HOW ABC (ACTIVITY-BASED COSTING) CAN BE USED BY 3PL COMPANIES FOR PRICING PROFITABILITY

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1 HOW ABC (ACTIVITY-BASED COSTING) CAN BE USED BY 3PL COMPANIES FOR PRICING PROFITABILITY A. Tassovali Business Administration CITY Liberal Studies Affiliated Institution of the University of Sheffield Thessaloniki, Greece Ch. Salikiriaki Logistics Manager Sindos S.A. Warehousing-Logistics Thessaloniki, Greece P. Ketikidis Vice Principal CITY Liberal Studies Affiliated Institution of the University of Sheffield Thessaloniki, Greece ABSTRACT: In logistics management there is lack of accurate cost within the supply chain. In order to overcome this problem, companies shifted from traditional accounting systems to activity-based costing (ABC). Moreover, focusing on the pipeline, there is a need for the design of a logistics-oriented costing system. The particular paper constitutes an implementation of activity-based costing in a 3PL company and particularly in the warehouse. The aim of the study was to create an ABC model. The company used the model first to calculate how much each customer costs and second for quoting to prospective customers. This model was not only a tool for pricing and costing purposes but also a tool for the improvement of processes. The company using the process map and the model was able to find areas for improvement. The successful implementation of ABC was the impetus for the implementation of ABC in other areas within the company. Moreover, the accurate costing system was a competitive advantage for the company, as the company, knowing its costs and its profit margin, was able to negotiate with customers more efficiently. Furthermore, the ABC information could be used for customer profitability analysis and can be also used for budgeting, as the company will be able to know its resource requirements according to the period of time it is used. The paper will provide an outline of our approach for developing the model by indicating the implementation steps. According to our framework, the activities performed in the warehouse were defined by means of observations and interviews; cost data were gathered and were assigned activities by means of cost drivers. Next, a data analysis was performed, as well as a what-if analysis. Difficulties that arose during implementation are also discussed, as well as the way they were handled. Keywords: Activity-based costing, Third-party companies, Methodology, Implementation. INTRODUCTION This study deals with a problem, which has attracted the attention of many organisations in the last decades either in the manufacturing or in the service sector. The problem is that companies are unaware of the profitability of their products or services, as well as who of their customers are profitable and who are not [11], and how various customers affect the bottom line of the business, [16]. This awareness of profitability affects adversely the companies survival and growth [7]. There are cases where companies were really surprised when they found out that customers, supposed to be profitable, were unprofitable [9]. Companies recognise that they do not make profit and they are not able to take correct decisions, since they are unaware of what is the cause of losing money [18].

2 The growth of third-party logistics (3PL) companies has generated the need for an accurate costing system, in order to prevent distortion of the information produced by traditional costing systems [11]. Furthermore, the competition between these companies generated the need for more accurate financial and non-financial information, in order for them to gain an insight in logistics activities, and either eliminate unprofitable activities or improve or reengineer others [17], which in turn results in lower costs and more competitive prices [12]. Implementation of activity-based costing (ABC) in 3PL companies is a powerful tool for pricing, since the providers are not forced to offer overpriced services in order to be protected from losing money because they are unaware of the true cost of each service [18]. Besides, for these companies, as well as for all service companies, it is important for the managers to know the cost of services offered to various types of customers or at different stages within the supply chain. Moreover, these companies need to know the cost of each customer separately in order to be aware of their profits [3]. The study was conducted in SINDOS SA company, a third party logistics (3PL) company, which is located in the industrial area Sindos of Thessaloniki. The company is a 100% subsidiary company of PROODOS SA, one of the leading international transport companies in Greece, which is also a member of the worldwide organisation Kuehne & Nagel. SINDOS SA was established in The operational work started on August at its own estate of m 2 in the industrial area of Sindos. The company has a turnover of about 3 million Euros and about 50 employees. The building of SINDOS SA consists of a m 2 warehouse and offices that occupy about 2000 m 2, and with its own train connection. The company is currently working on the implementation of the first established strategies on the way to attaining the ultimate objectives. SINDOS SA offers several services such as control of expiring dates and lot number, planning and ordering for replacement of stock, handling of returned goods, cross docking, paperless picking, physical inventory taking, distribution, labelling, unpacking, information technology, cash on delivery (C.O.D), issue of documents, printing of guarantee cards for electric appliances, and issue of customer invoices. GOALS OF THE STUDY The aim of the study was to design and implement an ABC model for the 3PL company SINDOS SA and test it for a major customer. In order the aim to be achieved, first an investigation into the current costing system, as well as an identification of problems in the current costing system, was necessary. A further concern was to investigate why the organisation introduces the application of ABC. Furthermore, techniques for the application of ABC were identified, as well as how the process for the application of ABC would evolve. An additional concern was to investigate how the effectiveness of ABC would be measured, and, to that end, suitable effectiveness criteria for that application were established, in order to describe the extent to which the implementation of ABC had proved effective. It was also important for the management to know what benefits the company could have from the application of ABC and how the effectiveness of ABC can be accounted for. Another concern was whether the application of ABC would provide information to formulate the pricing strategies. The establishment of criteria for a continuous following up and controlling of the warehousing projects was also considered to be necessary. A what-if analysis helped in identifying opportunities for cost reduction. In order the ABC model to be tested, a major customer was determined. Furthermore, the following questions were important for the management to be answered: which of the services and customers are profitable or not, what drives cost within the organisation and what inefficiencies exist within the organisation.

3 METHODOLOGY The model is developed in two phases: the first phase refers to the understanding of the problem, the establishment of ABC techniques and the preparation of a cost flow diagram, while the second phase refers to the application of the gathered data and the cost model into the software. In order for ABC to be implemented in the company, techniques for ABC application, found in the literature, were used (Figure 1). According to Brimson [1], the first step in designing an ABC model is to define the aim for which ABC should be implemented. More specifically, the definition of the aim reflects the problem that must be solved. In the particular company there was dissatisfaction with the current costing system and a feeling that it was inaccurate. In this term, ABC could yield more accurate information as far as the profitability of services and customers is concerned. The next step was to define the areas of the organisation in which ABC would be implemented. Since ABC served as a pilot program, the warehouse was considered to be the most appropriate area in the company to start the ABC implementation, since there was a strong feeling of cost inaccuracy for this area. Once the place had been defined, objectives came next. Objectives restated the problem and determined directions to proceed with the research, while the research questions that followed constituted a more comprehensive picture of the problem and indicated what should be researched and what kind of research should be conducted in order for a solution to be reached [5]. In order to proceed with the project, information on activities, customers, resources and services was necessary. For this purpose, techniques found in the literature have been selected. The data gathered were used for defining activities, preparing a process map, determining cost drivers and estimating the cost of each process. The most appropriate methods for implementing an ABC model found in literature are interviews, questionnaires, observations and financial reporting and statistics data [2];[19]. Except for questionnaires, the aforementioned techniques were used for the particular study. Interviews were taken from the logistics manager, the warehouses supervisor, the warehouse managers, the information technology manager, the data entry staff, and the financial manager individually and in their own workplace. Interviews were taken twice, since new insights arose during the research. The answers from the interviews were used to define activities as well as cost drivers, to prepare process flow charts indicating the relationship among various activities, and to clarify the relationship between resources and activities and thus to help in assigning direct and indirect costs to activities and processes. Observations were selected in order to obtain information about the work done, the manner in which the activities are performed, and the time spent on each activity [10]. Observation was used partly as a follow-up to the interview, since interviews were used to identify activities and to classify them as main and subactivities [8]. Observation has also been selected because it is a primary source of data and constitutes relatively unbiased data, as they are a record of what the researcher observes [5]. In this way, data is recorded the time it occurs and the observations are performed in the warehouse, which is the natural environment for the activities. For assigning resources to various processes, data concerning the cost of those resources was essential. The source of those data was the general ledger, the profit and loss statement per cost/profit centre, the fixed asset register, as well as customer statistics output/transactions data. As far as the accounting data is concerned, it was important to convert all data in an activity basis so that they could be further used. Once the necessary data had been collected, the next step was the definition of activities. This stage was one of the most difficult ones, since the definition of activities was done for the first time, and on it should be so detailed as to facilitate the whole process and to be aligned with the objectives. This stage lasted several months. A helpful tool in this step was

