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Business Readings
 Using ABC to Determine the Cost of
Servicing Customers
Problems...and cost saving opportunities...surfaced when this small welding company conducted an ABC analysis. BY MICHAEL KRUPNICKI, CMA, AND THOMAS TYSON, CMA Although most case studies of ABC applications have been in manufacturing, ABC can be used in a small service business to isolate costs for decision making. We conducted an ABC cost study in a small, family-run welding supply business. The purposes of the study were to determine the cost of servicing customers and to identify feasible cost reduction opportunities. The domestic welding supply industry used to be composed of primarily local, mom-and-pop type operations. Since the 1980s, several national franchises have expanded on a regional basis by buying out these family-owned businesses. The economies of scale and deep pockets of regional chains create new competitive challenges and a need for the surviving small companies to reevaluate how they do business. Mahany Welding Supply is a distributor of welding supplies and compressed gases in the greater Rochester, N.Y., area. It has a diverse base of customers in fields that include construction, metal fabrication, collision shops, restaurants, dentists and veterinarians, tool & die shops, gravel pits, highway departments, schools, and home hobbyists. Business is conducted out of a part store, part warehouse located near downtown Rochester. The company distributes products in four ways: walk-in trade and customer will-calls; a delivery truck that services customers within the city; a delivery truck that services a 40-mile radius of Rochester and visits one of five different geographic areas each day; and, to a small extent, UPS and common carrier shipments. The company employs seven people. Employee 1 handles purchasing, collections, sales, auditing, accounting, and general administration; Employee 2 divides time among equipment repairs, warehousing, and sales; Employee 3 runs the city truck route; Employee 4 runs the country truck route; Employee 5, the owner and president, splits duties between outside sales and repairs; Employee 6 specializes in accounts receivable billing; Employee 7 handles accounts payable and general ledger and communicates with the firm's CPA. There is definitely no "dead wood" and very little idle time. Under current ownership since 1959, Mahany Welding Supply has enjoyed three decades of steady growth. The owner, who operates the business in a very conservative management style, like many small, family-run business owners has financial goals limited to just staying in the black from year to year. Nonetheless, there is a growing concern that certain parts of the company have been subsidizing other parts and that profits from some customers are subsidizing losses from others. Applying ABC principles to historical data (fiscal 1994 financials) was used to address these concerns so that the business owner actually could see the problems and evaluate ideas on how to correct them. Whether or not an ongoing ABC system meets the cost/benefit relationship necessary to implement as part of Mahany's computerized accounting system is another matter. In effect, historical data could be entered into spreadsheet templates on a regular basis to evaluate how improvements are doing. ANALYZING THE DATA Initially, some informal time studies were conducted, a task that was made difficult because everyone's position is cross functional and encompasses more than one job. Also, because of the chaotic nature of a small business, there is no set time to do a particular function such as 9:00 a.m.-10:00 a.m., purchasing; 10:00 a.m.-11:00 a.m., collections; and so on. It just doesn't work that way at Mahany Welding Supply, or at most small businesses, so the time studies in Table 1 are best estimates within the scope of this project. The next step was to identify possible causal relationships between the occurrence of costs and activities as well as the underlying drivers of the activities. Company functions were broken down into 15 activities, as discussed next. 
Selling. As shown by the time study, a large percentage of the employees' time is spent selling. In the case of the truck drivers, selling means time spent delivering. Mahany's drivers are driver/sales representatives, and a great deal of the company's success depends on the driver's charisma, professionalism, product knowledge, and salesmanship. It would be possible to break their time down further by splitting it into time on the road and time at customers' facilities, but not much would be gained given the scope of the project. Typically, the cost driver for selling is either gross sales, orders received, or number of sales calls.1 Notwithstanding, the time spent in selling was used for the allocation in this project. The company's labor expense is fixed, and salespeople spend their time on tasks they deem most important. There is no added salary expense for overtime, and there are no commissions. Using time spent as the cost driver helps to identify the nonselling activities that are performed by everyone. In addition, using time spent seemed to make the most sense for the purpose of pricing different customers. Purchasing. Purchasing typically uses a cost driver such as the number of purchase orders (POs) issued or the number of vendors. In this project and in regard to costing customers, the number of POs issued did not seem to have a causal relationship with individual groups of customers. Instead, the number of sales invoices was used on the theory that the more invoices a salesperson writes, the more products are being sold regardless of their dollar value, and thus more of the purchasing resource is being consumed. Collections. Historically, Mahany Welding Supply's level of collection activity has followed sales volume rather than the number of customer invoices. Because past-due receivables grow at the same rate as new receivables, sales dollars were chosen as the cost driver for collections. Auditing. All invoices are checked for accuracy of product part numbers before being posted to the accounts receivable/billing program. Invoices are made out by hand and then entered into the computer. The time spent auditing is directly proportional to the number of invoices processed. Thus, the number of invoices processed is the cost driver for auditing. Administration. The time spent on general administration doesn't seem to have a causal relationship with any cost driver; therefore, because of the relatively small dollar amount, administration costs were divided evenly across the five selling employees. Warehousing. Although warehousing and distribution costs are not always a part of ABC studies, managing warehousing costs is critical to the profitability of industrial distributors. There is no substitute for an accurate determination and practical allocation of these costs. The particular method of cost allocation depends on the company and its products, but proper costing by specific activity and allocation to products based on their unique storage and handling requirements are critical for effective warehouse management. 
