Strategic Activity-Based

Management:
Product Mix and Pricing
Strategic Activity-Based
Management

 Strategic ABM works by shifting the mix of

activities away from costly and unprofitable
applications to more profitable ones.
Strategic Activity-Based
Management -Decisions

 Product mix and pricing

 Customer relationships
 Supplier selection and relationships
 Product design and development
Cumulative Sales Curve

Cumulative % of Sales
120%

100%

80%

60%

40%

20%

0%
0% 20% 40% 60% 80% 100% 120%

Cumulative Percentage of Products

Cumulative Sales Curve

120%

100%
Cum ulative Percent of Sales

80%

60%

40%

20%

0%
0% 20% 40% 60% 80% 100% 120%
Cumulative % of Products
ABC Product Profitability

 Cumulative sales curve

 The normal 20-80 rule.
 The highest volume 20% of products generate
about 80% of sales.
ABC Product Profitability

 60-99 rule.
 The highest-volume 60% of products generate
99% of sales.
 The lowest-volume 40% of products generate a
cumulative total of 1% of sales.
Traditional Direct Labor- Costing
System

 Generally report that all these low-volume

products are profitable since pricing is based
on a normal markup over standard costs.
ABC Product Profitability:
The Whale Curve

 ABC analysis will generally show that after

assigning accurately the cost of activities such
as
 setup, purchasing, quality assurance, inventory
management and product support
 Many products are extremely unprofitable
Cumulative Profitability
Whale Curve

350%
300%
Cumulative Profits

250%
200%
Series1
150%
100%
50%
0%
0% 50% 100% 150%
Product Profitability
ABC Analysis: Whale Curve

 Cumulative Profitability
 The most profitable 20% of products can
generate about 300% of profits
 The remaining 80% of products either are
breakeven or loss items
 Collectively they lose 200% of profits, leaving
the division with its 100% of profits
ABC Analysis: Whale Curve
Cumulative profitability vs Cumulative sales volume

The profitable products(20%) generate 80% of

sales and 300% of the unit’s profits.
 The hump of the whale indicates the profits
earned by the business unit’s most profitable
products.
 The remaining products generate 20% of sales
and lose 200% of the units profits.
ABC Analysis: Product Profitability

 The cost of high-volume products are relative

unchanged by the shift from traditional to ABC.
 Traditional and ABC profit margins for high
volume products are not grossly different.
ABC Analysis: Product Profitability

 The low-volume products tend to be unique,

customized products.
 The company relies on traditional standard
costing system to set prices for these products.
 May set the profit margin higher to reflect the
lack of competition.
ABC Analysis: Product Profitability

 the standard cost system severely underestimates the

cost of designing, producing sustaining, and delivering
these low-volume, custom products
 The higher margin fail by substantial amounts to cover
the cost of resources used for these products
 ABC costs are often more than 100% higher than the
costs assigned to these products by standard costing
systems (Stage II cost system).
ABC Findings

 ABC produces significantly different results.

 1. Willie Sutton rule:
 Large expenses in indirect and support
resources.
 2. High-diversity rule:
 Diversity in products, customers, and
processes.
Standard Cost Systems-Over
proliferate Products

 Companies over-proliferate their product lines

and over-customize their product offerings.
 Fail to see how decisions on product variety
and complexity inevitably lead to much higher
expenses in the indirect and support resources
required to implement this full-line product
strategy.
ABC Findings

 Japanese buyers of Nissan Stanza can choose from

nearly 200 variations with different engines, bodies,
tires, and transmissions.
 The company has sold fewer than a dozen units of
some combinations.
 Nissan is trying to save money by cutting back on the
number of variations it is offering, even if it means
sacrificing market share.
 It is trying to use the same parts in more models.
ABC Findings

 Sony eliminated several model’s sizes of

televisions, and Mitsubishi is cutting back on its
30 different varieties of fax machines.
ABC Findings

 Japanese electronics will eliminate 25 models

of video-cassette recorders and 10 models of
televisions.
ABC Findings

 Matsushita is scaling back from its 220 types of

televisions and 62 types of VCRs recognizing
that only 10% sold well
ABC Findings

 Lacking ABC models to identify the high costs

of product variety and proliferation.
 Even excellent companies can introduce and
sustain far more products than are
economically warranted.
 The company’s whale curve indicates the need
for it to address the issue of whether
customers truly value the wide range of
products it currently provides.
Should Unprofitable Products be
Dropped?

