Manufacturing Masters Its ABCs

Manufacturing Masters Its ABCs; Activity-based costing can help boost profits

Hugh Filman in Toronto. Business Week. New York: August 7, 2000. , Iss. 3693; pg. 86J

Abstract (Summary)
In early 1999, when managers at Alcoa Inc.'s metal-forging plant in Cleveland foresaw a downturn in the aviation sector, one of their key markets, they needed to figure out which of their aircraft products were pulling in the most profits. Alcoa's solution has been a cost-assessment system known as activity-based costing. This analytical approach has been compared to splitting the bill at a restaurant. Where traditional accounting divides the bill evenly between all diners, ABC determines who had the T-bone and who had the burger.

In the high-tech world of aerospace manufacturing, where a few products can account for most of a factory's output, a bad production decision can cause trouble for years down the road. So in early 1999, when managers at Alcoa Inc.'s metal-forging plant in Cleveland foresaw a downturn in the aviation sector, one of their key markets, they needed to figure out which of their aircraft products were pulling in the most profits. The plant's complex processes, varied output, and long product cycles made it tough to determine which lines produced the highest fixed overhead costs. With three- to five-year commitments, ``We had to make sure that we could make money on products,'' says Jeffrey A. Weeks, the plant's aerospace business analyst.

Alcoa's solution has been a cost-assessment system known as activity-based costing, or ABC. This analytical approach breaks down all activities in a manufacturing plant and determines the portion of overhead used to make each product. It's like splitting the bill at a restaurant, says Anthony A. Atkinson, a professor of accountancy at Canada's University of Waterloo. Where traditional accounting divides the bill evenly between all the diners, ABC determines who had the T-bone and who had the burger.

Pittsburgh-based Alcoa isn't the only one learning the ABCs of ABC. Once an arcane research topic, this approach is now the focus of intense study by hundreds of manufacturers. Thanks to the falling cost of computing power, even small companies now have access to powerful ABC software tools. These programs also dovetail nicely with so-called enterprise resource planning software--popular programs that coordinate the flow of data throughout a whole corporation. The ABC approach makes possible far more detailed factory management schemes, giving rise to yet another buzzword: activity-based management (ABM). According to Robert S. Kaplan, one of two Harvard business school professors who popularized the system, this amounts to a thorough reexamination of a whole business--process improvements, customer relationships, budgeting--based on what you learn by using ABC.

With the cost of every product in clear view, managers can perform once-impossible analytical feats. Suddenly, they can understand how scarce funds may have been misapportioned, or how a formerly marginal customer may in fact be a profit spinner. Alcoa employed ABC to capture indirect costs such as machine set-ups, quality control, and packing and shipping. After crunching this sort of information in ABC software developed by Hyperion Solutions Corp. in Sunnyvale, Calif., Alcoa is beginning to make smarter production decisions. Managers can now ask: ``Do we want to be in a line of business, or a particular product line, or do we want to sell off certain assets?'' says Weeks. And while Alcoa is still assessing the complex conclusions of its ABC self-study, it is already using the results to rejigger its prices.

``WHAT IF?'' Companies are also using activity-based management to learn more about each customer's value. With more manufacturers offering highly tailored products, determining the costs of different packages and servicing requirements for customers can be tricky. To help, Hyperion and other providers of ABM applications offer ``what if'' analyses of pricing and production scenarios.

The results can be surprising. One U.S. sports shoemaker, for example, wanted to shift sales from high-volume, low-margin megastores to smaller stores that bought less and paid more, notes Derek Sandison, a vice-president at Hyperion. But the what-if analysis showed the bigger outlets were more profitable. ``Even though the megastores were getting a lower price [from shoppers], they were shipping truckloads,'' says Sandison. In this case, the cost of dealing with small shops--higher numbers of deliveries and more frequent late payments--offset the higher prices they were willing to pay.

Despite its benefits, activity-based costing and management are not for everyone. ``If a manufacturing company has one product and one customer, then I could cost that on the back of an envelope,'' says Hyperion's Sandison. Even for big diversified companies, these programs may be too pricey to implement and maintain. A pilot project can cost from $100,000 to $500,000 for software and consulting, depending on the size, says Jeffrey M. Aldridge, partner in charge of the performance management program at Grant Thornton International in Chicago.


Nonetheless, Aldridge argues that an activity-based management system can generate $3 in savings for every $1 that a company invests. So for manufacturers who must grapple with complex processing operations and a range of products, learning the basics of ABC and ABM may be just what the doctor ordered.