At Mahany Welding Supply, warehousing essentially involves the activity of unloading freight trucks and putting away inventory. Employee 2 does nearly all of that, so the time study was fairly simple. Common cost drivers for warehousing include the number of incoming shipments, the number of line items on incoming shipments, forklift time, and storage space used. Again, because the extent of the project is on costing customers, sales dollars were chosen as the cost driver. This base is justified because nearly all types of customers use the same mix of products. There would be little if any benefit, and significantly more information collection cost, in allocating costs by space used, pounds received, or other volume-related measures. Order pulling. Order pulling often is combined with warehousing. It was treated separately and scrutinized carefully in this project because it is an area where resources were being wasted. As in the case of sales, selling time was chosen as the cost driver. In a larger and more specialized environment, the number of customer orders or line items, or even sales dollars, would be more appropriate. At this company these drivers didn't appear to have a causal relationship. The two truck drivers spend practically the same amount of time pulling their orders regardless of how many customers they are scheduled to visit. Billing. Employee 6 is a part-time employee. She specializes in accounts receivable/billing and is the sole person who posts customer transactions. Her labor expense, as well as postage and envelopes, are caused directly by the number of sales invoices she processes. Some invoices may have more line items than others, but to break down billing costs according to the line items would not pass the cost/benefit test. Although second or third notices often are sent out, only one billing per invoice was used in the calculation. Accounts payable/general ledger.Employee 7 is on a fixed salary. She pays bills, handles the general ledger, calls in the payroll, and corresponds with the CPA. Her activities could be broken down into fixed and variable costs. Bill paying is a variable cost and is based on the number of vendor invoices or the number of POs. The general ledger and all other functions are fixed general administration. The number of customer invoices was used for the cost driver under the assumption that the level of customer activity is related most clearly to Employee 7's workload. This base is somewhat arbitrary for lack of a causal factor. Advertising. Advertising consists primarily of advertising specialties such as pens, calendars, shirts, hats, and other small items with the company logo on them. The advertising budget is based loosely on last year's gross sales. These tokens are given out randomly to customers regardless of the size of their account. As sales increase so does the advertising specialty activity for the following year. Sales dollars are the best driver for advertising. Telephone. The telephone bill primarily is the cost of yellow pages advertising. Long distance calls are rare because most of Mahany's suppliers have 1-800 numbers. Telephone usage is allocated the same way as advertising...by sales dollars. Legal and accounting.No causal relationship can be determined for this expenditure category. Thus, these costs arbitrarily are allocated evenly across the five selling employees. Miscellaneous. Miscellaneous expenses seem to have a causal relationship with the level of sales volume. Sales dollars are used as the driver. Insurance. Insurance premiums are based, in part, on sales volume. Sales dollars are used as the driver. Rent and utilities.Rent and utilities can be allocated in a number of ways, including square footage used. Because of the homogeneous nature of Mahany Welding Supply's product mix and the layout of the facility, it wouldn't be practical to allocate on square footage. Sales dollars were chosen as the driver on the rationale that the more goods sold, the more strain they placed upon the facility. Although rent and utilities are not a variable cost, and a rise in sales will not affect the rent or the utilities, sales dollars merely are a convenient way to allocate these costs. DETERMINING THE RATES Once the activities and cost drivers are determined, charging rates can be computed. One activity not discussed was truck expense. Because of the emphasis on the cost of a customer, truck expense is allocated directly to each truck driver. The activities, bases, and computed rates are shown in Table 2. Now for the moment of truth. How much does it cost to service a customer? To start, the ABC cost allocation data were placed into a quasi-contribution margin income statement shown in Table 3. The statement reflects 1994 profit on sales based on individual salespeople, but it doesn't yet answer the four questions the project addressed initially. That is, how much does it cost to service Mahany's four types of customers? 
