Robert Kugel's Analyst Perspectives

Activity Based Costing (ABC) is one several popular techniques to apply marginal cost analysis to arrive at a more accurate measure of a product’s true economic cost. It became popular in the United States starting in the 1980s (earlier in Germany) as it became clear to many that traditional cost accounting techniques do not reflect the true, economic cost of production in complex, multi-product environments. Consequently, companies might price items higher than they should and lose market share, or consider them unattractive from a profitability standpoint and possibly under invest in them from a sales/marketing standpoint. Or, the company’s profitability might be impaired because standard cost accounting measures do not enable them to determine the decisions that will maximize their profitability. Sales people might be given the wrong set of incentives, heavily promote less profitable products while ignoring high margin ones. ABC attracted a great deal of attention in the English-speaking world in the 1980s and early 1990s because proponents presented compelling arguments for its adoption. Unfortunately, it quickly fell out of favor because the time and cost of doing the type of “boil the ocean” comprehensive analyses associated with it at that point did not provide commensurate benefits. This was especially true because marginal cost analyses must be performed periodically to keep them up to date.

Since then ABC has regrouped and adapted, opting for a simpler approach. It’s clear that the 80/20 rule (80 percent of the cost of a product is accounted for by just 20% of the components) applies to the cost structure in just about everything a company produces, so there’s no need to go through an exhaustive process of attributing all expenses. However, in some cases, the true marginal cost of producing an item (usually products but sometime services) is best expressed in an even simpler formula: the amount of time a product uses of a key asset. This is especially the case where a company has one or just a handful of expensive productive assets that is/are the key bottleneck in a process such as a computed numerically controlled (CNC) machine tool. Two products with the same raw materials, the same number of process steps and other direct and indirect expenses using a “standard costing” method. Logically, the two would be priced the same, but one could be generate far more to the bottom line because it requires considerably less machining time. Throughput accounting, a specialized marginal cost analysis, recognizes that every production process has one or more limiting factors in the production chain. Where there is just one, it becomes relatively straightforward to determine how to use throughput analysis to price products and adjust production schedules to maximize profitability. However, most companies face more complex situations and often have difficulty with the analyses necessary for product profitability management.

Maxager, an established manufacturing planning and analysis application, was established to facilitate the use of throughput accounting concepts to enable companies to better understand the true cost of their products or services, optimize their prices and manage production mix decisions to achieve the highest desired profitability level. It is aimed especially at companies with at least one or several key fixed assets where traditional cost accounting can distort economic costs because of the focus on sunk costs rather than opportunity costs (which, in these cases, is a function of time) but is also being used by manufacturing organizations with more complex production facilities and configurations. Companies use Maxager to do profitability analysis, perform ongoing price optimization and optimize their product mix. Price optimization enables companies to go beyond simplistic pricing models and decide on how best to balance pricing considerations with other strategic and tactical requirements. Optimization is not a static or occasional exercise but should be done with a frequency appropriate for circumstances and the nature of the business. Managing mix well for companies with throughput constraints requires having a clearer idea of the profit per minute for an item, not just giving sales people added bonuses for pushing the highest margin product.

I believe managing profitability will be increasingly important in this economic cycle because of the challenge posed by heightened business volatility. Companies are gaining expertise in using analytics and integrating with business planning more effectively to increase their understanding of their business and using this deeper insight to make better business decisions more consistently. I think companies that fit the profile of being able to do better costing with throughput analytics ought to look at Maxager to see how it might improve their bottom line.

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Regards,

Robert D. Kugel - SVP Research