 Should companies produce only a small

fraction of existing products?
 Should business unit retain only the profitable
80-85% of existing sales
 Profits may double or triple by eliminating the
loss products.
Product-Related Actions

 Many existing customers may want to buy from

a full-line producer.
 While business may earn the bulk of its profits
from selling higher-volume standard products
(vanilla/chocolate ice cream)
 It must also offer the occasional small quantity
of specialty products (butter-pecan fudge)
Product-Related Actions

 Many of the expenses assigned to products by the

ABC analysis will remain in the short run even were the
products to be dropped.
 The revenues will disappear immediately,
 but most of the costs will likely still be incurred.
 If no further actions are taken, the remaining expenses
spread back to the remaining products, causing many
of them to now look unprofitable. A death spiral.
Actions to Modify Whale Curves &
Increase Profitability

 Reprice products
 Substitute products
 Redesign products
 Improve production processes
 Change operating policies and strategy
 Invest in flexible technology
 Eliminate products
Short-term Pricing

 Relevant costs for short-term decisions.

 Estimate the incremental costs associated with an
order.
 The incremental costs include
– The extra materials that must be acquired to produce the order
– Any part-time or additional labor that must be paid to process
the materials
– The extra energy and maintenance costs for the machines that
will work on the order
Short-term Pricing

 Guidelines for short-term pricing decisions:

 Available capacity exists
 The price offered to the one-time special order
will not affect pricing for existing customers
 The customers cannot resell the product or
service to other customers.
ABC Costing for a New Order

 Based on activities.
Pricing Using Standard Markup

 Some firms use a standard markup over costs,

such as 20%, to obtain a quoted or targeted
price for a product.
Target ROI Pricing

 Over the long run, companies need to price

their products so that they recover all of the
resource costs and obtain an adequate return
on invested capital.
Target ROI Pricing-Advantages

 Relates price not only to the operating

expenses of product development and
manufacturing but also to the capital
investment required for the production and
distribution of the product.
Target ROI Pricing-Advantages

 Provides a defensible price, permitting the

company to cover its costs and earn a
competitive return on its invested capital.
Target ROI Pricing-Advantages

 Provides some stability to a company’s pricing

policies. When activity cost driver rates and
investment are based on practical capacity,
prices will not fluctuate with short-term
changes in actual sales.
Target ROI Pricing-Disadvantages

 Companies feel that they were entitled to the

price derived from an ROI calculation.
 They did not look closely at competitive forces.
Reprice Products (1)

 Some companies have little discretation in product

pricing.
 Their high-volume products are sold in highly
competitive markets where it is difficult to differentiate
the product along quality or functionality dimensions
 Customers find it easy to switch suppliers to obtain the
lowest price
 Repricing products in response to an ABC analysis
may not be a viable option
Reprice Products (2)

 Repricing products in response to an ABC

analysis may not be a viable option
 These companies must look elsewhere to
improve the profitability of their products
– Redesign
– Substitution
– Process improvement
– Deletion
Reprice Products (3)

 Many companies however have discovered

they have considerable discretion in adjusting
prices - highly customized products.
 Pricing strategies for products not sold in
competitive markets are often derived either
from standard markups over standard costs
or from extrapolation from prices charged for
existing physically similar products.
Reprice Products (4)

 If the costs of the low-volume specialty

products have been correctly assigned, the
cost of high-volume standard products will
decrease.
 Costs of mature products may drop by 5-8%.
 Mature products sold in competitive markets,
an increase of 3-5% margin is very significant.
Strategic ABM &
Competitive Strategy

 Porter pointed out that companies have two generic

strategies that can be successful
 Low cost strategy
– High volume product at lowest possible price
– Commodity like product
 Differentiation strategy
– Product leadership
– Customer service
– Earn price premium over commodity-like product
Strategic ABM &
Competitive Strategy

 To make differentiation strategy successful

 “Differentiation leads to superior performance
if the price premium achieved exceeds any
added costs of being unique”---Porter
 Price premium earned from differentiation
must be greater than the cost of
differentiation.
Strategic ABM &
Competitive Strategy

