The impact of activity-based costing (ABC) on customer profitability analysis (CPA)

has attracted relatively little attention in the management accounting literature. Bellis
Jones[1], Howell and Soucy and Smith [3] have examined the importance of customer
profitability without exploring the potential usefulness of ABC in developing an accurate
CPA.

CPA is justifiable if the cost-benefit of compiling the information is favourable and

the outcome of any subsequent strategic decision leads to income increases. Strategic
decisions may range from changing the delivery terms of a customer's contract to terminating
business dealings with an unprofitable customer.

Smith[3] observes that strategic consideration of customer-related costs can lead to a

cost-effective change in the way customers' needs are satisfied. Figure 1 encapsulates the
range of possible customer expense categories and identifies four key factors which impact
on customer profitability.

Further embellishment of this figure for each of the key factors allows the
development of characteristics which distinguish profitable from unprofitable customers.

A consideration of discounts, commissions and sales support allows the impact of

purchasing patterns to be specified, as shown in Table I.

Discount and commission data, sorted by customer, is likely to be readily available in

most computerized accounting systems. However, the determination of field service and sales
support costs for each customer will necessitate some form of ABC. For example, the average
length of time spent taking a customer's order might be measured and then applied as a
weighting factor to the number of telephone calls made. Large switchboard systems are
capable of providing such statistics automatically. Time and information management
systems can be added to smaller telephone systems to collect statistics relating to the
frequency of calls to customers' telephone numbers.

Sales representatives' planning sheets or an associated computerized system could

provide statistics regarding the number and distance of customer visits. Alternatively, an
estimated number of calls per customer, weighted according to the distance of the visit, might
be used as a basis of allocation of sales-support costs. Ultimately significant purchasing
pattern dollars revealed in a customer profitability analysis should focus management's
attention towards attempting to modify a customer's purchasing behaviour.

A consideration of distribution costs and frequency and special delivery requirements

allows a further distinction to be made, as shown in Table II.

Even with ABC, the split of the distribution cost between customers on a common
delivery run is difficult. Assuming each delivery consumes the same amount of time, the
most logical allocation of distribution cost is an even split between all customers to reflect
capacity-consuming packaging or, more commonly, significant distances from the
distribution point.

The number of customer deliveries should be extractable from the sales ordering
system and will be a useful input to the process of allocating distribution and shipping
frequency costs to customers. Resource costs associated with shipping frequency might be
split between standard and non-standard shipping activities, the latter requiring some form of
manual monitoring. However, such a process will be worthwhile if it highlights those
customers who place abnormal resource-consuming demands on the organization.

The number of customer deliveries should be extractable from the sales ordering
system and will be a useful input to the process of allocating distribution and shipping
frequency costs to customers. Resource costs associated with shipping frequency might be
split between standard and non-standard shipping activities, the latter requiring some form of
manual monitoring. However, such a process will be worthwhile if it highlights those
customers who place abnormal resource-consuming demands on the organization.

The impact of differential ordering and debt-handling procedures on the cost of the
accounting function further specifies the characteristics typical of the unprofitable customer,
as shown in Table III.

While the value of sales credits per customer is easily determined, the consumption of
resources associated with administering the number of sales credits can only be determined
only with analysis and measurement of occurrences of the activity driver.
 The activity costs of processing customer remittances can logically be allocated to
customers on the basis of the number of remittances received, but those customers who pay
late might be assigned a weighting factor to reflect a greater consumption of organizational
resources (for example, through follow-up telephone calls) than by on-time customers. A
further weighting factor might also be applied to customers who receive settlement discounts
on accounts greater than, say, seven days.

Order entry and processing would similarly be allocated to customers based on the
number of invoice line items, with customers with standing orders or complex orders
assigned an appropriate weighting factor. Despite the apparent arbitrariness of such weighting
factors, the final analysis resulting from their implementation may provide a number of
opportunities with which to alter the management of customer accounting activities.

Inventory-support and holding requirements, too, are often customer-specific with a

direct impact on their relative profitability, as shown in Table IV.

