Fair Does Not Always Mean Equal - Oracle

FAIR DOES NOT ALWAYS This ar ticle is about how profitability can influence decis ion-making in s electing which cus tomers to addres s and the right products /s er vices to provide.

MEAN EQUAL L O R E N Z O M A R I A N I A N D M AT I L DA F I L O L L I

.................................................................................................

6

A

re you wondering if your customers are paying you f a i r ly for w h at you a re of fe r i ng t he m ? A re you wonde r i ng i f you r com pany price list is really taking into consideration all the ser vices you provide? If you answered yes to either of these questions, then you are most likely in the same situation FineTiles found itself in a few years ago. 1 FineTiles realized t hat t re at ing it s c u s tomers fairly and equally does not necessarily mean charging all of its customers the same price for the same ser v ices. In 2013, FineTiles, a leading ceramic tile manufacturer, under took an internal project designed to improve the comp a ny ’s p r o f i t a b i l i t y. T h e c o mp a ny immediately found itself deeply analyzing the actual meaning of these two impor tant questions:

• What is customer profitabilit y? • What is product profitabilit y? T he re a s on Fi ne Ti le s’ m a nagement wanted answers to these important questions was simple: The better profitability is, the more management would focus on the profitable customers/products, which would result in a more profitable profit and loss statement (P&L). Howe ve r, c h o o s i n g w h i c h c u s t o m e r s a n d products to focus on wasn’t easy!

A business journey: Understand yourself while understanding your customer Today’s business world is a complicated, mult ilayered offer ing of products and services held together by complex propositions and contracts. Imagine a lasagna, which is par ticularly appropriate due to FineTiles’ location, near the bir thplace of lasagna in Italy. Understanding what

LO R E N Z O M A R I A N I is a partner at Reply Consulting, heading up enterprise performance management. After studying management, production, and industrial eng ineering at Politecnico of Milano, he worked w ith Arthur Andersen and Deloitte. He specializes in CFO needs such as planning and reporting systems, industrial accounting, statutor y consolidation, and g roup reporting. Lorenzo can be reached at l . m a r i a n i @ r e p l y. i t . M AT I L DA F I L O L L I conducted her studies in international business w ith a major in finance at Middlesex University in London and at Baruch College in New York City. Her work experience includes time w ith UBS Financial Ser v ices Inc. in NYC and Inditex-Zara (U.K.). She is currently a consultant at Reply Consulting in the “profitability-oracle” div ision. Matilda can be reached at m a t i l d a . f i l o l l i @ l i v e . c o m .

COST MANAGEMENT

SEPTEMBER/OCTOBER 2015

Cost Management, Volume 29, Number 5. Copyright 2015. Thomson Reuters/Tax & Accounting. Reprinted with permission.

Who is FineTiles? FineTiles is a leading international player in the ceramic t ile sec tor. Exper ience and innovat ion, c ap abi lit y, creat iv it y and design, and tradition and culture — in shor t, “a passion for ceramics” — are the strengths of FineTiles, who has been defining liv ing spaces since the beginning of the 1900s, combining aesthetics and top-qualit y materials. FineTiles has always made aesthetic research a strong point of its offering. Indeed, FineTiles was the first company to discover the need for ceramic tiles to become a fur nishing and an architectural feature, placing the responsibilit y for product creation in the hands of leading designers. Due to this choice, FineTiles decided to create an annual, new product catalogue to be distributed ever y year, and consequently the cost of design, m arket ing , and inter na l a nd ex ter na l logistic activities (inbound and outbound) r o s e s i g n i f i c a nt l y. Why d i d l o g i s t i c s increase so much? Tiles are heavy goods, and this leads to high shipment costs. If you add to this the fact that a customer may have several deliver y destinations, it becomes clear that a significant portion of margin could travel away, too.

