strategic planning process focus on a Strategic Business Unit (SBU). An SBU is the smallest manageable unit within an organization that can stand alone as a business. It is characterized by serving a distinct market and its performance can be tracked and measured. Examples of an SBU are: a division within a multi-division company, or a product line within a multi-product division.

One of the fundamental decisions made during a strategic planning process is whether to grow, maintain or harvest an SBU. The decision focuses on the current and future profitability of the unit and the amount of current and future investment required to achieve that profitability. In a nutshell, what is the return on investment?

Now, in order to describe a powerful new tool to define that profitability, I have to address the shortcomings of traditional accounting. Bear with me and don't glaze over. I promise not to get too detailed or prove my point with a long series of numbers.

One of the problems I encounter frequently is the inadequacy of traditional financials in defining the profitability of an SBU. Traditional accounting systems do a good job of tracking variable (or direct) costs of manufacturing a product. Variable costs are those costs that increase or decrease in direct proportion to sales, e.g., direct manufacturing labor and materials used in the product.

Traditional accounting systems, however, don't fare as well when faced with all the other costs of an organization. These costs, such as fixed asset depreciation, advertising, interest expense and the CEO's salary, are generally charged to the department incurring the cost.

Now a dilemma arises. How can those other costs be allocated to the SBU in order to evaluate its performance?

Generally a method is chosen because it is traditionally acceptable, such as allocating manufacturing overhead based on direct labor hours or corporate costs based on divisional gross sales. It is a nice, easy computation and accepted in most organizations because it is steeped in history. The fact that the allocation has little or no bearing on the actual consumption of resources by the unit is politely ignored.

The method chosen has a negligible impact on the overall profitability of the entire organization, but can have a significant impact on the reported profitability of an SBU within the organization. Some quick examples:

Assume that you have only two product lines. Product A is manufactured by your company and requires engineering modifications for each order. Product B consists simply of placing an order with your vendor and having the product shipped directly to your customer. A traditional accounting method allocates the engineering cost to both products based on their respective gross sales. Does that make sense?

In a multi-divisional company, the corporate costs of the CEO's salary, stockholder expenses, charitable contributions, etc., are frequently allocated to each of the divisions based on some type of formula. In reality, the divisions have absolutely no control over these costs. These corporate costs certainly must be incurred, but responsibility for them lies directly with the CEO and the Board of Directors.

At some point an organization evaluates the performance of the SBU. And guess how it's done? Does it surprise you that it's the income statement? With the methods traditionally used to allocate costs, the income statement can provide erroneous information.

Now on to the good stuff! In 1988, like a knight in shining armor, Activity Based Costing arrived on the scene. ABC is rooted in the fundamental principle that activities, not products, cause an organization to incur cost. And, SBUs consume activities. In the above example, engineering is the activity that results in spending money; Product A consumes engineering activities and Product B does not.

That's all there is to this new revolutionary concept! But hold on! Doesn't ABC sound strikingly familiar to something we already covered?

It should. ABC is really nothing more than the method used to track direct and indirect manufacturing costs, except it is extended to all activities of the organization. You can visualize how ABC works by making a spreadsheet with an organization's income statement on the left margins.

Each SBU of the organization would be in a separate column extending to the right with the last column reserved for "Non-Value Added Costs." Each line item of the organization's income statement is then individually allocated to each of the SBU columns based exactly on what that SBU consumes.

As you would expect, a whole new jargon has been created by the accounting profession to define ABC and the methods for making the allocations. To your joy, I won't cover them here. At this point, understanding the concept of ABC is all that is important.

Adopting ABC satisfies two goals. One is a more precise performance evaluation of the SBU. The other is the identification of those activities that don't add value to the ultimate customer and those that do. The non-value added activities should be targeted for reduction or elimination.

ABC cannot eliminate poor performance or poor management decisions. But it may provide more relevant information to improve the decisions made and improve on the childhood technique of Eeenie, Meenie.