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Statements on Management Accounting
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
C R E D I T S
T I T L E
IMA would like to acknowledge the work of the authorsof this
SMA: Nabil Elias, Ph.D., FCMA (Canada),University of North Carolina
at Charlotte; and Dan Hill,CMA, CFM, CorePROFIT Solutions, Inc.
Thanks also go
to Gary Cokins of SAS and DeWayne L. Searcy, Ph.D.,CMA, CPA,
CIA, of Auburn University, who served asreviewers, and Raef Lawson,
Ph.D., CMA, CPA, CFA, ofIMA, who serves as series editor.
Customer ProfitabilityManagement
Published byInstitute of Management Accountants10 Paragon
DriveMontvale, NJ 07645www.imanet.org
Copyright 2010 in the United States of America by Institute of
ManagementAccountantsAll rights reserved
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Statements on Management Accounting
T A B L E O F C O N T E N T S
CUSTOMER PROFITABILITY MANAGEMENT
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
Executive Summary . . . . . . . . . . . . . . . . . . . . . . .
. . . . . 1I. Introduction . . . . . . . . . . . . . . . . . . . .
. . . . . . . . 2II. CPM Implementation Framework . . . . . . .
.6III. Decision Phase . . . . . . . . . . . . . . . . . . . . . . .
. . . .8IV. Foundation Basics . . . . . . . . . . . . . . . . . . .
. . .10V. Customer Costs . . . . . . . . . . . . . . . . . . . . .
. . . . .18VI. Transaction Data . . . . . . . . . . . . . . . . . .
. . . . . .26VII. System Options . . . . . . . . . . . . . . . . .
. . . . . . . .28VIII. Business Algorithms . . . . . . . . . . . .
. . . . . . . .29IX. Profitability Information . . . . . . . . . .
. . . . .31X. Strategic Integration . . . . . . . . . . . . . . . .
. . . .32XI. Behavioral Considerations . . . . . . . . . . . . .
.37XII. Conclusion . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . .39Glossary . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . .39References . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . .41Appendix 1:
Example of Applying the CPMImplementation Framework . . . . . . . .
. . . . . . . . . . .43Appendix 2: Technical Considerations for the
Management Accountant . . . . . . . . . . . . . . . . . .51
ExhibitsExhibit 1: Customer Profitability
Whale Curves . . . . . . . . . . . . . . . . . . . . . .3Exhibit
2: More Whale Curves . . . . . . . . . . . . . . . .4Exhibit 3: CPM
Implementation
Framework . . . . . . . . . . . . . . . . . . . . . . .
.7Exhibit 4: The Multidimensional
Views of Profitability . . . . . . . . . . . . . .11Exhibit 5:
Customer Account Hierarchy :
Bank and Credit Union Example . .12Exhibit 6: Product Hierarchy
Bank and
Credit Union Example . . . . . . . . . . . .13Exhibit 7:
Customer Profitability Report . . . .14Exhibit 8: Customer Lifetime
Value . . . . . . . . . . .15Exhibit 9: Cost What You Can Source .
. . . . . .25Exhibit 10: Profit-Lift from Existing
Customers . . . . . . . . . . . . . . . . . . . . . . .33Exhibit
11: Profit-Lift from New Customers .34Exhibit 12: Business Rule
Documentation . . . .54
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E X E C U T I V E S U M M A R YManaging profitability requires
not only a customer-centric focus but also a thoroughunderstanding
and effective management of customer profitability. Customer
profitabilitymanagement (CPM) is a strategy-linked approachto
identifying the relative profitability of differentcustomers or
customer segments in order todevise strategies that add value to
most-profitablecustomers, make less-profitable customers
moreprofitable, stop or reduce the erosion of profit byunprofitable
customers, or otherwise focus onlong-term customer
profitability.
Managers are often surprised to find out that asmall percentage
of customers generate substan-tially more than 100% of profits, and
the remaining customers are either breakeven orunprofitable. Using
a customer profitability management system replaces intuitive
impressions of customer profitability with fact-based information
and supporting analysis.
The backbone of a CPM system is a costing system that is focused
on tracing and causallyassigning costs to each customer or
customersegment without arbitrary broadly averaged costallocations.
Assigning revenues to customers orcustomer segments can present a
few issues, butthe major challenge in implementing a CPM system is
the selection and implementation of anaccurate and informative
costing system. A costing system should not only accurately
assignproduct costs and gross margin to customers orcustomer
segments, but it should also assign thecosts to serve.
Cost accuracy and visibility are important inCPM. Using
time-driven activity-based costing(TDABC) provides costs that
identify resourceconsumption by customers or customer seg-ments.
The signals provided by the CPM system,
based on full costing of traceable costs to cus-tomers and
making visible business-sustainingcosts, will lead management to
consider strategiesto increase profits. The signals do not
provideanswers in themselves, but they could lead to gen-erating
alternative courses of action. Decisionsrelated to customer
profitability strategiesrequire tailor-made analysis.
There are system issues that must be consideredin the design and
implementation of a CPM system. Awareness of the commitment of
time,financial, and personnel resources required by aCPM system is
critical to its success.
Investments in customers should be consideredin view of an
estimate of customer life value. Thatis, in addition to current
customer profits, thepotential of generating future profits from a
customer should also be considered. Managing customer life value is
a means to enhancing long-term profitability.
Essential to the success of CPM is the buy-in byemployees and
managers who will be affected byits implementation. Resistance to
change is a phe-nomenon that applies equally to CPM as it doesany
other organizational change. To develop theCPM system and then seek
the support ofemployees and managers is not likely to result
indeveloping a sense of ownership, nor will it guar-antee an
effective CPM system. To get employeesand managers to buy in at the
outset, they shouldbe involved in its development and their
ideasmust be sought. Only with a sense of ownershipwill the
organization be able to navigate the trou-bled waters of
change.
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I . I N T R O D U C T I O NMany companies and managers are
unaware thatthe secret to improving profitability is to measureand
manage customer or customer segment profitability. Companies that
implement cus-tomer profitability management (CPM) systems are able
to see which customers contribute to profits, which customers do
notcontribute to profits, and which customers erodeprofits. CPM is
a strategy-linked approach toidentify the relative profitability of
different customers or segments of customers, to devisestrategies
that add value to most-profitable customers, make less-profitable
customers moreprofitable, stop or reduce the erosion of profit
bycustomers, and otherwise focus on long-term customer
profitability.
A CPM system is a profitability measurement andmanagement
system, and its backbone is a costingsystem that is focused on
assigning costs to eachcustomer or customer segment. A CPM
systemalso assigns net revenue to each customer or customer
segment. The resulting profit is identified with each customer or
customer segment. As can be expected, customer-relatedcosts are
more problematic to trace or assign thancustomer-related revenues.
It is important toemphasize that the quality of the CPM cost
information is critical for the quality of CPM. Ourapproach is to
focus on a cause-and-effect costingsystem, such as activity-based
costing (ABC), thatis relatively accurate in assigning costs to
products, customers, customer segments, or otherrelevant cost
objects. We briefly discuss a simplification of ABCtime-driven
activity-basedcosting (TDABC).
The CPM Whale CurveOnce profitability is measured for each
customeror customer segment, they are ranked from mostprofitable to
least profitable and are plotted on aprofit graph, popularly
referred to as a whalecurve (WC) or profit cliff chart, where 100%
ofprofits are the sea level (see Exhibit 1). The Y-axisof the graph
shows profits in dollars or as a percentage of profit from all
customers, and theX-axis shows cumulative customers or
customersegments ranked from high to low in terms ofprofitability.
Typically, about 20% of customersgenerate anywhere from 150% to
300% of compa-ny profits (50% to 200% above sea level), about70% of
customers are at breakeven, and 10% ofcustomers reduce or destroy
anywhere from 50%to 200% of company profits, bringing
cumulativeprofit to sea level (Kaplan and Narayanan 2001).
Exhibit 1, Customer Profitability WhaleCurves, shows customer
profitability in dollarsor percentages plotted on a whale curve. As
canbe seen, the potential improvement in profit inthis case is $47
million, or a 112% increase in current profit level.
Exhibit 2, More Whale Curves, shows anothertypical customer
profitability whale curve, wherethe highest tip of the curve is
higher than inExhibit 1. The potential improvement in cus-tomer
profitability increases with the distancebetween the highest tip of
the whale curve andsea level. In this case, the potential
improvementin profitability is $96 million, or a 200% increasein
current profit level.
