Customer, ProduCt, And Channel Profitability Analysis

Limitations of AggregateCalculationsHere gross margin is understood at asegment level, but because there islittle understanding of how overheadcosts are consumed by the business,this is known only as an aggregatesum. In this instance, therefore, it ispossible to calculate net profit only atan aggregate level, which is 8% in thetable above. Aggregate calculationsof profitability like this offer little in theway of information that would be usefulto managers seeking to make incisivebusiness decisions. The solution formany businesses is to apportion overhead costs across segments in anattempt to achieve greater insight.The table below shows the resultsof apportioning expenses to each customer segment based on the numberof accounts in each segment.Apportioning costs in this way is therefore unlikely to produce reliable results.A better approach is to allocate costsbased on the consumption of resources. This can be done only by first determining how customers (and productsand distribution channels) consumeactivities and then by understandinghow these, in turn, consume resources. The limitations of apportionmentbecome particularly apparent when oneconsiders shared services. A high percentage of the total cost base of manyorganizations resides in technology,infrastructure, and back-office functions. Apportioning such large amountsof expense using simplistic driverssuch as the number of accounts ortransactions is likely to result in grosserrors. This, in turn, could easily resultin erroneous and potentially costlydecisions. The only remedy is a moresophisticated approach to analyzingcosts, and this is where activity-basedcosting comes in.Here segment 1 is identified as havingthe highest net margin at 14%, whilesegment 2 is running at a 20% loss.Clearly, managers would use this information to make critical strategic decisions to maximize the opportunity insegment 1 and improve the situationin segment 2.This method of apportioning costs isnot necessarily wrong. For instance, ifcustomer behavior and cost to serveare identical in each segment, the allocation is satisfactory. However, this ishighly unlikely. In practice, customersin each segment are likely to exhibitdifferent behaviors that consumeresources and cost in different ways.For example, customers in segment 1may have twice the number of transactions as other customers and shouldincur a greater proportion of the totalcost.Example of Cost Apportionment Providing Customer Segment ProfitabilityCustomer SegmentNumber of accountsPercent of accountsRevenueCost of goods or servicesContributionGross marginApportioned overheadNet profitNet margin %TotalSegment 1Segment 2Segment 3300,000100% 12,000,000 7,800,000 4,200,00035% 3,200,000 1,000,0008%150,00050% 6,500,000 4,000,000 2,500,00038% 1,600,000 900,00014%60,00020% 1,200,000 800,000 400,00033% 640,000– 240,000–20%90,00030% 4,300,000 3,000,000 1,300,00030% 960,000 340,0008%SAP Thought Leadership – Customer, Product, and Channel Profitability Analysis7

Improving the Visibility of OrganizationalProfitabilityAchieve Deeper Insight with Cost andProfitability AnalyticsThrough an activity-based costingapproach, organizations are able toreliably and accurately calculate howproducts, customers, and channelsconsume activities, and how activitiesconsume resources and cost. Activitiescan be defined at the macro level (suchas direct-debit payment) or at a moredetailed level (such as counter paymentat a rural branch), recognizing thatcosts vary by product, by deliverychannel, and by geography and period.Figure 1 shows the basic cost flow inan activity-based costing model.Expense costs (from the general ledger) are assigned to activities to determine an activity cost rate. Activities areassigned to the “cost objects,” that is,the product, customer, channel, or other item being costed. These costobjects drive the consumption of activities (activity drivers), which, in turn,drive the consumption of corporateresources (resource drivers).By following this relatively simpleapproach, organizations can gain anaccurate understanding of how costsflow through a business and see theway in which they are allocated torespective cost objects. Profitabilitymeasurement is then simply a case ofbringing in revenue details to calculateprofitability by customer, product, channel, or another dimension.Resources and CostsResource DriversCostAssignmentActivitiesActivity DriversCostAssignmentCost ObjectsRevenuesProduct, customer, channel, andso onProfitabilityProduct, customer, channel, andso onFigure 1: Achieving Profitability Insight Using an Activity-Based Costing Approach8SAP Thought Leadership – Customer, Product, and Channel Profitability AnalysisOf course, reality is often more complex, and, in certain instances, it is necessary to reassign the cost of indirectactivities to direct activities. Similarly,indirect expenses incurred in one business area may be driven by demand inanother department. For example, hiring new staff in the sales departmentincurs HR costs and may requirereallocations.By applying an activity-based costingapproach to the example providedabove, it is possible to highlight thedifference between this and the apportionment method of costing alreadydescribed. In the previous table, overhead costs of 3.2 million are assignedto the specific activities that incur thesecosts; in the following table, theseactivities include sales calls, order processing, pick and pack, shipping, andcustomer service calls. Activity analysis in the organization has revealedactivity-unit rates as indicated in thetable, and these are incurred each timethe particular activity is performed. Theassigned activity cost is then calculatedas a simple function of multiplying theactivity-unit rate by the frequency ofactivity usage (activity driver). In thetable below, the cost for sales calls insegment 1 is determined by multiplyingthe activity-unit rate for a sales call( 10) by the number of sales callsmade (54,000) for an assigned salescall cost of 540,000. Once all activitycosts have been calculated by segment, they are summed to reveal theoverall assigned overhead cost by customer segment. This is then deductedfrom the contribution to reveal net profit for each segment.