 Standard cost system can not estimate the

incremental cost of achieving differentiation.
 Companies with a differentiation strategy require an
ABC system to measure accurately the costs of
increased variety and customization.
 Companies will be able to see whether customers are
willing to pay higher prices to compensate the
business unit for its higher costs.
Strategic ABM &
Competitive Strategy

 If the company is able to differentiate its

products and services without incurring a cost
penalty, this capability will be identified by the
ABC system.
 The company does not have to seek price
premiums for its unique features and
services.
Substitute Products

 An alternative to raising prices on low-volume,

customized products is to substitute existing,
lower-cost alternatives.
 Customers are relatively indifferent to certain
aspects of product variety that impose high
costs on the producer.
Substitute Products

 Pricing and product substitution are

complementary.
 Marketing and sales representatives can give
the customer the choice between paying a
higher price for exactly the right functionality or
obtaining a lower price by accepting relaxed
product specifications.
Substitute Products

 Using an ABC analysis, marketing and sales

representatives can have intelligent, fact-based
discussions with customers to determine their trade-off
among functionality, uniqueness, and price charged.
 Some sales representative have notebook computers
with installed ABC models so that they can conduct
real time discussions with customers about the trade-
offs between product variety and price.
Substitute Products

 Produce innovation and variety are important

and valued.
 ABC does not discourage business units from
attempting to meet customer needs with new
and varied products.
 ABC does provide a discipline to ensure that
the value customers receive from new and
different products more than offsets the costs
of offering these products.
Redesign Products (1)

 Many products are expensive because of poor

product designs.
 Without ABC system to guide their product
design and product development decisions,
engineers ignore many of the costs of
component and product variety and process
complexity.
Redesign Products (2)

 They design products for functionality and do

not consider the costs of adding new and
unique components, new vendors and complex
production process requirements.
 The best opportunities for lowering product
costs through excellent design occur when the
products are first designed.
Redesign Products (3)

 ABC analysis will reveal design aspects-a

particularly expensive or complex component
or a complex process specification that adds
little to product performance and functionality-
that can be eliminated or modified even for
existing products.
 However, the options for redesigning existing
products may be limited.
Redesign Products (4)

 Redesigning products is an attractive option

since it will usually be invisible to customers
and the company will not have to reprice or
substitute another product.
Improve Production Processes (1)

 ABM involves continuous and discontinuous

process improvement.
Improve Production Processes (2)

 Traditional product costing of complex products

relies on a bill of materials that identifies all the
components and subassemblies of the final
product.
 The cost system then adds the cost of labor
and overhead associated with the product.
Improve Production Processes (3)

 Traditional costing system

 Obvious ways to reduce product costs:
– Lower materials purchase prices
– Lower direct labor cost
– Lower machine-related costs
Improve Production Processes (4)

 Lower materials purchase prices.

– Searched for cheaper suppliers.
– Purchased materials and components in bulk to
obtain volume discounts.
– Built automated warehouses to house and move the
materials purchased and delivered in bulk.
– Deploy extensive inventory control and scheduling
resources to arrange for delivery and to expedite
items that were delivered late from unreliable
suppliers.
Improve Production Processes (5)

 Lower direct labor costs.

– Spent thousands of dollars on industrial engineering
studies to reduce a product’s direct labor content by
tenths of hours
– Automate processes whenever possible and
– Shifted labor-intensive processes to low-wage
countries.
Improve Production Processes (6)

 Lower machine-related costs.

– Invested in expensive, inflexible, high-speed
machines to reduce machine time per unit.
– These machines were difficult and expensive to
change over from one product variety to another.
– Industrial engineers encouraged workers to run
existing machines at higher and higher speeds,
risking poor-quality products, unexpected
breakdowns, and high maintenance and repair
costs.
Improve Production Processes (7)

 All these actions appeared sensible when

viewed through the lens of
– The materials
– Labor and
– Machine hour costs.
Improve Production Processes (8)

 Encouraged managers to spend heavily to

reduce
 Their unit level costs of materials, labor, and
machine time.
 But doing so produced an enormous escalation
in batch and product-level expenses.
Improve Production Processes (9)

 ABC cost system retain the

– Bill of materials structure
 It adds a new dimension
– A bill of activities
Improve Production Processes (10)

 ABC reveals the costs of activities performed for this

product
– Scheduling and handling production orders
– Setup
– Acquiring materials
– Setting up machines engineering support for the product
 This bill of activities suggests a whole additional set of
actions that can lead to lowering the costs assigned to
this product.
Improve Production Processes (11)