The improvement in profit depicted in these fig-ures is
predicated on the assumption that thepotential profitability is the
highest level of profiton the graph, which is contributed by a
small per-centage of customers before being eroded byunprofitable
customers. In fact, with CPM, the
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3B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
$100
$90
$80
$70
$60
$50
$40
$30
$20
$10
$0
Customer ProfitabilityWhale Curve$
Number of Customers (RankedMost to Least Profitable)
Cum
ulat
ePro
fits
($M
illio
n)
0 5 10 15 20
250%
200%
150%
100%
50%
0%
Customer ProfitabilityWhale Curve%
Number of Customers (RankedMost to Least Profitable)
Perc
ento
fCum
ulat
ive
Profi
ts
0 5 10 15 20
Top eight customersprovide 212% ofbottom line
All other customerseither dont add tothe bottom line orsubtract
from it.
Eight customersare profitable
Five customersbreak even
The remainingseven are unprofitable
Sea Level
Customer ProfitRanking1234567891011121314151617181920
Cumulative %
52%100%143%179%198%205%210%212%212%212%212%212%212%210%202%190%171%150%126%100%
Cumulative Profitinmillion
$2242607583868889898989898988858072635342
22201815832100000-1-3-5-8-9-10-1142
Data for Above ChartsCustomer Profitinmillion $
EXHIBIT 1: CUSTOMER PROFITABILITY WHALE CURVES
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4B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
$160
$140
$120
$100
$80
$60
$40
$20
$0
Customer Profitability Whale Curve$
Number of Customers (Ranked Most to Least Profitable)
Cum
ulat
iveP
rofit
s($
Mill
ion)
0 5 10 15 20
CustomerProfit Ranking
123456789
1011121314151617181920
Cumulative %
67%125%175%217%250%275%292%298%300%300%300%300%300%298%296%277%256%215%163%100%
Cumulative Profitin million $
326084
104120132140143144144144144144143142133123103
7848
Customer Profitin million $
322824201612
8310000-1-1-9
-10-20-25-3048
Data for Above Charts
$160
$140
$120
$100
$80
$60
$40
$20
$0
Customer Profitability Whale Curve %
Number of Customers (Ranked Most to Least Profitable)
Perc
ento
fCum
ulat
iveP
rofit
s($
Mill
ion)
0 5 10 15 20
Potential profitimprovement of$96m
Sea Level
{
What's the potential if the break-even and unprofitable
customers are turned into profitable customers?
EXHIBIT 2: MORE WHALE CURVES
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potential improvement in profit is even greaterthan indicated on
the whale curves by turningmarginally profitable customers into
more profitable customers and turning profit-erodingcustomers into
profitable customers or otherwiseeliminating the profit
erosion.
Organizational Types That Benefit from CPMCPM is suited for all
types of profit and not-for-profit organizations where products (or
servicelines) and customers are not homogeneous. Incompanies where
products and customers arehomogeneous, using the same distribution
chan-nels and pricing policies, there would be littleneed to use
CPM other than to increase visibilityto types of activities and
their costs. But there arefew if any companies that meet this
description.CPM is thus suited to organizations where products or
service lines are different, customersor customer segments are
heterogeneous, and pre-sale or post-sale customer service
requirements vary.
These latter nonproduct or nonstandard service-line costs are
commonly referred to ascosts to serve. As products and service
linesincreasingly become more commodity-like, withcomparable cost
levels among competitors, thereis a shift toward activities to
serve customers asthe basis for gaining a competitive
advantage.Hence, identifying activity cost drivers, tracingthem to
customers, and measuring the costs to serve forms a key benefit of
CPM.
Service organizations such as banks, insurancecompanies, and
other financial service companiesnaturally fit the circumstances
that benefit fromthe application of CPM. Manufacturing compa-nies
can apply the same concepts in business-to-business settings and in
repeated, more frequentproduct purchase environments.
Not-for-profitorganizations that are customer-based can also
benefit from applying CPM. For example, creditunions can
successfully apply CPM to make mem-bers (what credit unions call
their customers/owners) more profitable, and in turn, reduce
thefees or rates to their members.
Organizations that may not benefit from CPMinclude those whose
costs to serve are small andpre-sale and post-sale services are not
importantin gaining a competitive advantage. This would bethe case
in organizations whose customers arerelatively homogeneous or
indistinguishable. Insuch rare cases, customer gross margin may
besufficient to obtain CPM benefits. Because of therelatively low
costs to serve, CPM in these organizations could be referred to as
CustomerGross Margin Management. The strategic impli-cations are
the same as in CPM nonetheless. Onthe other hand, organizations
whose customersare not homogeneous, and who compete or cancompete
on pre-sale or post-sale activities, areprime candidates for
reaping the benefits of CPM.
Impediments to CPM ImplementationIf CPM offers such competitive
and sustainableadvantages, why is it not more widely imple-mented
and used? We do not have any surveydata to offer as an answer to
this question, but wecan speculate on the most likely reasons for
thelack of CPM implementation.
First, it is clear that many companies are traditionally managed
as functionally structuredorganizations without the customer focus.
Thistypically would exist in organizations that rely onsupply push
rather than demand pull strategies. In such situations it is
difficult formanagement to appreciate the effects of applyingCPM.
Even in organizations that utilize demandpull strategies, it is not
clear that managers fullyappreciate the potential benefits of CPM.
It is also
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possible that some managers may not have a clearidea of what to
do if they identified profitable andunprofitable customers.
Second, driver-based costing applications can betime consuming
and costly, thus making theapplication of CPM difficult. In other
cases thelack of available data (e.g., outsourced IT systemsor not
collecting cost driver data) may hinder theinterest in gathering
and implementing new systems.
Third, some of the available material on CPMmakes it hard to
understand and implement (seeCokins 2008). One of the purposes of
this SMA isto provide guidance as to how to effectively imple-ment
CPM. Applying CPM requires not only adesire and commitment by
management to CPM,but it will also require an investment of
resources.It is not easy to quantify the personnel effort andcosts,
on the one hand, and the benefits of CPM,on the other. But, the
incremental investment,efforts, and costs of organizations that
have suc-cessfully implemented CPM are justified byincreased
profitability and enhanced customervalue. The well publicized
success of CPM at BestBuy is just one example.
The value that CPM brings to an organization willdepend on the
quality of the information devel-oped for managing customer
profitability and onits ability to become customer-centric.
Becomingcustomer-centric requires the buy-in by decisionmakers and
their ability to forge effective imple-mentation teams.
CPM implementation and profitability reportingshould not be seen
as a one-off system.Information should flow on a regular basis,
trig-gering a process of customer profitability assess-ment,
feedback, analysis, decisions, and imple-mentation. This process
enables management to
tap the potential for increasing profitability bydevising
different customer targeting strategies,implementing differentiated
services or servicelevels to customers, and making operating,
mar-keting, or pricing adjustments in its attempt tomake all
customers profitable and manage overallcustomer profitability.
The potential benefits result from identifyingcustomer or
customer-segment profitability andthen developing appropriate
differential strate-gies for different customers. Held
perceptionsand biases in an organization may be shattered inlight
of facts and analysis. Armed with new infor-mation about customer
profits, managers canfocus on appropriate actions related to
profitablecustomer retention and acquisition, makingunprofitable
customers profitable and reducingor eliminating profit erosion
resulting from customers who destroy shareholder value.
I I . T H E C P MI M P L E M E N TAT I O NF R A M E W O R
KImplementing a CPM system requires a frame-work as displayed in
Exhibit 3, The CPMImplementation Framework. This frameworklays out
the phases for implementation, withsome phases being highly
interrelated and run-ning in parallel while other phases
proceedsequentially.
The major phases to implement a CPM system: 1. Decision Phase2.
Foundation Basics3. Customer Costs4. Transaction Data5. System
Options6. Business Algorithms7. Profitability Information8.
Strategic Integration
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The decision phase, required for any strategicinitiative, is
where the value and reasons for pursuing a CPM system are explored,
the finan-cial consequences analyzed, and a go or no-godecision is
made. Another important componentof this phase is establishing the
purpose of theCPM system to guide its development and
implementation.
The next three phasesfoundation basics,customer costs, and
transaction dataare highlyinterrelated. A decision in one of these
areasdirectly impacts decisions in the other two.
The foundation basics phase establishes the costobject and
ultimately what will be measured.This phase also includes
establishing the systemscosting principles, how profitability will
be calculated, and how contentious accounting
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Decision Phase
Foundation Basics
CustomerCosts
TransactionData
SystemOptions
Business Algorithms
ProfitabilityInformation
Strategic Integration
EXHIBIT 3. CPM IMPLEMENTATION FRAMEWORK
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issues (e.g., capitalizing marketing costs) will behandled.
Lastly, this phase is where customers,products, and channels are
defined.
The customer costs phase is where considerationis given to the
extent to which cost assignmentscan accurately be made to products
or servicelines, and the costs to serve can accurately beassigned
to customers based on causality. Thisphase is where traditional
general ledger unit-based cost allocations are replaced with
cus-tomer, or cost object, costs. CPMs need for rela-tively
accurate customer-level costs points to theuse of some form of
activity-based costing (ABC).