More Precise View of Segment Profitability with Activity-Based Costing MethodologyCustomer SegmentActivity CostTotalSegment 1Segment 2Segment 3300,000100% 12,000,000 7,800,000 4,200,00035%150,00050% 6,500,000 4,000,000 2,500,00038%60,00020% 1,200,000 800,000 400,00033%90,00030% 4,300,000 3,000,000 1,300,00030%85,000 850,00054,000 540,0004,000 40,00027,000 270,00090,000 270,00060,000 180,00010,000 30,00020,000 60,00090,000 450,00060,000 300,00010,000 50,00020,000 100,00090,000 1,350,00060,000 900,00010,000 150,00020,000 300,00035,000 280,00026,000 208,0002,000 16,0007,000 56,000Total assigned overhead cost 3,200,000 2,128,000 286,000 786,000Net profit 1,000,000 372,000 114,000 514,0008%6%10%12%Number of accountsPercent of accountsRevenueCost of goods or servicesContributionGross marginOutbound sales calls at 10 per callNumber of sales callsAssigned cost for sales calls 10Order process at 3 each per orderNumber of ordersAssigned cost for order processing 3Pick and pack at 5 per orderNumber of ordersAssigned cost for pick and pack 5Shipping at 15 per orderNumber of ordersAssigned cost for shipping 15Customer service at 8 per callNumber of customer service callsAssigned cost for customer service 8Net margin %SAP Thought Leadership – Customer, Product, and Channel Profitability Analysis9

Reflecting What Is Actually HappeningUnderstand Exactly Where Costs AreIncurredThe results of this analysis lead toquite different profitability results foreach customer segment from thoseachieved through the apportionmentmethod (see the “Example of CostApportionment Providing CustomerSegment Profitability” table above).It is clearly evident from the net profitresults achieved that there is a dis crepancy between the apportionmentmethod of costing and an activitybased costing approach. With theapportionment method, customer segment 1 appears to be the most profitable, at 14% net margin, while segment2 is making a loss of 20%. However,with the activity-based costingapproach, the results are startlingly different. Here segment 3 is revealed asthe most profitable, at 12% net margin,while segment 1 is the least profitablewith 6%. As for segment 2, the lossmaker in the apportionment approach,a more accurate methodology showsthat this segment is running at a netprofit of 10%.But why is the difference so great?Simply because activity-based costingmore accurately reflects what is actually happening in the business andassigns costs based upon a greaterunderstanding of where those costs10SAP Thought Leadership – Customer, Product, and Channel Profitability Analysiswere incurred. In segment 2, the apportionment method drove costs to thissegment based upon the number ofcustomer accounts, without any consideration as to how those customersbehaved and how much of a drain theywere on company resources. In reality,this customer segment placed very little weight on the organization, requiringminimal account management; it had alower frequency of purchase ordersand needed far less customer support.Segment 1 customers, by contrast,proved to be a high-maintenance groupin all respects.In this organization, any managementdecisions made as a result of theapportionment methodology wouldbe based upon poor profitability dataand most likely would be wrong. Onlythrough the more accurate analysis ofprofitability would managers have thetrue business situation as well as reliable information on which to base theircritical business decisions.