through detailed reports that compared actual sales versus budgeted sales, w ith breakdow ns by product and customer, and compared revenue with cost of goods s ol d ( C O G S ) at s t a n d a rd co s t . T h i s obtained a picture of the first marg in detailed by product and by customer. This manager ial repor t ing book allowed various but t y pical analyses: 1. Variance analysis: What did we sell more or less of compared to our budget hy pothesis? 2. Mix analysis: Are our customers buy ing the products we actually expected to sell? 3. Margin analysis at standard cost: Are they buy ing high-price and high-value products or ones at lower prices? 4. Production efficiency analysis: How are our production costs mov ing compared to standard/budget costs? These typical analyses provide useful information, but they do not answer the important question: Does profit depend only on marg in? What ab out nonproduction costs (generally referred to as indirect costs)? Moreover, the most important question of all is: Are all of our customers actually buying the same products? The latter question may sound triv ial at first glance, but it is not. Of course different customers may buy different SKUs, but this wasn’t the meaning of the question. The fact is that even in the case of the same SKU being ordered, how customers buy the products and take delivery of them can be quite different because of the different related ser v ices.

When is Product A not Product A?

How did FineTiles originally monitor its financial performance? As most companies do (it might be more appropriate to say “as most well-organized companies do”), FineTiles monitored its performance

Customer X and Customer Y may order the same product code, but if X is asking for deliver y to three different points and Y to only one, it can be firmly said that they are actually buying different types of ser vices. And what if Customer X asks for three different invoices to be posted to different cost centers, and Customer Y wants only a single invoice? Once again, these are different ser v ices. Maybe Customer X orders from the catalog while Customer Y asks for product samples. Is Customer Y pay ing for the samples?

INCREASING PROFITABILITY


Margin analysis: Is this enough?

COST MANAGEMENT

.............................................................................................................................................................................

t h e re s u lt i n g c o s t s a n d re l ate d prof itabilit y are is a complicated and timeconsuming job — just like preparing a good lasagna! FineTiles went through this analysis pro ces s and obt aine d t wo s i g nific ant results: • a better understanding of the real costs of ser v ing its customers; and • a better understanding of its ow n, internal production processes that the company was able to optimize. A n d g u e s s w h at . At t h e e n d of t h e a n a l y s i s p r o c e s s , t h e c o mp a ny a l s o improved financial performance!

THE MOST IMPORTANT QUESTION OF ALL IS: ARE ALL OF OUR CUSTOMERS ACTUALLY BUYING THE SAME PRODUCTS?

7


8

.............................................................................................................................................................................

THE ABC ASSIGNMENT MODEL ASSIGNS MORE INDIRECT COSTS TO PRODUCTS AND CUSTOMERS WHEN COMPARED TO CONVENTIONAL COSTING, FITTING PERFECTLY WITH FINETILES’ SITUATION.

The FineTiles team was aware of this issue and realized it was essential to conduct a deep analysis using experienced suppor t to b etter underst and it. Help came in the form of activit y-based costing met ho dolog y and f rom t he Reply Consulting team. According to Professor Kaplan, activit y - b a s e d co s t i ng ( A B C ) i s a co s t i ng methodology that identifies all the activities in an organization and assigns the co s t s of e a ch re s ou rc e to t h e re l ate d ac t iv it y, and then to all produc ts and ser v ices according to the actual activ ities they consume. 2 The ABC assignment mo del as s i g ns more i nd i re c t co s t s to products and customers when compared to conventional costing, fitting perfectly w ith FineTiles’ situation. The company needed to do a better job of assigning costs such as distribution, administration, and other commercial indirect costs. The ABC model really came f rom Porter’s value chain. 3 According to Porter, a value chain is a set of activ ities that a firm operating in a specific industr y performs in order to deliver a valuable product (or ser vice) to the market. The value chain analysis enabled FineTiles to identify all value-added activities from a customer perspective and then attribute a cost to them. This may sound easy, but in fact, it isn’t easy at all. Accounting at FineTiles is managed t h r o u g h “ by n at u r e” r e c o r d s . T h e s e records are arranged by type of expense, not by cause of expense. This is unfortunate, as the cause of the expense would ident if y t he reas on w hy t he comp any decided to spend that money in the first place. Consequently, the first step and the first outcome of the project was transforming a “standard” P&L by nature to a P&L by ac t iv it ies, t hus underlining why FineTiles spent money or, from the customer’s perspective, how much value FineTiles was delivering.