The transaction data phase poses many chal-lenges. Although most
companies have vastsources of disparate data buried in their
variousIT systems, harnessing it to serve a CPM systemis costly and
time consuming.
The reason these three phases are so interde-pendent is that
decisions about which activities toinclude in costing are dependent
on what transac-tion data is available (or obtainable). On the
otherhand, the transaction data to seek for availabilityis
dependent on what activities are to be costed.And the cost object
and costing principles estab-lished in the foundation basics must
be compati-ble with both the available transaction data andthe
proposed costing activities.
The system options phase involves selecting thecosting and
profitability IT systems. This phaseruns parallel to and is
interrelated with the foundation basics, customer costs, and
transac-tion data phases. IT resources, data sourcingrequirements,
and costing considerations must befactored into the selection of
the appropriate ITsystems.
Once the first five phases are complete, then thedesign and
build of the business algorithms, orrules, will begin. The business
algorithms mustintegrate with the IT systems and be consistentwith
the principles established in the foundationbasics. Testing of the
business algorithms runsconcurrently with their design and build,
followedby a total and thorough testing of the completedsystem.
The profitability information phase follows testing, where
monthly or quarterly results areproduced and distributed. This
phase is where theCPM system enters production, system maintenance
and upgrades occur, and the qualityof results is guaranteed.
Finally, and most importantly, is the strategicintegration
phase, where CPM information isintegrated into the companys
strategic and tactical decisions. For example, CPM resultscould be
incorporated into the organizationsperformance measurement systems.
The ultimategoal is to use customer-based information toimprove
company performance and profitability.
Each phase of the CPM implementation frame-work is discussed in
this SMA. A separate discussion of the behavioral considerations
whenimplementing a CPM system is also provided.Appendix 1 is an
example of the implementationframework applied in the financial
servicesindustry, and Appendix 2 covers technical considerations
for the management accountantnot discussed in the main body of the
SMA.
I I I . D E C I S I O N P H A S EThe decision phase is when
senior managementbecomes aware of CPM and attempts to under-stand
its potential benefits, costs, and strategic
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implications. It is important that managementunderstands CPM,
how it will benefit the organi-zation, and how to develop and use
the informa-tion to run a more profitable
customer-centricorganization. The benefits and costs are
discussedin the next subsection. In order for managementto be more
effective, managers should obtainsome training in CPM. Once a
decision is made toimplement CPM, as with any project, manage-ment
should apply appropriate project manage-ment techniques with the
full support andendorsement of senior management.
Benefits and Costs of CPMIt is important to estimate the costs
and benefitsof implementing CPM. If management is aware ofhow CPM
can improve customer profitability, arough estimate of the
recurring benefit is the dif-ference between actual profitability
and the peakof the whale curve, although the benefits canoften
exceed this amount. The problem is that inthe absence of a customer
profitability system, itis difficult to arrive at a precise
estimate of thebenefits of implementing CPM. Judgment mustbe made
in the absence of precise information.
The cost of implementation will depend on theexisting costing
system and its appropriatenessfor CPM. If a company has a variant
of an ABCsystem, the cost of implementation may relate
torefinements necessary to capture data related tocustomers as the
cost object to track their consumption of resources. The extent to
whicharbitrary cost allocations characterize the costingsystem
might indicate the need to redesign thecosting system, which of
course can become acostly proposition. On the other hand, there
aresimplifications that may prove less costly, such astime-driven
ABC.
An accurate CPM system requires an accuratecosting system that
assigns costs to cost objectsbased on the cost objects consumption
ofresources. Implementing activity-based costing insome form or
another may be required to obtainaccurate customer profitability
estimates. Itshould be kept in mind that in a competitive
environment, an accurate costing system isrequired whether or not a
CPM system will beinstalled. Given that cost accuracy supports
survival in a competitive business environment,the incremental cost
of adapting a costing systemto suit the needs of CPM could be
relatively marginal. Without customer profitability infor-mation,
customer profitability management is ashot in the dark.
Management must appreciate that effective CPMimplementation
integrates customer profitabilityinformation into a companys
strategic decisionsrelated to exploring profit opportunities
witheach customer or customer segment. Such strategic decisions
affect financial outcomes, butthey could require operational or
marketingadjustments to meet customer needs as shaped byCPM
strategic decisions. In this fashion, CPMprovides long-term
competitive advantages thatcan be sustained as long as it is
periodically calcu-lated, reviewed, evaluated, and used.
Obtaining CPM Buy-InIt is important for management to pave the
wayinternally for CPM implementation by dispellingthe myths and
existing perceptions of customerprofitability. Senior managements
unquestion-able support is required, and they should obtainthe
support of all those who are likely to beaffected by the CPM
system. Once the decision ismade to embark on implementing CPM, it
isimportant to pay attention to the behavioralissues that can make
a difference in its success orfailure. These issues are discussed
more fully
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below. Briefly, any change creates resistance dueto the
uncertainty it creates, particularly by thosewho might be adversely
affected by it. Buy-in canbe obtained by getting affected
employeesinvolved from the beginning. Successful CPMimplementation
requires a team approach. Aswith any major organizational change,
tact, com-munication, education, training, and excellentleadership
skills can make the differencebetween the success or failure of
CPM.
The Role of Data in CPMTo make the decision to implement CPM
requiresan appreciation of the role and importance oftransaction
data. The reason that many compa-nies currently find improving
profitability elusiveis that the customer-detailed information
theyneed is buried in transactional databases. If all acompany does
with its customers is manage theaccounts receivables, and all it
focuses on is over-all customer profitability as reinforced by
high-level, general ledger (GL)-based performancemeasures, it is
missing important strategic opportunities to manage customer
profitabilityand to increase the lifetime economic value of
itscustomers. CPM measurements will replace theoften erroneous
impressions, guesses, or hunchesabout the relative profitability of
customers withmore objective information. For example, Searcy(2004)
reports cases where entrenched perceptions about sales volume and
profits wereshattered when a company properly calculated
itsprofitability measures by customer and channelsegments.
I V. F O U N D AT I O N B A S I C SThe foundational design of
the CPM system isdriven by the purpose established in the
decisionphase and starts with the definition of the costobject:
customer, customer segment, product,channel, customer account, etc.
The cost objectdetermines what will be measured and managed.Clarity
of purpose and thoughtful and clear definition of the cost object
will lead the way to aneffective CPM system.
Establish the Cost ObjectThe cost object chosen must be
compatible withboth the transaction data available from the
com-panys core application systems and the costingprinciples.
Compromises may be required asdesired features may not be available
in thetransaction data. The cost object chosen mustalso support the
CPM systems purpose asdefined in the decision phase.
For example, in the financial services industry,the customer
account often becomes the costobject and the platform on which to
attach allcosts consumed. This approach works for thatindustry
because information is already main-tained for every customer
account. Individualcustomer accounts belonging to the same customer
are combined for customer-levelreporting and management. Thus,
customer Asprofitability is the sum of the profitability of
herindividual accounts, such as her checkingaccount, CD accounts,
auto loan account, andhome equity line of credit account.
An important consideration in establishing thecost object is
whether its revenues are measura-ble. The ease or difficulty of
collecting revenuedata for the cost object depends on the
industryand the companys core application systems. Incases where
revenue is not measurable for thecost object (e.g., fast food),
then the cost object
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will need to be aggregated to the level at whichrevenues are
measurable (e.g., customer segment).
The cost object as the basic building block of theCPM system has
a major advantage: multidimen-sional profitability. In the
financial servicesindustry every customer account (the cost
object)is not only identified with a customer, but alsowith a
product (or service line), the sales channel,the organizational
unit assigned, the geographiclocation, the age of the account
holder, and anynumber of other data tied to a customers
account.Although the CPM systems main purpose is tomanage customer
profitability, a customeraccount cost object allows profitability
to bemeasured by any of the dimensions attached to acustomers
account, such as product profitability,branch profitability,
profitability by region, andprofitability by age. These are
different ways ofmeasuring the same thing from different
perspec-
tives, and from which arise the profitability identity. Exhibit
4, The Multidimensional Viewsof Profitability, shows the
profitability identityas follows:
Total Customer Account Profitability = Total Product Account
Profitability = Total Organizational Account Profitability
Although not all industries have customeraccount cost objects
that can be used in this manner, those that do can take advantage
of themultidimensional approach. For example, product profitability
that includes customer costsis far more reliable than product
profitabilityderived from average GL-based allocationassumptions.
As another example, data summedby channel will yield channel
profitability, possi-bly available for the first time to the
company.