Avoiding the Pitfalls of PoorCosting-Model DesignCascaded Versus Multidimensional Cost AllocationsIn the example already detailed, costanalysis has been performed using asingle-dimension view: customers. Ina more realistic multiproduct and multichannel environment, costs should beallocated to a combination of costobjects that realistically represents howcosts are incurred. It is essential, therefore, that costs be allocated to preciseintersections of customer, product,and channel dimensions. It is only sensible to use an activity-based costingapplication that has the functionalityto do this allocation in a single pass ofthe data. For this, a multidimensionalapproach is required. Software applications that do not allow single-step multidimensional allocations have to use acascade approach of allocating costssequentially to customer, product,channel, or other dimensions.A comparison between single-step andcascaded allocation is best achievedby way of example. In this instance,consider a customer support team inan airline, providing support for threetypes of customers: travel agents, corporate clients, and private individuals.The team supports three products:business class, cabin, and discount.The decision has been made to allocatecost of the activity “customer support”using the number of support callsreceived as the cost driver. The numberof calls is shown in the following table.The pressure to better manage costs and ensure thatall revenue growth is profitable has led many organizations to reassess the qualityof their cost and profitabilityreporting; the main focus isto provide business managers with reliable decisionsupport.Number of Customer Support Calls ravel SAP Thought Leadership – Customer, Product, and Channel Profitability Analysis11

If the cost of this activity is 100,000for the period under analysis, allocatingthis amount to each cost object (combination of customer and product dimensions) in a single-step multidimensionalapproach results in the costs detailedin the next table.Note that these cost results reflect thereality of the business situation in thatthe customer support team has neverdealt with any support requests fromprivate customers, and, as a result, nocost is allocated to this cost object.Consider, however, that the airline doesnot have access to a multidimensionalcosting engine and relies on a relational, cascade approach. In this case, twoseparate one-dimensional allocationsare typically performed. First, activitycosts are allocated to one dimension,products in this example. Results ofthis allocation are shown in the following table.Single-Step Multidimensional Allocation of Activity Costs to Cost ObjectsMultidimensional allocationSingle-step costingPRODUCTBusinessCabinDiscountTOTALTravel Agents 10,000 30,000 10,000 50,000(1,000/10,000)x 100,000CustomerCorporate 10,000 20,000 5,000 35,000Private 0 5,000 10,000 15,000TOTAL 20,000 55,000 25,000 100,000Step 1: Allocating Costs Across the Product DimensionCascaded allocationStep 1: Product 000)x 100,000CustomerTravel AgentsCorporateSAP Thought Leadership – Customer, Product, and Channel Profitability AnalysisPrivateTOTAL 20,000 55,000 25,000 100,000