• Customer A asks for a take-away slice. • Customer B sits at the restaurant and asks for the slice to be div ided in three (and to be ser ved on three separate plates). • Customer C needs the slice to be delivered to his home. Charg ing these three customers the exac t same amount for the slice of lasag na wouldn’t b e ent irely cor rec t if we t ake into consider at ion our effor t. For customer A, we used fewer resources and less t ime — and thus less costs. As for Customer B, we prov ided t ime and customer ser v ice, s o our costs for pers onnel are hig her. Moreover, we would h ave a d d i t i o n a l e x p e n s e s du e t o t h e ut ilit ies required for washing up, as the client asked for three plates. For Customer C, we wouldn’t p ay for the addit iona l ut i l it ie s a nd t he w a it i ng s t af f , but we would have costs that are related to the deliver y, such as staff, vehicle, and f uel expenses. According to t he A B C mo del , e ach resource and activit y would be analyzed to appropriately attribute all the costs and correctly choose the right pricing model to adopt in sel ling our pro duc ts (our lasagna), thus making our offerings profitable. And what if we offer a wider range of products? In this case, the analysis would be characterized by a higher level of complexity, and the ABC model would become even more essential.

FineTiles’ profitability project

Taking the lasagna example mentioned previously, let’s imagine we have a restaurant and we are selling a slice of lasagna to Customer A, Customer B, and Customer C.

Getting back to FineTiles, the ABC project for the company required the team to identif y major value-driv ing activ ities and then to understand how these ac t iv it ie s ab s or b f i na nc i a l re s ou rce s . This isn’t a job that can be performed sitting in an office; rather, it needs someo n e t o b e o n - s i t e at t h e p r o du c t i o n f ac i l it ie s to ex a m i ne a nd u nde rs t a nd ever y par t of the production process in order to comprehend why and how products are different. After this impor tant step, the attention then shifts to: • the logistics, to investigate how different deliver y terms drive deliver y costs;

COST MANAGEMENT


How much is that lasagna?



EXHIBIT 1 Customer Profitability Allows Better Decision-Making

• pay ment t y pes (a multit y pe payment costs more than a single one). Infor mat ion ret r ie v a l is one of t he major efforts that is often faced in a complex A B C proj e c t . In f ac t , a prop e r ly examined cost allocation may require a significant number of drivers that result f rom detailed infor mat ion residing in different ERP modules. These modules are often updated by different people in an organization. To prevent project deadlocks, a clear idea of how to approach the analysis must be in place. Fundamental to the project is hav ing a good project design phase, and sometimes simplif ying a few aspects of the ABC model. If the indicator, the effor t required to get information, is reasonable, this may indicate that it is the right path to take. In fac t, you may develop a ver y detailed and flawless analysis, but this might turn out to be the w rong route to follow due to the high costs of the amount of time retriev ing the information requires. At the end of the analysis phase, the resulting activity model will require a lot of data to feed it. A great temptation is to use Excel just to check how your model w ill work, and what results w ill come from it. Don’t do it. Tr y to resist! Without an enterprise solution, you will never be able to efficiently define a first model, test a hy pothesis or two, change drivers, see the results, and then go back to the model and rev iew it. With an enter prise solution, you will review the model carefully because the effor t required is not as great. Finding incorrect attributions



COST MANAGEMENT

.............................................................................................................................