11
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
CUSTOMERPROFITABILITY
Account #Account 1Account 2Account 3Account 4
:
CustomerSmith FamilySmith FamilyABCAutoJack Cove
:
ProductChecking AcctMrtg LoanChecking AcctAuto Loan
:
Org CenterBranch 1Branch 1Branch 1Branch 2
:
Revenue$ 10$ 125$ 1,500$ 36
:
Total Exp$ 8$ 35$ 1,530$ 23
:
NIBT$ 2$ 90$ (30)$ 13
:
If profitability iscalculated atthe account orlowest level,then
di!erentviews ofprofitabilityflow fromexisting data
S Customer Profitability =
S Product Profitability =PRODUCTPROFITABILITY
ORGANIZATIONPROFITABILITYS Product Profitability =
EXHIBIT 4. THE MULTIDIMENSIONAL VIEWS OF PROFITABILITY
-
A word of caution when selecting the cost object:The cost object
determines the detail availablewithin the CPM system, which further
deter-mines the ability of the system to drill down anduncover
underlying problems or answer specificquestions. There is always a
tendency to add asmuch related data as possible to provide
deeperdrill-down and the ability to answer questions notyet
considered. Detail does not come withoutcosts, however. The
one-size-fits-all informationsystem that can answer all questions
posedrequires more complex costs and transactiondata, which adds
significantly to the cost of developing and maintaining the CPM
informationsystem.
Define Customer, Product, and ChannelDuring the foundation
basics phase it is impor-tant to precisely define what constitutes
a cus-tomer and whether customers will be combinedinto households
or relationships. If so, a customerhierarchy table can assist in
these combinations.
A hierarchy table is simply a document or data-base table
showing how subgroups roll up, or arecombined, into groups, which
can further be com-bined into higher-level groupings. See Exhibit
5,Customer Account Hierarchy, for an example ofa customer hierarchy
for a bank or credit union.
Another foundational basic is the definition ofproducts or
service lines. A product hierarchydefines the products and how they
are combinedinto groupings. It is often practical to roll
upproducts with similar processes into a higher-level product for
costing purposes. If the like-kind products appear to be
homogeneous in theirconsumption of activity costs, then
combiningthem into one costing product will reduce systemand report
complexity. Exhibit 6, ProductHierarchy, shows a product hierarchy
for a
12
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
Mr. Smith Checking AccountMr. Smith Savings AccountMr. Smith
Auto Loan
Mrs. Smith Checking AccountMrs. Smith Auto Loan
Mr. &Mrs. SmithMortgageMr. &Mrs. Smith Certificate of
Deposit
ABCAuto Checking Account Store 1ABCAuto Checking Account Store
2ABCAuto Checking Account Store 3ABCAuto Checking Account Store
4
ABCAuto Parts On-Line
ABCAuto Checking Account Store 1ABCAuto Checking Account Store
2ABCAuto Checking Account Store 3ABCAuto Checking Account Store
4
Mr. Smith
Mrs. Smith
Mr. &Mrs. Smith
ABCAuto Parts
ABCAuto Parts On-Line
Account Level Customer Level Relationship Level
Smith Family
ABCAuto PartsCorporation
EXHIBIT 5. CUSTOMER ACCOUNT HIERARCHYBank and Credit Union
Example
-
typical bank. The column titled Costing Productindicates the
product level at which cost driverrates are developed.
Other foundation basics include the organization-al hierarchy
and the definition of delivery chan-nels, if applicable. The
organizational hierarchydefines general ledger cost or profit
centers, displaying the relationship of the centers ordepartments
where work or activities take placeand resources are consumed.
A customer delivery channel may be includeddepending on the
industry and other considera-tions. The customer delivery channel
is where
customers interact with the company, or the cus-tomers
touch-point. Large retail stores offersales venues through their
stores or on their website. In this case, there are two
customerdelivery channels: physical stores and a website.
Costs can vary significantly between customerdelivery channels.
It is likely that physical storesales require relatively more
resources and aretherefore more costly than website sales. A
retailcompany may therefore consider strategies toencourage their
customers to buy through itswebsite rather than visiting its
physical stores, a
13
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
Core Product
Commercial Loan - PrimeCommercial Loan - LIBOR
Auto Loan - NewAuto Loan - Used
Regular CheckingInterest CheckingPremier Checking
Regular SavingsMoneyMarket Savings
ABCCosting Product
Commercial Loan
Auto Loan
Noninterest Checking
Savings
Core products using the sameprocesses with similar costs
aregrouped together. Revenuecomponents are assigned at theaccount
level since theymay di!er(e.g., Prime versus LIBOR rates).
The activities for these products arecosted in the ABC system.
Combininglike-costed core products reducescomplexity and improves
usefulness.
Develop ABCcosts forthese products
Revenuesdi!erent,costs the same
EXHIBIT 6. PRODUCT HIERARCHYBank and Credit Union Example
-
process called channel migration. A channeldimension included in
the CPM system wouldhelp with these strategic initiatives.
In addition to defining who the customer is, it isalso important
to consider identifying relevantcustomer segments. Customer
segments definepatterns of customer characteristics and
behaviorthat drive customer profitability (Epstein et al.2008). In
some cases it may be necessary to segment customers to obtain
measurable costobjects; otherwise, it may be more appropriate
tocombine customers by segments once customer
profitability information has been obtained. Thiswill be
discussed further in the section on strategyintegration.
Calculating Customer ProfitabilityThe final area to be covered
during the founda-tion basics phase is the method of calculating
customer profitability and how various account-ing issues are
handled. Customer profitability istypically measured as net revenue
less customercosts, overhead, and taxes.
Net revenue is the cost objects total revenue lessreturns,
allowances, or other adjustments.Customer costs are the summation
of activity
14
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
Customer ID / CustomerSegment
Net RevenueProduct CostsCustomer GrossMargin
Costs to ServeCustomer (or Segment)Margin
Corporate Sustaining Costs AmountPre-tax Customer Profit
IncomeTaxes (40% )
Customer Profit
Amount
$10,000$ 4,500$ 5,500
$1,200$3,300
$2,000$1,300
$ 520
$ 780
Percent ofNet Revenue
100%45%55%
12%33%
20%13%
5.2%
7.8%
Costs to Serve include sales, order filling,customer support
& service, and othercustomer identifiable costs.
EXHIBIT 7. CUSTOMER PROFITABILITY REPORT
-
15
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
Year 0 1 2 3 4 5 6 7 8 9 10
($5,0
00)
$900
$1,000
$1,200
$1,300
$1,400
$1,400
$1,500
$1,500
$1,500
$1,500
($5,0
00)
($4,100)
($3,100)
($1,9
00)
($60
0)$8
00$2
,200
$3,700
$5,200
$6,700
$8,200
($5,0
00)
$833
$857
$953
$956
$953
$882
$875
$810
$750
$695
($5,0
00)
($4,167)
($3,30
9)($2,35
7)($1,4
01)
($44
8)$4
34$1,309
$2,12
0$2
,870
$3,565
Investmen
tRe
covery
Payb
ack
PVof
Investmen
tRe
covery
Net
Presen
tVa
lue
TimeV
alue
ofCu
stom
ers
$10,00
0$8,0
00$6,00
0$4,00
0$2,00
0 0($2,00
0)($4,00
0)($6,00
0)
01
23
45
67
89
10
Payb
ack
Net
Presen
tValue
Atyears5
-6investmen
tisrepa
id
Atyear
7target
return
isachieved
Payb
ack
Ittakestim
etorecoverthe
investmen
tinacqu
iringn
ewcustom
ers.
EXHIBIT 8. CUSTOMER LIFETIME VALUE
-
costs that are assigned to the customer as the costobject. If
ABC is used, then each cost objects costis the activity driver rate
times the quantity orother measure of the activity driver consumed
bythe cost object.
Costs are discussed below in Section V: CustomerCosts. In
general, costs assigned to cost objectsinclude product costs and
any costs to service thecustomers. The difference between net
revenueand product or service line costs is the costobjects gross
margin. The costs to serve appearbelow the product gross margin
line, and includecosts of such activities as order getting, order
fill-ing, and customer support and service. The coststo serve are
assigned to the customer as the costobject and then subtracted from
the cost objectsgross margin to obtain customer margin.
Customer margin contributes to corporate-sustaining costs (or
corporate overhead). Incomebefore taxes is thus equal to customer
marginless corporate-sustaining overhead. Incomebefore taxes less
taxes provides customer netincome or profit. Exhibit 7,
CustomerProfitability Report, provides an example ofsuch a
report.
Return on Capital ConsiderationsWhile customer profitability
provides valuableand oftentimes never-before-available
informa-tion, only goes so far. Ultimately, what is mostimportant
is the return on the capital invested toachieve those profits.
Linking customer profitswith capital can be done in several ways,
such asreturn on investment (ROI), return on equity(ROE), residual
income (RI), or some variant ofthese approaches.
Linking customer profits and capital requires anassignment of
capital to the cost object. This canfundamentally be done in two
ways. One way is to
assign capital based on capital usage or capacityutilization.