The second step in the cascadeapproach is to allocate these productcosts to customers according to thetotal number of calls per customer. Thisgives final costing results as shown inthe next table.At the completion of step 2 in the cascaded allocation, the final outcome differs significantly from that achieved inthe single-step approach. Notably, thecascade approach shows that it costs 3,000 to provide customer support toprivate individuals, which is interestingbecause the company receives no callsfrom such customers. The results inother cells also vary dramatically – anderroneously.This simple costing exercise serves todemonstrate the wildly differing resultsthat can be achieved using the sameraw data in supporting single-stepmultidimensional and cascade costingapproaches. Imagine the huge variationin results that would be achieved ifadditional dimensions also requirecosting. The cumulative effect of errorsin the cascade approach could be significant, producing grossly unreliablecosting results that could lead managers to make erroneous and inappropriate business decisions.Many homegrown spreadsheet-basedapproaches to activity-based costinghave to rely on a cascade approachowing to the relational nature ofspreadsheet data. Such approachesare likely to result in exceptionally largeand complex spreadsheets, which arehard enough to create, let alone toupdate and change. Forgetting theimplications of a cascade costingapproach for a moment, one minorerror in a cell calculation, macro, ordata input would render such spreadsheet calculations useless. Whileappealing in terms of system cost andavailability, a spreadsheet approach toactivity-based costing is not scalable,reliable, or maintainable.Most packaged solutions using a cascade approach recognize their limitations and provide workarounds to thisproblem, usually creating pseudo costobjects by combining every combination of product, customer, and channel.However, such workarounds generallyproduce extremely large models thatare laborious and costly to maintain andgenerate results that are difficult tointerpret.Step 2: Allocating Costs to the Customer DimensionCascaded allocationStep 2: Customer 0)x 20,000CustomerTravel Agents 10,000 27,500 12,500 50,000Corporate 7,000 19,250 8,750 35,000Private 3,000 8,250 3,750 15,000TOTAL 20,000 55,000 25,000 100,000SAP Thought Leadership – Customer, Product, and Channel Profitability Analysis13

Assignment Methodologies for CostingModelsGain a More Detailed and Accurate PictureThe only sensible approach for costingacross multiple dimensions of a business is to use a single-step multidimensional approach that produces accurateand reliable business information throughmodels that are easy to build and maintain on an ongoing basis.Using the Most AppropriateAssignment MethodologyAny activity-based costing model wouldneed to contain a number of differentassignment methodologies – that is,the means by which costs are assignedthrough the model to their respectivecost objects, such as products, customers, and channels. This makes itpossible to construct cost models thatmore accurately reflect the differingpatterns of cost consumption in a business. The primary assignment methodologies are described below. Keep inmind that the best practice is to usewhichever methodology is most appropriate to a particular activity anddepartment and to make use of anyreliable data already collected andstored in enterprise systems.Ideally, through choosing an appropriate assignment methodology, it shouldalways be possible to reconcile thetotal expenses assigned with the sumof the object costs calculated. However, sometimes it is necessary for organizations to resort to estimates andapproximations when constructingcosting models as some of the requiredmodel driver (activity or resource driver) information simply isn’t available in14business systems. In such cases, management experience and best judgmentare called upon so that the most appropriate allocation of cost may be made.For example, in a sales organization theresource driver for “account management” may be identified as an estimateof management time in performing thisactivity, and an allocation methodbased upon this estimate may be usedin the model. By comparison, the calltime information for “technical support” may be readily available in existing call management software, and amore precise assignment methodologymay be used. Whether they are basedon driver estimates or on accurate datafrom software, such costing modelsare likely to produce a much moredetailed and accurate picture of coststhan could be achieved if an apportionment method were used.Time SplitsTime splits are the easiest activitybased costing methodology to understand. When departmental expensesare assigned to activities, time splitsare frequently used as a resource driver. Managers are surveyed to ascertainwhat proportion of time is spent on different activities. Time splits are thenused to allocate expenses to activities.Costing with time splits is a straightforward process requiring little data otherthan the general ledger and the time ittakes to interview and collect data fromeach responsibility center. As a result,this method is frequently used for pilotSAP Thought Leadership – Customer, Product, and Channel Profitability Analysisstudies where the imperative is to deliver early results to the business, prior torefining methodologies and addingrefinements to models. Time splits stillremain the main assignment methodology in departments that do not carryout highly repetitive activities, such asmarketing and support functions.Previously, one practical issue of thisapproach concerned the capture of thenonsystem driver data needed to runtime-split costing models, which oftenproved an onerous and time-consumingactivity as

This paper describes how the sap Businessobjects profitability and cost management application leverag-es activity-based costing as the foun-dation for robust customer, product, and channel profitability analysis; how best to utilize various methodologies; and what represents b