 The insights from a bill of activities as well as

an analysis of the costs of products stimulate
process improvements.
Change Operating Policies and
Strategy (1)

 Several companies in view of Toyota’s goal of “ efficient

lot sizes of one” made arbitrary reductions in their
batch sizes and allowable inventory levels.
 This led to many low-volume runs and more frequent
shipments to customers
 Subsequently, with the insight from an initial ABC
model, the companies realized that their cost structure
had increased substantially because of the increased
number of batch-level activities.
Change Operating Policies and
Strategy (2)

 Without any fundamental improvement in

performing batch-level activities, frequent
changeovers not only raised batch-level
expenses, they also consumed valuable
equipment capacity.
Change Operating Policies and
Strategy (3)

 ABC bill of activities and associated

classification by cost hierarchy provide a
powerful connection to contemporary
developments in operations management.
Change Operating Policies and
Strategy (4)

 The focused factory approach recommends

that high-volume products should be produced
in facilities optimized to perform unit-level
activities efficiently.
 Such facilities, however, may be quite
inefficient for performing batch and product
sustaining activities.
Change Operating Policies and
Strategy (5)

 Low-volume, high-variety products should be

produced in facilities that perform batch and
product-sustaining activities highly efficiently-
job shop with skilled operators and general
purpose equipment.
 But it may be quite inefficient for unit-level
activities
Change Operating Policies and
Strategy (6)

 The unit-level activities are more expensive at

the job shop since a higher quantity and quality
of direct labor is required to operate the
general purpose machines, and the general
purpose machines run slower than the
specialized, highly automated production
equipment.
Change Operating Policies and
Strategy (7)

 For small-run sizes of new and customized

products, the much lower batch and product-
sustaining expenses in a job-shop environment
more than compensate for the somewhat
higher unit-level labor costs and machine run
time.
Invest in Flexible Technology

 The capabilities of flexible manufacturing

systems (FMS) and other information-intense
production technologies, such as
– Computer-aided design(CAD)
– Computer-aided engineering (CAE) and
– Computer-aided software engineering (CASE)
 Can be viewed as greatly reducing the cost of
performing activities such as changing over
production from one product to another
Invest in Flexible Technology (2)

 These can be viewed as greatly reducing the

cost of performing activities such as
– Changing over production from one product to
another
– Scheduling production runs
– Inspecting products
– Moving materials
– Designing products while retaining the efficiencies
of high-speed automated production.
Invest in Flexible Technology (3)

 The business case for investing in these

advanced (and expensive) manufacturing
technologies can now be justified by appealing
to the reduction in costs currently incurred for
performing batch and product sustaining
activities with conventional manufacturing
technology.
Invest in Flexible Technology (4)

 These costs are visible only if the organization

has developed an ABC system for explicitly
measuring them.
 These large and now visible batch and
product-sustaining costs become the prime
targets for elimination with new investments in
computer-integrated manufacturing technology.
Eliminate Products

 If none of the above actions to transform

unprofitable products into profitable ones is
feasible or economically justified, managers
may have to confront the final solution
 Kill unprofitable products.
Eliminate Products (2)

 Marketing and sales personnel may object to

dropping unprofitable products, even when no
other action is feasible to make them profitable.
 They argue that the products complementary
to other products that are profitable.
 In order to sell tank loads of chocolate and
vanilla, the company must be prepared to
occasionally sell half pints of butter pecan
fudge swirl.
Eliminate Products (3)

 Such argument is based on demand curve, not

their cost curves.
 ABC is a cost-estimating model, says nothing
about product demand curves.
Eliminate Products (4)

 Assign the loss from unprofitable products to

the appropriate responsibility.
– A product manager.
– A customer representative.
 Allow the person to manage the mix of
profitable and unprofitable products to
maximize total profitability.
Eliminate Products (5)

 Make shifts in the incentive structure by

awarding commissions and incentive pay
based on profitability not sales.
Eliminate Products (6)

 Allow unprofitable products to continue to be

produced, marketed, and sold, but not count
their sales in sales persons’ quotas and
incentive pay.
 Hence, if the unprofitable products do increase
total profitability, sales reps can continue to sell
them; but if they do not contribute to total
profitability, the incentive to continue selling
them is greatly reduced.