• the billing process, to verif y whether all ser v ices have been invoiced and how ; and • IT, to understand how all these phenomena are traced in the systems. After taking these steps, FineTiles was r e a d y t o g o b a c k t o i t s m a n a g e m e nt account ing team to create algor ithms that, using appropr iate dr ivers, could explain (or rather attribute) the cost of the activ ities and ultimately the cost of ser v ices delivered. Luck i ly, FineTi les could count on a s t r u c t u re d e nte r pr i s e re s ou rce pl a n ning (ERP) system that t raced detailed infor mat ion, namely Or acle eBusiness Suite , organi z e d by account and cos t c e nt e r, i n c lu d i n g t h e d e t a i l s of e a c h product, customer, and, eventually, each line item of each invoice (w hen applicable). The projec t team, compr ised of FineTiles’ management and Reply consultants, collected all cost information, a n a l y z e d a n d g at h e r e d d r i v e r s f r o m op e r at i o n s , a n d at t r i b u t e d t h e c o s t s first to the ac t iv it ies and ult imately to the customers. To give you an idea of the drivers used, some of those adopted by the FineTiles’ project were: • invoice line items to allocate commercial costs and administrative costs (many small orders could cost more than a few big ones); • line items shipped to different locations (multiple destination customers cost more than single destination ones); and

9


.............................................................................................................................................................................

10

in a w ide, detailed, and complex analysis in a spreadsheet could drive you to madness! FineTiles chose Oracle Hyperion Profitabilit y and Cost Management to tackle its ABC project, and the tool properly handled all of its modeling needs, data loads, data processing, and consistency checks.

Project outcomes Hard work w ill y ield good results when d o n e p r op e r l y. T h i s w a s t h e c a s e at FineTiles. Obv iously, this company received a lot of a cc u r ate , de t a i le d i n for m at ion along with improved insight about which products and customers were profitable and which were not. Getting to know the real margin for products led to improved d e c i s i on - m a k i n g for t h e com m e rc i a l pricing strategy. This knowledge enabled FineTiles to properly define its price and applicable discounts and, most importantly, to understand which customers were request ing more ser v ices. The heightened level of awareness of these aspects prov ided suppor t to FineTiles in deciding whether it should change the way it invoices a customer (if the case allowed the company to do so) or if it should change the discount plan. By being able to discuss the service costs w ith its customers, FineTiles was able to agree upon a reduced discount that ultimately increased the profit f rom customers. An improved classificat ion of customers and cor rec t produc t information are essential to achieve a more profitable performance. Exhibit 1 depicts an example of perfor mance improvements over a threeyear period in a company that undertook a profitabilit y analysis. The ABC project not only prov ided a host of new and significant information, but it was essential for management to deepen its understanding of its own busin e s s . T h e s u c c e s s o f t h e p roj e c t w a s

COST MANAGEMENT

largely due to the analysis the organization had to under take to examine, in great detail, its business activ ities in order to understand where it was actually spending money. The results als o indicated which of the activ ities should be paid for by customers (because they were considered valuable by customers) and which of them shouldn’t (because they were considered of no value for customers). Adopting the ABC method, FineTiles’ management completely changed the way the company analyzed the business and also the way it was run. This resulted in better financial results and a new opportunity to improve operations and promote new ser v ices. Truly, FineTiles used its ABC system to move from gaining new information to analyzing its activ ities, pro duc ts, and customers — and ult imately to taking action on this new information. Having a clear idea of which activities your business is based on and implement ing a profitabilit y projec t w ith a robust and flexible solution w ill quickly give you a broad range of interesting and useful information. However, if you do not have a clear understanding of which activ ities are the most valuable in your business, we believe that an ABC project (followed by an implementation of enterprise costing/profitability software) is absolutely necessar y to retrieve all the essential information described in this ar ticle and to improve financial performance. S o enj oy your slice of lasag na, but rememb er to t ip for t he ser v ices you re ce ive i n add it ion to p ay i ng for t he slice! n NOTES 1 Actual name withheld by request — FineTiles is used as a pseudonym. 2 Kaplan, R.S. and Bruns, W., Accounting and Management: A Field Study Perspective. (Boston: Harvard Business School Press, 1987). 3 Porter, M., Competitive Advant age: Creating and Sust aining Superior Performance. (New York: The Free Press, 1998).