Information derived in Table 3 can be used to determine the cost to service walk-in customers, which are handled by Employee 1 and Employee 2: The cost to service an equipment repair customer creates a problem. The company's computer system has not been set up to separate and track invoices for repairs, so repair invoices (parts and labor) made out by Employee 2 and Employee 5 are buried in the general sales figures. Obviously, the data would be more informative if management separated out these costs. In the future the company will start tracking repairs separately so that the analysis will be more accurate. The walk-in customer calculation also will be more accurate when repair invoices are separated. The problem is a minimal one for this analysis given its purpose is to determine the cost of servicing a repair customer, i.e., calculating a labor rate. The amount of Employee 2's and Employee 5's total expenses divided by the amount of time they each spend on repairs determines their hourly rates. MANAGERS, NOT ABC, MAKE DECISIONS What do we do with the information now that we have it? First we must consider all the limitations that are a part of the calculations. In order for accounting data to be useful they must be reasonably accurate. Although the analysis is not exact, it is accurate enough so we can make some general conclusions. For one thing, it is eye-opening to see that company-wide net income of $58,079 included two employees' aggregate net loss of $56,237! As with most complicated business issues, it is best not to jump to conclusions. At first glance, Employee 5's numbers appear to be of great concern. But, Employee 5 is the owner of Mahany Welding Supply, enjoys working, and is easing into retirement. Instead of simply drawing a salary and playing golf, Employee 5 contributes substantially to the business. It is difficult to quantify the value of a company figurehead who has nearly 50 years of industry experience. Of more concern is the net loss for the country truck. Should we drop the country route? The calculations would suggest so, assuming they are accurate. But there are better solutions. The country route has been operated since 1946, and it seems foolish to abandon it without first trying to make it profitable. One factor to consider is that a fair amount of walk-in trade also is country route customers who might quit the company altogether if the route is dropped. Can we reshuffle the route so that it is more economical to run? Should we hire a salesperson to call on route customers? Should we impose a delivery charge, demand a minimum sales charge, or both? There are many ways that the country route could be made more profitable, or at least only a marginal loser. Before the route is dropped, a keep or drop analysis should be undertaken, taking into account the revenue and overhead that would be lost with the route's elimination. Perhaps the 80%/20% rule would penalize profitable route customers if we dropped it completely. Only through careful consideration and discussion by company staff can this decision be made. Now that we know how much it costs the company per hour for repairs, a desired level of profit can be added, and an hourly rate can be set with confidence. Actually sitting down and laying out an activity-based costing system for a real company is much more difficult than a typical textbook ABC problem. Determining what causes a cost to occur is much more difficult than it originally might seem. This project proved how important management support and adequate resources are to implement an ABC system properly. Some of the practical difficulties that we encountered include:
The ABC analysis indicated that 15 different activities caused costs to occur in the company. After identifying the activities, performing time studies, finding a causal link between activities and costs, computing allocation rates, and putting the data into a contribution margin format, the desired cost numbers were obtained. Even if this analysis were not refined and tried again, it still identified the costs of servicing different customers, which is the main reason the project was implemented. There is an old adage that says that 80% of your business comes from 20% of your customers. If this is true, it could mean that 80% of your resources are used to service 20% of your business. Is that 20% profitable? Probably not, and it could be dragging down the company. Is ABC only for companies that are under extreme competitive pressures or experiencing financial difficulties? Definitely not, for these companies obviously already are trying to come up with ideas and solutions. Companies that are doing well and think the good times will last forever are the ones that could get blindsided. This ABC study provided information that will help Mahany's managers make better decisions. The mechanics of an ABC system are straightforward, but a company intending to conduct an ABC study must be prepared to devote sufficient resources to it. People involved in the project must spend a great deal of time looking at what really drives costs in their business by observing activities, interviewing employees, and performing quantitative methods such as regression analysis. A company that doesn't commit the necessary resources is bound to be disappointed with the results. Michael Krupnicki, CMA, who is now president, was operations manager for Mahany Welding Supply, Rochester, N.Y., at the time the study was conducted. He also is an adjunct professor at Rochester Institute of Technology. He can be reached at (716) 271-0870. Thomas Tyson, Ph.D, CMA, is professor of accounting at St. John Fisher College, Rochester, N.Y. He can be reached at (716) 385-8431 or e-mail: tyson@sjfc.edu. Both authors are members of IMA's Rochester Chapter, through which this article was submitted. 1 Ronald J. Lewis, "Activity-Based Costing for Marketing," Management Accounting, November 1991, p. 34.
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