4 the process flow chart, which clarified which activities are performed in the warehouse and how. Rationalisation of activities was necessary in order for the number and type of activities to offer the appropriate information and to facilitate the whole process. Then activities were classified as primary and secondary, so that the cost of secondary activities could be assigned to primary activities. Finally, primary activities were compiled and depicted in a list. Based on gathered data and once activity analysis was completed, cost drivers were defined [15]. The selection of cost drivers was done in such a way, that each cost driver represents resource consumption and a cause-and-effect relationship. Moreover, the number of cost drivers was selected carefully, since a small number of cost drivers could lead to cost distortion, while many cost drivers could render the system very complex. According to the ABC techniques, first-stage drivers were determined, in order to accumulate the indirect cost as well as second-stage cost drivers, which were actually activity measures. Furthermore, since many activities are not correlated directly to other activities but they support the whole organisation, their distribution bases were carefully selected, in order for any error to be minimised. The availability of necessary data was a key factor in selecting cost drivers. First, a list of cost drivers was prepared and next, the final cost drivers were selected, according to the available data, as well as to the feature of cost drivers as volume-sensitive. Once cost drivers selection was completed, the next most important step in the implementation of ABC was a design of a cost accumulation and distribution model (Figure 2), [13]. In this term, the model is an internal mechanism that indicates the flow of cost among the activities, the accumulation of cost in activities and finally the assignment of cost to the final cost objects, which are actually the services. This model was a two-stage one, where the costs were first accumulated to the activity centres and next the cumulative cost was reassigned to the processes. What was important in the design of the model was to achieve accuracy and not precise calculations with irrelevant cost assignment [4];[15]. Thus, the techniques for data selection were very helpful in this step, since they indicated the linkages between activities and cost. Moreover, through the activity analysis, overhead costs were isolated first to activity centres in a cause-and-effect relationship, so that, even if second-stage cost drivers were not the appropriate ones, the possibility of a wrong accumulation on processes would be less than on the first stage. Up to this point, the first phase of the design and implementation of an ABC model had been completed. According to the cost flow model, the gathered data were inserted into a spreadsheet for the starting of the calculations. Calculations for assigning cost to processes were based on resource conversion tables, where each activity output measure was converted in operating time. This operating time is actually the average time needed for each activity to be performed and it was taken from time measurements. This way, each process was first charged with a direct cost. As far as overhead costs are concerned, they were first assigned to the activity centres using various distribution bases. Once this stage had been completed, the overhead costs were assigned to processes. To assign overhead costs either to activity centres or to the processes, a comprehensive activity analysis was necessary since overhead costs were, up to this point, arbitrarily allocated to departments with the current costing system. Thus, some overhead costs had not been assigned to the warehouse while others were assigned at different rates than in the current costing system. Once the calculations had been completed, each process was charged with a cost, and a profitability analysis for the major customer was already available. The implementation of the model followed with a regression analysis, since regression analysis is the part of the method, which indicates the correlation between the selected cost drivers and the resource consumption [10];[15]. The correlation between the variables indicated whether the company could reduce costs without affecting the effectiveness of the processes. A powerful