Adjustments are then made to thecapital charge to reflect higher
customer risk byusing a rate higher than the average cost of
capital and conversely to reflect lower customerrisk by using a
rate lower than the average cost of capital. The types of customer
risks to considerwill vary by industry.
A second approach, commonly used by financialinstitutions, is to
assignbeyond capital usagemore capital for riskier investments or
customersand less capital for less-risky investments or cus-tomers.
In this case the cost of capital rate is heldconstant and not
adjusted for risk; risk is account-ed for in the amount of capital
assigned to eachcost object or customer.
A partial application of RI in manufacturing is tocalculate only
the cost of direct investments inassets related to the
customere.g., imputed capital cost on inventories and accounts
receiv-able. A complete application of RI would requireassigning
direct and indirect investments inassets financed through long-term
capital.
Cost object return on capital, however measured,can be plotted
on a whale curve similar toExhibits 1 and 2 in order to gain
insights intomanaging customer profitability. Using ROI or RIadds
to the tools of managing customer prof-itability by accounting for
the cost of capitalneeded to serve the customer or customer
seg-ment. A full discussion of attributing capital andmeasuring ROI
and RI lies beyond the scope ofthis SMA.
Customer Lifetime Value (CLV)Customer profitability results and
return on capital measures will, by definition, cover a specific
time period, such as a month, a quarter, ora year. Snapshot views
of any dynamic system can
16
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
-
be misleading. As such, trends of customer profitability results
over several time periods provide more meaningful information and
shouldbe designed into the report library requirements.
Measuring customer profitability over an expected tenure is
known as Customer LifetimeValue (CLV). Pfeifer, Haskin, and Conroy
(2005)refer to CLV as the discounted future cash flowsrelated to a
customer. When a decision is made toacquire a customer, such as
through a proposedmarketing campaign, a company should projectthe
discounted future cash flows resulting frommaking the acquiring
investment. It should continuously monitor the changes in
customervalue that result from the ongoing interactions orlack
thereof between the customer and the company. A discount factor
such as the cost ofcapital can be used to discount the
projectedfuture cash flows over the customers expectedtenure with
the company. Depending on the riskof the investment made in a
specific customer orcustomer segment, the discount rate can
beadjusted higher or lower to reflect that risk. If therelationship
between specific customers and thecompany is uncertain,
probabilistic models can beused to estimate the discounted CLV of
thesecustomers.
Exhibit 8, Customer Lifetime Value, shows anexample of an
investment in a customer. Thecumulative cash flows are negative at
the time ofmaking the investment. As the customer con-tributes
revenues and incurs product costs andcosts to serve, however, the
difference results incustomer margin as the measure of
customerprofit. The investment will be recovered whenthe customer
margin or profit equals the cus-tomer investment. Beyond that
point, the cus-tomer value is positive.
Other Accounting IssuesIn addition to the costing issues that
will arise,thorny accounting issues should be addressedduring the
foundation basics phase to avoid laterdiscord and manipulation. Two
thorny accounting issues that create heated debate inthe financial
services industry are:
Unsuccessful sales efforts. A loan officer mayapprove six loans
out of the 10 loan applica-tions he takes in a day. The time spent
onreviewing and declining the four unapprovedapplications
represents unsuccessful saleseffortstime and effort expended where
noproduct is sold nor customer created. In anoth-er example, credit
card direct mail campaignscan cost tens of thousands of dollars,
yet aresponse rate of 5% is considered stellar. The95% of direct
mail pieces that resulted in nocredit card applications are
unsuccessful salesefforts. Unsuccessful sales costs can be
spreadamong the sales that were successfulin thiscase unsuccessful
sales being part of the cost of successful sales. Another approach
spreads theunsuccessful sales costs across all accounts ofthat
product typein this case unsuccessfulsales being a cost of offering
that product to themarketplace. (This approach is often preferredby
marketing executives since it reduces thecost driver rate for the
sales activity.) The bestapproach for the company should be
selectedearly to avoid misunderstanding, maneuvering,or gaming the
system.
Controllable versus uncontrollable costs. Notall costs are
controllable by a departmentsmanager. How much control does a
branchmanager have on the storefront rental expensefrom a contract
negotiated by the banks facilities group five years ago? The branch
manager will argue that customer profitabilityshould exclude
facilities costs because they are
17
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
-
uncontrollable. This is refuted on the groundsthat the purpose
of the CPM system is to meas-ure customer profitability and all
costs shouldbe includedcontrollable and uncontrollable
(corporate-sustaining costsbeing the possible exception). This
choice elevates the purpose of managing customerprofitability over
that of employee performancemeasurement, although the two are not
necessarily incompatible.
V. C U S T O M E R C O S T STo know customer profitability, one
must knowcustomer costs. How customer costs are meas-ured is
critical for the effective application anduse of CPM.
The Trouble with Conventional CostingConventional cost
accounting systems, with theirfocus on product or service line,
cost centers, andfunctional cost classifications are neither
ade-quate nor helpful for CPM purposes. These costsystems generally
derive directly from the generalledger (GL) where some form of
unit-based allo-cation of GL costs to the cost object is made
(e.g.,by number of employees, by number of PCs maintained). The GL
data tracks only cost occurrencewhat was spent rather than why
itwas spent (activity specification) or how activityresources are
consumed by cost objects. Thesesystems do not provide costs based
on customeror customer segment behavior.
Conventional cost allocation methods imply thatall customers or
customer segments are homoge-neous. When support costs (indirect or
shared,commonly called overhead) are assigned on thebasis of a
unit-based common denominator, suchas units, revenues, or number of
customers, support costs are averaged and do not reflect
theresource consumption patterns by individual
customers or customer segments. This typicallyresults in a
misallocation of costs. Unless all customers or customer segments
are homoge-neous in their pattern of consumption of manu-facturing
and nonmanufacturing support costs,some cause-effect cost
assignment system such asactivity-based costing (ABC) should be
employed.Before exploring this topic, it is first important
toidentify the different types of costs involved inCPM.
The Types of CostsCustomer costs consist of all costs necessary
toprovide the product or service line to the customer, not only to
the point of sale and delivery but over the entire life cycle of
the product or service line. These costs include coststhat add
value for the customer, such as productor service-line costs and
the costs to serve. Theyalso include costs that do not add value
for thecustomer but are necessary for the business.
1) Product costs
a. Direct material and direct labor, if applicable.These include
the typical product or service-line costs, often referred to as
direct costs.
b. Manufacturing or service-line support costs.These support
costs include indirect costs,which are typically assigned as
product costsusing unit-based allocation schemes (e.g.,labor
hours), but preferably assigned usingcause-and-effect relationships
(e.g., activity-based costing).
2) Costs to serve
a. Marketing, selling, and distribution costs,typically assigned
using unit-based allocationschemes (e.g., sales or product costs),
butpreferably assigned using cause-and-effect
18
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
-
relationships (e.g., activity-based costing).These costs also
include order-getting andorder-filling activities.
b. Post-sale service, such as warranty or coveredrepair costs,
and in some cases disposal costs,typically assigned using
unit-based allocationschemes (e.g., sales or product costs),
butpreferably using cause-and-effect relationships (e.g.,
activity-based costing).
3) Business (or corporate) sustaining costs
Not all costs are related to customer productcosts or costs to
serve (Cokins 2006). Forexample, the cost of landscaping,
accounting,IT services, patents amortization, and executive
salaries are not incurred for a customer or customer segment but
areincurred to sustain the business. These costsmay or may not be
assigned to customers.Caution should be used in interpreting
theresults if they are assigned to customers,however, there is
likely no cause and effectrelationship. On the other hand, not
includ-ing these costs means that decisions basedon customer
profits may in fact translateinto business or corporate losses.
Customer costs are the sum of the customersproduct costs and the
customers costs to serve.Ideally these customer costs are assigned
on thebasis of cause and effecte.g., using activity-based costing
or some variation. Each activitycost is based on its activity cost
driver rate andthe customer-related consumption of that activi-ty.
As mentioned above, whether or not toinclude business-sustaining
costs is situational.Regardless, the resulting information should
beinterpreted in light of whether business-sustaining costs are
included in customer costsor not. Refer to Exhibit 7, Customer
Profitability Report, for an example of a multi-stage customer
profitability statement.
Costing SystemThere are at least three cost system options.
Thefirst is unit-based traditional costing, whichassumes that
products, customers, and other costobjects are homogeneous in their
consumption ofactivity resources. Since homogeneity is not avalid
assumption, the second option is to useactivity-based costing
(ABC). Because ABC imple-mentation requires time and resources,
Kaplan(2004) suggested the use of a simplified approach:time-driven
activity-based costing (TDABC). Weadvocate a form of causal cost
assignment, whichlargely means ABC or TDABC. A brief comparisonof
these methods is provided below. A full discus-sion of the
application of ABC lies outside thescope of this SMA. (See the IMAs
Statement onManagement Accounting titled ImplementingActivity-Based
Costing, 2006.)