Customers requiring immediate deliveries will necessitate the organization holding

greater inventory levels. The increased costs of storing inventory can be assigned to such
customers using weighting factors. Determination of such weighting factors per customer
requires an accumulation of statistics relating to required delivery promptness. These
statistics may necessitate manual collection, or could be modelled from computerized
systems to reveal the average number of days between a customer's order and the
corresponding delivery date.

Decisions can be made to change the characteristics of a customer from profitable to

unprofitable, but the success of such decisions depends on the accuracy of the information
provided in the CPA. While ABC can improve the accuracy of such information,
conventional ABC systems have limitations that need to be addressed.

Not all ABC systems will analyse cost drivers in the area of customer-related costs,
despite the likelihood of their not being volume-dependent. More sophisticated ABC systems
may manage customer-related costs effectively, but this depends largely on the objectives of
the ABC system and/or the nature of the production process.
 Where the primary objective of the ABC system is to determine product profitability,
then the cost drivers selected will probably be quite different from those selected for
customer-related resource consumption analysis. Delivery costs, for example, might be
assigned accurately to customers based on distance travelled to the customer premises; but
where product profitability is the ultimate objective, it is simpler to assign delivery costs
based on the volume or weight of the product delivered to customers, irrespective of where
the product was delivered.

For example, to allocate accurately delivery costs of $10,000 over a total distance
travelled to customers of 2,000 kilometres, it is necessary to trace the distances travelled to
each customer and assign costs at the rate of $5 per kilometre. In many cases the individual
distances could reasonably be estimated without too much difficulty. From a product-
profitability perspective, allocating accurately the $10,000 over different products requires
tracing of the distances travelled by each product to each customer. The nature of such a task,
particularly in an environment with a diverse product range, would be extremely onerous. An
alternative, but less accurate, way of allocating the cost would be to use a capacity or volume-
based measure. This may be feasible from a cost-benefit standpoint.

By contrast, in environments where custom-made products dictate the nature of the

production process, the activity drivers from both a product-profitability and a customer-
profitability perspective are likely to be similiar because the custom-made product is
delivered to a customer and the associated distance travelled will be the same for either the
customer or the product as the cost object.

In mass-manufacturing environments, it would seem more likely, then, that the

activity drivers selected for a customer profitability analysis would differ from the activity
drivers selected for a product profitability analysis.

Johnson[4] suggests that activity-based concepts are being oversold and that focus on
total customer satisfaction is of paramount importance. He argues that if customers really
want frequent deliveries in small-lot sizes, and an alternative supplier can meet the customer
needs, then activity analysis might be misleading the supplier. This assumes that the supplier
is prepared to decline the customer's business and allow a competitor to supply that customer.
Using ABC in a customer profitability analysis, the supplier may indeed accept that the
customer is unprofitable and be willing to meet the customer's needs. Kaplan[5] discusses
three types of potentially unprofitable customer who might be retained:
(1) new and growing customers, who promise profitable business in the future and may
provide a stepping stone for penetrating lucrative new markets.
(2) customers providing qualitative rather than financial benefits, including customers at the
edge in the development of new markets who provide valuable insights into likely trend
movements in consumer demand;
(3) customers providing increased capability because of their status as recognized leaders in
their markets or fields of expertise.

Thus, where a CPA reveals that a particular customer is unprofitable, it does not
necessarily follow that this customer should be eliminated. Nor does it follow that the ustoner
must be persuaded to accept terms and conditions that will reduce the customer's level of
satisfication. Negotiations with a customer might well reveal that less frequent deliveries
would actually benefit the customer (i.e. less workload for the receiving officer, fewer
purchase orders, fewer transaction input entries, less paperwork) without causing costly
stockpiles.

Clearly, there is scope for negotiating with customers to influence their behaviour (so
that they act in ways which are more profitable for the firm) without compromising the
customer's level of satisfaction. Some aspects of improved negotiation might include:

1. non-cash incentives from sunk-cost investments for example, sponsoring a season of a

major cultural event primarily yields advertising benefits; however, seats in the
accompanying corporate boxes might also yield enticing customer incentives. Similarly, a
company's accumulated frequent-flyer points may perhaps be spent on customers, new or
existing;
2. restructure of delivery runs to create a more timely but less frequent service for the
customer;
3. capacity maximization on delivery runs that are required for profitable customers by
offering a more frequent service for the potentially unprofitable customer with unpredictable
demands;
4. purchase of equipment on behalf of customers which they can use rent-free, in lieu of
discounts and/or agent's commissions. The cash saved on reduced discounts/commissions
potentially should exceed the cost of the asset. Additionally, ownership is retained and a
stronger bond is forged with the customer, there by generating greater negotiating power in
future;
5. free short-term financial advice which will create efficiencies for the customer, leading to
reduced internal workload and consumption of resources;
6. new products at no cost in return for reduced discounts, to serve a dual purpose: improving
customer profitability while providing a useful vehicle for the promotion of new products;
7. a trade-off between quantity discounts and settlement discounts that minimizes the costs of
cash overdraft and maximizes long-run production scheduling.

The overriding consideration with a CPA is that management will at least be armed
with information about unprofitable customers and can focus attention on developing those
innovations/strategies that might reduce the lack of profits of a particular customer, without
reducing that customer's satisfaction. Alternatively, provided a shift of thinking is possible,
management can restructure the manufacturing process that will ultimately lead to a shift in
the results of a customer's profitability.

The role of the mechanics of ABC in developing a CPA should not be

underestimated. With ABC, general ledger amounts are dissected, making the assignment of
costs to customers easier. In particular, the associated on-costs of employing sales staff and
motor vehicles would be analysed in detail and be readily available. This would embrace
vehicle operating costs (depreciation, petrol, licensing, insurance and vehicle signage) as well
as superannuation, fringe benefits and payroll tax, holiday and long-service leave
entitlements, worker's compensation insurance, mobile telephone and training costs. Several
of these items might conveniently be omitted from a non-ABC customer profitability analysis
because of the complex analysis required to divide the general ledger amounts between the
activities of different salespersons.

Resource to activity allocations (e.g. gas, water, electricity) provide a more accurate
representation of resource consumption by customers. A non-ABC alternative is likely to
cause customer-cost distortions in such translations. Additionally, activity drivers will assist
in the assignment of activity costs to customers, where otherwise arbitrary allocation methods
would be employed. Thus, distribution costs might be assigned on a zone basis depending on
the delivery destination activity, rather than being spread across all customers in an arbitrary
fashion.
A systematic approach is essential in attempting to develop an activity-based costing
CPA. Lewis [6] outlines a simple ABC system for recognizing marketing costs by product
line. He also indicates how these ideas can be easily transferred into a profitability analysis
statement by territory. It follows that Lewis's ideas could be extended further to a full CPA,
or at least provide a useful starting-point for developing a CPA.

For more sophisticated models, Turney and Stratton [7] present an activity-based
model using micro and macro activities which lead to assignment of cost to final products.
This two-tiered activity structure could apply just as well to an assignment of cost to
customers as it does to final products. The primary advantage of this type of model is that
dual objectives may be satisfied, as follows:

1. customer costing objective-depicting the profitability of a customer using the cost of macro
activities;
2. performance improvement objective-isolating detailed areas for potential improvement by
focusing on micro activities.

The two-tiered activity model reduces many of the difficulties associated with
conventional ABC systems where the activity drivers to the final cost object are so
aggregated that the level of accuracy is potentially compromised.

Detailed analysis of customers, and associated service-cost differences, may be

justified it the cost of obtaining and maintaining information is not excessive, or if the
information so generated is useful in the making of strategic decisions.

Analysis of the revenue streams generated by customers, relative to their service

costs, may lead to some customers being eliminated from the business or, at least, a change of
emphasis in the way in which resources are allocated between customers.

In each case incremental costs and price elasticities of demand must be examined and
a customer loyalty profile established to determine sensitivity to prices or to the levels of
service provided. How will our internal costs change in response to variations in the level of
service provided? A fundamental analysis of customers, and the effect of variations in service
on internal cost structures, will provide the information to support strategic decisions relating
to the customer base. A more accurate ABC model, tracking resource consumption by
customers, is likely to cause fewer customer-cost distortions than are non-ABC alternatives.

The need for a strategic approach is evident. We must not be tempted to pigeon-hole
TQM, ABC or CPA and examine each in a blinkered fashion. They must be employed
simultaneously so that all aspects of customer focus can be considered, with projected costs
and revenues appropriately quantified.