5 complementary tool to activity-based costing is a what-if analysis [13], where the company using the activity-based information and examining different situations is able to see how the changes affect the bottom line. Finally, a comparison with the current costing system was necessary to indicate the benefits the company could obtain from the implementation of ABC. FINDINGS AND DISCUSSION Two activity centres were defined within the warehouse: warehousing and storage. The selection of two activity centres within the warehouse was done with the aim of calculating the cost for the two services offered to customer separately, since the price charged to the customer is different for these two services. Thus, these activity centres included all services offered to the customer concerning the warehouse, such as unloading, storage, replenishments, inventory, picking, loading. From these services unloading, picking and loading are included in warehousing while storage, replenishments and inventory are included in the activity centre storage. As far as the customer s products are concerned, two types of products were defined for the major customer: assortment 1 and 2, where assortment 1 includes items of great volume, while assortment 2 includes items of small volume. The subactivities included in the main activities were almost the same for the two categories of products. Assortment 2 includes a value-added service, which is putting instructions before loading. The tables below indicate the activities for assortment 1 and 2, as well as the cost driver for each activity for the activity centre warehousing. Goods in Nr. Activity Cost driver 1. Receiving goods Number of delivery notes 2. Vehicle unloading/goods putting away Number of pieces unloaded 3. Goods in inspecting Number of receiving reports 4. Recording goods received Number of line items per shipment in 5. Supervision for the whole process Table 1 Goods in Determination of Cost Drivers Picking Nr. Activity Cost driver 1. Customer order processing Number of customer orders 2. Picking assortment 1 Number of goods picked 3. Picking assortment 2 Number of goods picked 4. Inspecting quantities and SKU's Number of goods picked 5. Putting instructions Number of instructions Table 2 Picking Determination of Cost Drivers Goods out Nr. Process Cost driver 1. Loading Number of pieces loaded 2. Loading processing Number of delivery notes issued 3. Supervision for the whole process Table 3 Goods out Determination of Cost Drivers

6 As mentioned earlier the process flow chart indicated the relationship among various activities. It was surprising, how helpful this map was from the first steps of ABC implementation. It gave a clear picture of the way activities are performed and thus contributed to changes earlier than expected. This happened because the management realised that activities, which create value to customers, were not performed effectively. This change also contributed to the rationalisation of activities. Tables indicating the manpower demand and supply were prepared, based on time measurements and on the activity analysis. The manpower capacity table indicated that there was excess capacity, which was not actually real, since the employees worked exclusively not only for the major customer but also for two other customers. Furthermore, these tables offered such information that could be used for capacity planning and changes in operations. Since the company charges the customer with a single price for unloading, picking and loading, the sum of the cost of these three processes would give the cost of the unloading/loading service offered. The prices are given to the customer in pieces for unloading/loading and square meter for storage. Thus it was important to calculate the cost for each piece and square meter. It was surprising to find out that the company operates at a loss for assortment 1 concerning warehousing and storage while assortment 2 was profitable. This difference in profitability between the two products categories is due to the same price used for charging the customer for all services, without taking into account that the two types consume different resources. Moreover, the comparison between the current costing system and the ABC model indicated that profitable processes with the current costing system proved to be unprofitable with ABC. Thus the calculation for the total profitability of warehousing, including goods in/out, indicated that the customer is not profitable, whilst as far as storage is concerned, the profitability analysis indicated that the customer is profitable for both systems; but the profitability percentage is quite different due to the loss of the assortment 1 with ABC. The results stimulated the management to rethink its pricing policy and to search for solutions in order to cover the loss. More specifically, ABC revealed what drives cost within the company, the relationship among activities, the relationship between activities and cost, the profitability of processes and customers. The management understood that ABC is not a solution but a tool. If this tool can be used rationally it can reveal areas within a company where changes are necessary for its survival and growth. Moreover, the management can achieve better solutions if it combines the ABC information with other information such as marketing information. In this case the management is aware of the market condition and, at the same time, it is aware of the situation internally. This helps the company to meet both the organisation requirement and customer requirements by offering more effective and efficient services. The regression analysis indicated that the coefficient of correlation was about 0.63 for each process, which indicated a strong correlation. This in turn validated the selection of some cost drivers and indicated that the company could affect its direct cost, without affecting the effectiveness of the processes. The what-if analysis was conducted in the ABC spreadsheet, where some components that were changed culminated in a different result each time. This availability of examining different scenarios allowed the company to calculate its cost and profit. That analysis was very useful since the company could choose among different options, in order to be more effective and efficient.