Conventional CostingDirect product and customer costs do not
raisequestions about the utility of their assignment tocustomers or
customer segments as the costobject. The same cannot be said for
assigningindirect product or shared customer costs.
Unit-based conventional costing systems assignfunctional costs
(e.g., salaries or insurance) on thebasis of unit-based cost
drivers (e.g., direct laborhours, dollars of customer revenue) that
assumehomogeneous consumption of indirect or sharedcosts by cost
objects (e.g., products, customers).The most profound criticism of
conventionalcosting relates to not assigning support costs tocost
objects on the basis of their consumption ofactivity resources,
resulting in simplified butoften misleading results.
19
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
-
A CPM system attempts to capture the differentresource
consumption patterns of different cus-tomers or customer segments
so that manage-ment is better able to manage the profitability
ofeach customer or customer group. In the absenceof such
measurement, management is unlikely tomanage customer profitability
appropriately, asconventional costing systems ignore the
con-sumption patterns of activities by cost objects.
Activity-Based Costing (ABC)Activity-based costing (ABC)
provides an answerto such criticism. In ABC, activities must be
iden-tified, activity cost pools established, cost driversselected,
and cost driver rates developed. Thecost driver rates are then
applied to differentcustomers or customer segments in order
toassess their profitability.
ABC requires first that activities be identified,and the costs
of resources consumed by thoseactivities are assigned using
resource drivers. Thisfirst step requires converting the general
ledgerfunctional accounts into activity costs. The costsof support
activities may be assigned to higher-level activities based on
their consumption ofsuch support activities. (See multistage ABC
inCokins 2008). Costs of activities that are con-sumed
homogeneously by all products or servicelines are also combined
into activity cost pools.
At this stage, organizations can see the cost ofeach activity,
which often raises issues related tomanaging activities to minimize
their costs.Activity-based management (ABM) requires re-evaluating,
re-examining, and re-designingprocesses and activities for better
cost manage-ment. While ABM enhances corporate profitabili-ty and
supports the objectives of CPM, it is notdirectly an integral part
of CPM.
After identifying the activities and their costs, thenext step
is to select appropriate cost drivers fromavailable transaction
data for each activity oractivity pool. An estimate is then made of
thequantity or capacity of each cost driver for a peri-od of time
(usually a year).
Cost driver rates are developed by dividing activity costs or
activity cost pools by the estimated cost driver quantity. The cost
driverrates are then applied to cost objects, such asproducts,
channels, customers, or other costobjects (usually decision
points), by multiplyingthe quantity of the cost driver consumed of
eachactivity by the cost object times that activitys costdriver
rate. The sum of activity costs thusassigned to a cost object
represents the costobjects total product and customer costs.
Customer costs in this way include the sum of allassigned
product or service-line activity costs forthe product or service
line purchased by the customer or customer segment (product costs),
aswell as the costs to serve the customer or customer segment using
cost driver rates.Corporate-sustaining costs may also be assignedto
customers or customer segments, but linkingsuch costs to customers
is necessarily arbitrary.
It should be noted that ABC is not necessarilybound by the GL.
For example, inventory-carrying activities generate costs that are
not recognized as expenses in GAAP, such as imputedinterest, cost
of capital charge, or replacementcost depreciation. Such costs may
be included inABC for management purposes.
ABC often requires survey information to assignresource costs to
activities and to assign activitycosts to cost objects. Such survey
informationmay not be accurate and may often need to beupdated as
operations or activities change. There
20
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
-
are different levels of precision that are attainablein applying
ABC. The most accurate informationmay require too many cost drivers
with compli-cated data to be developed and captured in thecosting
system. A high level of precision, there-fore, may be too costly to
attain. A balance shouldbe struck for the optimum level of
precision, tak-ing both accuracy and costs into consideration.
Time-Driven Activity-Based Costing (TDABC)Because several
applications of ABC in the questfor cost accuracy became cumbersome
and costlyto develop, Kaplan and Anderson (2003) developed a
simplified application of ABC theycall Time-Driven ABC (TDABC). Two
majoradvantages of this simplified approach are (1)avoiding
extensive surveys, re-surveys, and survey subjectivity, and (2)
highlighting capacityutilization or lack thereof. Two parameters
arenecessary to apply TDABC. The first is the practi-cal capacity
of a resource determined in units oftime, and the second is the
time required to perform a unit of each identifiable activity.
Thecost of the resource is divided by the capacity ofthat resource
to determine the cost per unit oftime. This is then assigned to
cost driver rates bymultiplying the cost per unit of time of
theresource by the amount of time a unit of activitytakes to
perform. The cost driver rate is thenapplied to the cost object
based on the quantity ofcost driver units consumed by the cost
object.
As a special case of ABC, TDABC is relatively newand the
evidence seems to support its advantages.But evidence about its
disadvantages is alsobeginning to emerge. For example, direct
observa-tion of the time to perform a unit of activity maybe
affected by the observation process itself, bysampling error, or by
defining when the unit ofactivity begins and ends. It is also
unclear thattime is the driving force of many resources
(Adkins 2008). For further discussion on ABC, seeIMAs Statement
on Management Accounting,Implementing Activity-Based Costing
(2006).
The choice of a costing system is critical to CPM,and the
tradeoffs in the choice between conven-tional unit-based costing,
ABC, and TDABC willdepend on the circumstances of the
organization.It is important to recognize that there exist
different forms, adaptations, and simplificationsof ABC to provide
satisfactory cost information ata reasonable cost. Pursuing precise
cost informa-tion dramatically increases the cost of developingand
maintaining an ABC system. We tend to favorABC due to its focus on
cost assignments based oncausality. Arbitrary cost allocations that
do notattribute causality may be marginally beneficial,but they can
also lead to misguided decisions.
Cost Driver Types, Quality, and Data AvailabilityThere are three
general types of cost drivers. Costdrivers may be based on
transactions (counts),duration (time), or intensity (direct
tracing). Forexample, the setup activity costs may be assignedusing
the number of setups if setups are similarbetween products
(transactions or counts), usingthe number of setup hours if setups
vary by prod-uct in the time they consume (duration), or bytracking
the size of the setup crew required, thelength of time it takes to
complete a setup, and theactual shop supplies required
(intensity).
The quality of selected cost drivers is critical inCPM. For
example, customers that place large butinfrequent orders might be
assigned more thantheir proportionate share of the costs to serve
ifcosts are assigned on the basis of sales volume orsales dollars,
making them appear less profitableand hiding the lack of
profitability of customersthat place small and frequent orders and
drive upthe costs to serve.
21
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
-
The application of ABC requires that activity costdriver data be
available or can be developed andmaintained. For many organizations
the activitycost driver data at the customer level, particular-ly
for the costs to serve, is not directly available,although it may
have been captured in transac-tion data and can be sourced by the
CPM system.
Issues with Using ABC Costs in CPMThere are a number of issues
related to usingABC or a variant in CPM applications. These
areaddressed below.
a. Cooperation between finance and otherdepartments One issue in
developing CPM is that thefinance function and customer-level
management must communicate clearly sothat cost information aimed
at measuringresource consumption is captured correctlyin the
system. This requires more coopera-tion between finance and other
functionsthan is typically observed in many organiza-tions. If the
company is currently using ABC,the application may have to be
modified toinclude all customer-related costs and toapply ABC costs
to customers as the costobjects. If the company is not using ABC,
thenits subsequent design must be driven by therequirements of the
CPM system.
b. Accuracy of costs Cost accuracy results from accurate
costclassification, activity definition, activitycost pool
determination, cost driver selection, data collection, and cost
objectassignment. A successful installation of CPMrequires an
accurate and functional costingsystem, preferably based on ABC or
somevariant.