7 IMPLEMENTATION CONSIDERATIONS In order to determine the extent to which ABC has proved effective, effectiveness criteria were defined [4]. Such criteria included the extent to which the staff started to think in ABC terms, became familiar with ABC terminology, the starting of a second ABC pilot program, the development of the company s information system, a request for ABC training, an increase of the number of ABC users, a request for customising ABC spreadsheet, higher profitability of services, better knowledge of the resources consumed for each service, and decision making based on ABC. During the implementation of ABC the staff familiarised itself with ABC terminology and became aware of ABC as a concept. This was done through interviews, which proved to serve a twofold aim: data necessary for the implementation of ABC were gathered and the interviewee had the opportunity to ask and learn about ABC. After the first implementation of ABC, another pilot program started for the rest of the customers. To run the new pilot program there was a request for training of users within the company. Since the necessary data were not available, a new software database was designed for this purpose. The spreadsheet design for the implementation of ABC was customised to the requirements and circumstances of the particular company. As mentioned earlier, ABC had worked as a pilot program for the company. Thus difficulties were inherent in a project of this type. The major difficulty was the lack of the necessary data. Thus some assumptions were necessary in order to proceed with the project. Moreover, historical data had been used since collection of up-to date was time consuming. As far as overhead costs are concerned, it was difficult to assign them on the activity centres and on the processes since the structure of the chart of account and the general ledger was not very helpful. Much time was consumed on the analysis of activities and customers related to overhead costs. Thus it was very important for the first phase of the model to be well prepared in order for the processed data to yield meaningful results [4]. The difficulties that arose indicated that there are some key factors that must be taken into account before deciding on the implementation of ABC. Such factors are: Clear objectives, as well as how the process will evolve A clear definition of the problem faced by the company is very important and prevents, to an extent, the failure of the ABC implementation. Thus, the ABC team should be aware of what it must do and how. Support from the top management Support from the top management plays a key role, since the coordination of different departments may not be possible, if the top management do not render the application of ABC necessary. Moreover, ABC results contribute to decision-making. If the results are useless for the management and the top management is not prepared to change strategies, if necessary, there is no sense in ABC implementation. Involvement of the employees The implementation of ABC requires much data and time. If one of those or both are not available due to resistance of employees or due to their limited time the application is adversely affected. Availability of data The decision taken by the management on the implementation of ABC and the willingness to apply ABC are not enough. If there are not available data, the results may be the same as in the traditional costing system. Availability of time Defining activities, cost drivers, gathering data and processing them is a time consuming process. If there is a limited time either from the ABC team or the employees or the management, the result will probably not be the desired one.

8 ABC model The ABC model itself, as a mechanism, plays an important role in the successful implementation of ABC. Thus, if the model is too simple, it is not accurate enough, while when it is complicated it may require much time and data and finally lead to a system that yields more information than required. Software The company can choose among different software tools. This could be a spreadsheet, a specialized ABC tool, OLAP (on-line analytical processors), ERP (enterprise resource planning) [14]. Whatever the company chooses, it should facilitate the whole process. BENEFITS OF IMPLEMENTATION The scope of the study at hand was to design and implement an ABC model. This was expected to be a tool for pricing. Indeed, the company used the model first to calculate how much each customer costs based on the services offered, and second for quoting to prospective customers. Moreover, through the activity analysis, the company found out what kind of value-added services it offers to each customer and how much each one costs. Based on this, the company established a new pricing policy. Moreover, the accurate costing system is a competitive advantage for the company, since the company, knowing its costs and profit margin, is able to negotiate with customers more efficiently. Furthermore, the ABC information is used for classifying customers into categories based on various criteria [6]. Another important benefit is that the company can control its costs, since the management know what drives cost within the company. This model is not only a tool for pricing and costing purposes but also a tool for the improvement of processes [8]. The company, by using the process map and the model, can find areas for improvement. Thus ABC is the basis for reengineering processes, which allow cost reduction, while the effectiveness of processes remains stable or even improves. The knowledge of what drives cost within the company and the extent to which cost components affect other cost components, in combination with the customer profitability analysis is an advantage for the company against competition. Having all this information, the company can choose to loose money in some cases, if market prices must be used, and to align its pricing strategies according to its aim. The successful implementation of ABC is the impetus for its application in other areas within the company. As mentioned earlier, historical data were used for the design of the ABC model. However, those data gave a new insight in the cause of costs. The usefulness of the ABC model will become more tangible as it will include up-to-date information and will be linked to monthly reporting in the near future. This renders the model appropriate for decision-making. Moreover, this ABC model will also be used for budgeting, since ΑΒC enables the company to know its resource requirements according to the period of time it is used [2]. More specifically, the company is able to plan its future strategies based on activities that support these strategies. CONCLUSIONS This paper constituted a framework for the implementation of ABC in a particular 3PL company. Some considerations and findings can be generalized for companies of this kind. Other factors are unique for each company and must be examined and taken into account for a decision on ABC implementation. Furthermore, the implementation of ABC indicated that services have a different cost according to the resources they consume. This was a very helpful tool for the company, since the company charged the customer the same price for different types of products with

9 different costs of services. Thus, by knowing its cost the company is able now to choose whether it will change its pricing policy. ABC has worked for the particular company as a pilot program. Up to the point of ABC implementation nothing was done to improve accuracy of the current costing system or to reengineer processes. The implementation of ABC as an experience and the difficulties that arose indicated areas for improvement and it was a first step for changing attitudes and policies. Moreover, the top management acknowledged that ABC can be used for strategic as well as for operational decisions. REFERENCES [1] Brimson, J.A. (1991). Activity accounting an activity-based costing approach, New York: John Wiley & Sons, Inc. [2] Brimson, J.A. & Antos J. (1999). Driving Value Using Activity-Based Budgeting. New York: John Wiley & Sons, Inc. [3] Christopher, M. (1998). Logistics and Supply Chain Management Strategies for Reducing Cost and Improving Service. Second edition. London: Prentice Hall [4] Cokins, G. (1996). Activity-based cost management making it work a manager s guide to implementing and sustaining an effective ABC system, Boston: McGraw-Hill [5] Cooper, D.R., & Schindler, P.S. (editors). (1998). Business Research Methods. Singapore: Mc-Graw-Hill International Editions. [6] Daly, J.L. (2002). Pricing for Profitability Activity-Base Pricing for Competitive Advantage John Wiley & Sons, Inc. New York [7] Esculier, G.G. (1997). Using improper costing methods may lead to losses, The TQM Magazine, 9, [8] Forrest, E. (1996). Activity-Based Management A Comprehensive Implementation Guide Boston: McGraw Hill [9] Gering, M. (1999)., Activity-based costing and the customer, Management Accounting: Magazine for Chartered Management Accountans,77,26-27 [10] Glad, E. & Becker, H. (1997). Activity-based costing and management. Chichester: John Wiley & Sons [11] Griful-Miquela, C. (2001). Activity-Based Costing Methodology for Third-Party Logistics Companies, International Advances in Economic Research,7, [12] Gunasekaran, A., Marri, H.B. & Grieve, R.J. (1999). Justification and implementation of activity based costing in small and medium-sized enterprises, Logistics Information Management, 12, [13] Hicks, D.T. ( 1999). Activity-Based Costing Making It Work for Small and Mid-Sized Companies, New York: John Wiley & Sons, Inc. second edition [14] Nair, M. (1999). Activity-Based Information Systems An Executive s Guide to Implementation. New York: John Wiley & Sons, Inc. [15] O Guin M.C. (1991). The Complete Guide to Activity-Based Costing New York: Prentice Hall [16] Plowman, B. (1997). The cost of the customer, The TQM Magazine, 9, [17] Pohlen, T. & La Londe, B.J., (1994). Implementing activity-based costing (ABC) in logistics, Journal of Business Logistics,15, 1-23 [18] Richardson, H. (2000). The New Shape of ABC, Transportation & Distribution, 41, [19] Turney, P.B.B. (1991). Common Cents The ABC Performance Breakthrough Portland: Cost Technology