In developing customer cost information, it isimportant to keep
in mind that complexity iscostly, not only in the development of
the costinformation, but also in maintaining the cost driv-er
information. A balance must be struck betweeninformation accuracy
and complexity. As manyimplementers have discovered, attaining a
highlevel of accuracy in costing may not only chal-lenge the
comprehension of those who use thesystem, but it also increases the
cost of developingand maintaining the system.
c. Capitalization and amortizationGAAP accounting currently
requires theexpensing of costs considered period costs,such as
marketing and R&D costs. A questionarises in costing for CPM
purposes ofwhether such costs are capitalized as assetsand
amortized over a reasonable period oftime. Other candidates for
capitalization andamortization include unsuccessful salesefforts
and large marketing campaigns.Whether a company decides to expense
orcapitalize these expenses in the CPM systemwill depend on its
particular circumstances;regardless, these decisions should be
madeduring the foundation basics phase when thefocus is on the best
CPM system for the company.
d. Arbitrary cost allocationsIt is important to recognize that
some costassignment is arbitrary in nature. Even whenABC is used,
some cost assignment may stillbe arbitrarynamely facility and
business-sustaining costs. Examples include: 1) facilitysustaining
costs in manufacturing, which aretypically assigned as product
costs; 2) facilitysustaining costs of marketing, sales,
distribu-tion, and post-sale services, which are typically assigned
as costs to serve; and 3)business-sustaining costs of research
and
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development, landscaping, corporate head-quarters, and senior
executives salaries.While the cost assignment for some of
thesecosts using ABC can be arbitrary, it is impor-tant to realize
that conventional costingresults in arbitrary cost assignments, not
onlyof facility and business-sustaining costs, butalso of most
other indirect and shared costs.In ABC, the allocation of facility
and business-sustaining costs is necessarily morearbitrary than
activity costs based on causality.
e. Cost controllabilityOne question that typically arises in
theimplementation of a CPM system is this:What is the systems
primary purpose (aquestion addressed in the decision phase)?Some
stakeholders may prefer that the system focus on measuring employee
perfor-mance rather than customer profitability.This SMA is
concerned with customer profitability management, and employee
performance is certainly related to CPM. Butthe primary focus of a
CPM system should beon having the best available information
tomanage customer profitability.
The issue of cost controllability arises in connection with
employee performancemeasurement. This would require some
modification or adaptation of CPM informa-tion that is focused on
controllability andemployee performance measurement.Separating
costs as controllable or uncontrollable is tricky and difficult to
capture in the costing system, as controllabil-ity is dependent on
managerial hierarchy andtime horizon. It is less difficult to deal
withthe controllability issue in the reporting system than it is in
the costing system. Forexample, it is possible to deal with this
issue
in a multiple performance indicator systemsuch as the balanced
scorecard rather thanembedding controllability as a primary
criterion for the CPM costing system.
f. ABC provides full absorption costsABC is often implemented as
a full-absorption costing system that ignoresthe difference between
fixed and variablecosts in assigning costs to the cost object.
InCPM, this full cost is only partial, as customercosts may or may
not include business-sustaining costs.
The reasons for the full-costing focus of ABCare twofold. First,
cost trends in recentdecades are toward cost structures that
areheavily loaded with fixed costs. To assigncosts to cost objects,
fixed costs cannot beignored, and the case is no less compelling
forcustomer activity-based costing. Second, thetraditional approach
toward managing fixedcosts is through long-term decisions
thatchange the levels of fixed costs.
Supporters of ABC claim that fixed costsmust be managed through
the managementof capacity. Any unutilized capacity costshould be
highlighted so that managementcan either improve profitable
capacity utiliza-tion or decrease the level of capacity. Ineffect,
capacity costs are considered to besomewhat flexible, and that view
contributesto corporate agility that is necessary for survival in a
dynamic economic environment.If not, management is likely to accept
the current level of fixed costs as uncontrollablein the short
term, thus deterring managersfrom searching for alternative options
to utilize or to decrease capacity.
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On the other hand, it is important to realize thatlong-term
performance measures, such as cus-tomer profitability using ABC,
can only providesignals for management about long-term
prof-itability. Any decision that might be considered asa result of
these signals requires an entirely dif-ferent analysis related to
the differential effect ofthe decision on cash flows and company
prof-itability. Customer profitability indicators tell management
where to look but not what to do.For example, to delete an
unprofitable customerbased on ABC may result in decreasing
ratherthan improving profits, since some of the fixedcosts may not
be avoidable, at least in the shortterm.
g. The cost behavior dilemmaFixed costs are typically included
in ABCassigned customer costs, and the resultingcustomer profit
does not represent the effecton company profits if a similar
customer isadded or this customer is lost to the company.This
raises the question of whether customer profitability should be
measured intwo ways: full-absorption ABC and variable-costing ABC.
In other words, the idea is to usevariable costing in addition to
full-absorptioncosting.
The behavior of resource costs is challengingas it relates to
the ability to adjust capacity ofany resource. This adjustability
criteriondepends on the planning horizon and the easeor difficulty
in adjusting capacity (resourcecost stickiness). In addition,
decision makingis future-oriented while cost accumulationand
assignment using any costing system arenecessarily historical. Any
decision related toadding or dropping a customer or customer
segment, or modifying a customer relation-ship, necessarily
requires special decisionanalysis related to the differential
effects ofthat decision.
The application of ABC is sufficiently com-plex and challenging.
To develop two sets ofABC costs, variable and full, is
cumbersome.Even if both systems were developed, theresults of each
system will only provide signals but will not directly help in
decisionsrelated to customers without further analysisthat focuses
on those specific decisions.Accordingly, developing a dual ABC
system isa possibility that should only be considered inlight of
the resulting complexity and cost.Regardless of the choice of a
full ABC only, avariable ABC only, or a dual ABC system, theresults
should be viewed as providing signalsthat require further
decision-specific analysisto evaluate any proposed action.
h. Reconciliation of cost information with the general
ledgerCustomer cost information is derived fromcost driver
quantities and cost driver con-sumption. Such information is
derived fromactivity cost pool information, which in turnis derived
from the general ledger (GL) ordirectly from GL subsystems that
feed the GL(e.g., accounts payable, payroll). The customer costs
assigned to all customers orcustomer segments should reconcile
withactivity cost pools, which in turn should rec-oncile with the
GL accounts or their expensetransaction sources of functionally
classifiedexpenses. Customer costs for a time period, intotal,
should be the same as the GL functionalcosts unless the ABC system
includes imput-ed costs not recognized in the financialaccounting
system.
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25
B U S I N E S S P E R F O R M A N C E M A N A G E M E N T
Costof
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93
EXHIBIT 9. COST WHAT YOU CAN SOURCE
-
i. Unutilized capacityIn applying activity-based costing, there
aretwo main approaches related to the selectionof capacity to use
in the development of costdrivers: ABC and TDABC. Early
applicationsof ABC tended to ignore unutilized capacity.These
applications estimated usage orexpected capacity utilization as the
denomi-nator in developing activity driver rates. Thecost of
unutilized capacity was thus not isolated, and activity driver
rates were usuallyhigher than if the cost of unutilized capacitywas
isolated. While it is possible to use practical capacity of each
cost driver in deter-mining each activity cost driver rate,
whichwould isolate the cost of unutilized capacity,supporters of
time-driven ABC tout theirapproach not only because of its alleged
simplicity but also because it isolates thecost of unutilized
capacity and assigns onlythe costs associated with utilized
capacity inthe activity driver rates.
Supporters of time-driven ABC claim that itis simpler to use
than traditional ABC andthat it avoids the subjectivity of
extensivesurveys. Both traditional ABC and TDABCcan use practical
capacity in determining costdriver rates. Incorporating practical
capacitydoes add a layer of complexity, as well as anelement of
subjectivityand possiblyattempts to game the system.
Nonetheless,incorporating practical capacity has the dualbenefit of
keeping cost driver rates constant;as the denominator, the
practical capacitylevel of each cost driver does not
frequentlychange. It also isolates the cost of unutilizedor unused
capacity, which can be helpful inmanaging capacity costs by
evaluating alter-natives for the utilization of unused capacityor
for the reduction of capacity.
It should be noted that practical capacityusage is not unique to
TDABC and can beused in connection with any application ofABC. All
that would be required in ABC is touse practical capacity, instead
of expectedusage, of each cost driver in the denominatorin
determining the activity cost driver rate.This would have the
effect of showing theunused capacity of each cost driver and
thecost of unused capacity of each activity. Thusthe argument for
TDABC reduces fundamen-tally to its simplicity.
Regardless of whether practical capacity isincorporated in ABC
or not, it is clear thatcosting issues dominate in the
measurementof customer profitability. The careful devel-opment of
the costing system and its mainte-nance are critical in customer
profitabilitymeasurement and management. It is no exag-geration to
describe costing as the Achillesheel of CPM.
VI. TRANSACTION DATAThe two preceding sections discuss the
founda-tion basics and costing for a CPM system, both ofwhich are
highly dependent on the availability oftransaction data. In the
foundation basics, thecost object is established, but measuring the
prof-itability of the cost object requires transactiondata be
available for it. Likewise, other foundationbasics, such as the
product and the channel, aredependent on the availability of
transactioncounts (cost driver quantity) for those items.Regardless
of the desirability of a particular costobject, that cost object
cannot be used withouttransaction data to support it.
For example, in the banking industry an impor-tant component of
customer account profitabilityis the number of times an account
holder cashes acheck. Developing activity driver rates for
cashing
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checks requires data at two levels: (1) how manytotal checks
were cashed to use as the denomina-tor in the ABC cost
calculationspractical capacity could be used instead; and (2) how
manychecks were cashed by each customer account(the cost object) to
apply in calculating customeraccount profitability. Knowing how
many totalchecks were cashed enables the calculation of costdriver
rates, but this is of little value if the numberof checks cashed is
not available for each andevery customer account (the cost
object).
Data SourcesThe sources of the transaction data used in theCPM
system will vary by industry and come fromdisparate computer
systems within each compa-ny. Some data will come from the
financial systems, such as general ledger data. Other data,such as
transaction driver data, will come fromcore application systems
such as sales and ERPsystems. Some companies are fortunate enough
tohave built a data warehouse depository, whichmay contain much of
the needed data and provides one-stop data shopping.
The elemental concept that transaction data mustbe available for
an activity driver can be expressedin the maxim, Cost what you can
source, andsource what you can cost. This says to include
anactivity cost only when its driver data can besourced for the
cost object, and not to source driver data for the cost object when
there are norelated activity cost pools from which to developcost
driver rates.
It is not uncommon to find situations whereactivity cost pools
can be built, but activity driverusage data (the number of times an
activity is performed) is not available for the cost object.
Forexample, it may be observed that an employeespends 5% of her
time answering customer questions, but the core application
systems
cannot tell which customers asked questions andwhich did not;
the activity driver data is not available for the cost object. In
this case, the activity cost pool will require another
approach,such as combining it with a more general
customer-sustaining activity cost pool. The resultis the activity
cost pool, although disproportion-ately consumed by a subset of
customers, ischarged to all customers using the more
generalactivity driver.
Exhibit 9, Cost What You Can Source, provides agraphical
representation for a bank or creditunion of tracing the cost of
resources from functionally classified general ledger costs
toactivities, forming activity cost pools, that arethen traced to
the individual cost objects usingcost driver rates. The cost driver
rates are multiplied by the activity usage counts to yieldcosts for
individual customer accounts (the costobject).
Add Demographic DataThe analytical robustness of the CPM system
isenhanced with the addition of cost object datathat is not cost-
or revenue-related. Customerdemographic data, for example, can
provide information such as age, address, Zip Code,income group,
and purchasing preferences. Otherdata may be internally generated,
such as thelength of the customers relationship with thecompany,
the customers sales representative, andthe customers payment
history.
Once profitability is determined for the costobject, then
profitability can be viewed not onlyfor the cost object (e.g.,
customer account), butalso by the demographic data added. For
example,one can analyze customer profitability by agegroup or
generation, or by the length of a customers relationship, if this
data is sourced forthe cost object. Demographic data is another
take
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on the concept of multidimensional profitabilitydiscussed
earlier (refer to Exhibit 4, TheMultidimensional Views of
Profitability).
Accurate, repeatable, and timely sourcing oftransaction and
other data to the CPM database isdifficult and requires great
diligence to design,implement, and maintain. Sourcing data posesone
of the greatest risks of failure to a CPM sys-tem. See Appendix 2,
Technical Considerationsfor the Management Accountant, for
additionalinformation on sourcing and maintaining data ina CPM
system.
VII. SYSTEM OPTIONSThe selection of the information system
infrastructure needed to support the CPM systemwill be dependent on
the decisions made in thehighly interrelated foundation basics,
costing, anddata phases. Once the groundwork has been laidfor these
three phases, then selection of the information system
infrastructure can begin.
Selection of the Database EnginesIn general, there are two
separate calculationengines needed for CPM: one for costing,
whichcalculates the cost driver rates; the other for costobject
profitability, which applies those cost driv-er rates to the cost
object. Some commercialproducts combine the cost system and the
profitability system into one CPM database infrastructure, but most
often the costing andprofitability systems are two separate modules
orapplication systems.
There are three basic choices when selecting aCPM application
system, whether for costing,profitability, or both:
1. Develop in-house2. Purchase3. Outsource
Developing an in-house application providesmaximum opportunities
to custom design theCPM system. Customization comes at a cost,
however, including significant managementaccounting and information
technology resourcesand long implementation timelines.
Further,internally developed applications often becomeoutdated as
they have difficulty keeping up withthe technology of commercially
developed off-the-shelf products. A large bank a few yearsago
developed its own costing system in-house atgreat expense, only to
abandon it three years laterfor lack of features available in
commercial products.
Although purchasing a commercial off-the-shelfsoftware
application will reduce the ability to customize, it will also
reduce the cost and time toimplement a CPM system. Even with a
purchasedapplication, though, it will not start generatingcost
driver rates and customer profitability theday it is installed.
These applications are morelike Excel when first opened: a blank
worksheet.It is left to the purchasing company to input allthe
necessary data, establish their relationships,write the formulas
that perform the calculations,and generate the companys cost driver
rates andcustomer profitability. Advanced commercialCPM systems do
some of this internally; nonethe-less, products, channels,
relationships, transac-tion usage data, and model specifics must
beestablished by the purchaser.
The third system option is an outsourced or hosted solution.
Often referred to as anApplication Service Provider (ASP) or
Software asa Service (SaaS), the approach entails providingcompany
data to a third-party vendor, which runsthe costing and/or
profitability system on itscomputers and returns output tables and
reportsto the company. A hosted solution provides thefewest
opportunities for customization, but it also
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provides the lowest initial costs and fastest timeto implement.
Ongoing periodic payments aregenerally required as the monthly or
quarterlyprofitability reports are produced and delivered.Data
security and customer privacy require special attention with a
hosted profitability solution.
Other Application System ConsiderationsInformation systems and
databases external tothe CPM system will be called upon regardless
ofthe system option chosen. These external systemsmay already exist
or may need to be developed.Two basic types of external systems are
thosethat: (1) provide information to the costing orCPM systems and
(2) receive information fromthe costing or CPM systems.
First, external systems will provide informationthat is used by
the CPM system in calculatingactivity driver rates and customer
profitability.The accounts receivable system would likely pro-vide
data to the CPM system, as would an order-ing or sales tracking
system. Transaction datafrom core application systems is an example
ofdata sourced from external systems.
The second type of external system is the end-result reporting
system used to deliver the calculated costing and customer
profitabilityinformation to employees. Examples wouldinclude
summaries on departmental balancedscorecards, the profitability of
specific customersreported to sales staff, or data warehouses
withquery tools for costing or customer profitabilityanalysis. How
the costing and customer profitability results are disseminated
throughoutthe organization will have a big impact on thesuccess of
the CPM system.
One final system consideration is the ongoingmaintenance and
occasional upgrades and
refinements that the costing and profitabilitysystems will
require. Customer profitability systems, whether purchased or
internally devel-oped, will have software upgrades
requiringinstallation and testing. Refinements to the system will
also be required when processeschange that affect the cost driver
rates or whendata not available before can be sourced.
Anyrefinements or upgrades need to be designed,documented,
installed, and tested.
V I I I . B U S I N E S S A L G O R I T H M SThe formulas and
calculations used to generatecost driver rates and cost object
profitability arereferred to as business algorithms or rules.
Thebusiness algorithms must be designed, docu-mented, input to the
costing and profitabilitysystems, and tested. The model builder
tells theapplication system how to manipulate data tocalculate cost
driver rates and cost object profitability, much like an Excel user
programsformulas into a spreadsheet.
The degree to which the company is involved inthe design and
implementation of the businessalgorithms depends on decisions made
in the system options phase. The in-house developedsystem and, to a
lesser extent, the purchasedapplication system provide almost
unlimited customization of the business algorithms. Theoutsourced
solution, while providing the purchaser little control over the
business algorithms, normally uses industry best practicesbusiness
algorithms.
To the extent possible, line and back-officeemployees should be
involved in the design of theCPM system; they are sure to know more
abouthow their areas work than do the model builders.Including
employees in the design of the CPMsystem, or at least providing
them an understand-ing, will go a long way in obtaining their
buy-in.
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Employee acceptance will encourage using thecustomer
profitability information in construc-tive and creative ways that
add value to the organization. Section XI,
BehavioralConsiderations, discusses this subject further.
Customization and CostsWhile the in-house developed or purchased
CPMapplication systems provide plenty of opportunityto customize
the business algorithms, this customization comes at a cost and
produces several unavoidable pitfalls. Situations arisewhere there
is more than one approach to calculating activity driver rates and
cost objectprofitability with the different approaches yield-ing
different results. As a consequence, control ofthe business
algorithms will spawn politicalinfighting over which methodology to
use, witheach department manager encouraging whichev-er methodology
benefits his department the most.For example, the cost of marketing
campaignsmay be assigned to current sales or capitalizedand
amortized; the marketing department willgenerally favor
capitalization since it lowers thecost driver rate of making a
sale.
The way to avoid political infighting over businessalgorithms
and accounting methodologies is tomake the difficult accounting
choices during thefoundation basics phase, when the focus is
ondesigning an accurate and strategic CPM system.
CPM System Docum