“Nothing else in the world . . . not all the armies . . . is so powerful as an idea whose time has come.”
—Victor Hugo, French novelist1
INTRODUCTION
Internet Is Changing Everything
The Internet is clearly the revolution of the twenty-first century. Many consider its potential impact on society to be greater than the changes that came from the telephone, highway systems, and even electricity. We are all becoming digital citizens as part of a global networked society.
Some e-commerce experts attempt to profoundly distill the impact of the In- ternet into a single sentence. Some describe it as the opportunity for people to join communities of common interest without boundaries or borders. Others view it as the ultimate network across which data, voice, and video communications are carried. Some see the Internet as an expansion into a more mobile informa- tion society in which the individual has universal access to personal data, not ac- cessed from a home base but from wherever he or she may be sitting, standing, or traveling.
My simplistic view is that the Internet is shifting power from the seller to the buyer—irreversibly.The ability for the buyer to access incomprehensible amounts of data using search engines to seek out products and services is now unbounded.
The buyers’ increasing desire for unique requirements will likely force suppliers
to respond with increasing flexibility. This may add costs to suppliers as pressure is placed on their prices.
Ironically, suppliers are assisting in the shift of power to buyers. They are providing increasingly more information about their products and services via their websites. Teenagers will perform exhaustive searches to identify the exact make and model of an appliance they want, then they will locate a much cheaper source from which to purchase the appliance. Adults are learning to do this, too.
Internet portals and exchanges are creating digital marketplaces that intro- duce increasing flexibility to match suppliers with buyers via virtual auction websites and bidding systems. The buyer has access to a much greater market than ever before. The Internet is a gift to buyers everywhere.
The buyer who benefits from this shift in power will not only be the end- consumer shopping at a retail store. Purchasing agents and requisitioners in busi- nesses and governments will also gain the upper hand over suppliers. This is the new business-to-business, or B2B, economy. Buyers are already exhibiting new capabilities to determine for themselves broader ranges in terms and conditions with their suppliers. They can compare and contrast features of products and ser- vices offered by competing suppliers. To complicate matters for suppliers, con- sumer expectations are rising faster than some businesses can deliver. Consumer tastes, preferences, and expectations are not static. Many customers base their standards on their last best service experience. The bar rises constantly.
Some argue that e-commerce is not as major a factor as the media are pre- senting it. They see e-commerce as simply streamlining the matching of re- sources to customers. But it is removing, in a single punctuated change, substantial transaction costs, including some intermediary organizations, such as wholesalers and distributors. From this viewpoint, e-commerce is not considered a major transformation because the market exchange behavior will continue to exist as it has for centuries—only much faster and more dynamic. But the Inter- net will continue to shift power toward consumers. The historical pattern has been that competition will award to consumers long-run savings generated from new technologies in the form of lower prices.
Pressure on Prices: How Will Suppliers Counter?
Suppliers must now react more quickly than ever before. Call centers and cus- tomer support functions have become integral for suppliers, and these services in- volve new costs not present in old business models. A major consequence of the shift in power to buyers is that tremendous pressure is placed on supplier prices.
Suppliers will no longer be capable of protecting a niche market or of enjoying as large or long lasting profit margins as they have in the past.
How can suppliers counter this change? One option is for them to alter their customers’ behavior to minimize the shift. In addition, trading partners along the supply chain can mutually measure and remove the unnecessary costs that they create among each other. Each trading partner can gain much better insight into
the true and relevant costs for their products, stock keeping units (SKUs), service lines, freight, channels, and customers from major advances in profit contribution reporting and analysis and margin management.
This section describes the role that activity-based costing is now playing and will play as the Internet, e-commerce, and supply chain management mature. As previously mentioned, the Internet is shifting power from sellers to buyers—
irreversibly. Search engines and great data access have become prevalent.
Before discussing activity-based costing I want to cover the current situation of most suppliers. Suppliers are in upheaval. They are the organizations that have to adjust the most to changes caused by the Internet.
Quandary of Reengineering
Imagine that an organization has completely and successfully reengineered itself and become lean and agile, not anemic. Further, imagine that it has streamlined its business processes and workflows, thenit discovers that its board of directors, owners, and shareholders are demanding even better performance and ever higher returns on investment (ROIs), market share, and profits. What are this or- ganization’s options? Across-the-board cost cutting and employee layoffs may no longer be an acceptable option without risking rapid deterioration of customer service and eventual sales decline.
Some of the actions the company can take are discussed in “Seven Options to Raise the Profit Cliff Curve” in Chapter 3; they are summarized here. One pos- sibility is to raise prices to increase revenues, but in many markets small price in- creases can lead customers to delay their purchase or to switch to competitors or substitutes. Both outcomes lead to lost sales.
Another possibility for the organization is to abandon unprofitable products, service lines, channels, or customers. However, this action first requires the abil- ity to properly and accurately measure costs to determine true profit margins.
Measuring the revenues is not a problem, but measuring costs is. ABC/M solves that problem. With knowledge of profit contribution margins, the organization can more intelligently rationalize what to change and which business lines or cus- tomers to drop. However, as an organization drops its products, service lines, and customers, to actually realizeincreased profits, management must either:
• Simultaneously removethe resulting unneeded costs, usually in the form of employees, at a faster rate relative to the abandoned revenues, or
• Fill the created idle capacity with new and profitable orders.
Pruning and dropping products and customers is not easy and is a fairly emo- tional process.
Another less draconian option is available to suppliers. They can alter the be- havior of their trading partners. Through collaboration, persuasion, or creation of incentives for one’s suppliers and/or customers, fewer demands on work can be placed on the organization’s employees. The newly freed-up time of employees
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plus their associated operating expenses can then either serve new customers or handle increased business from existing customers. (Alternatively, employees can be transferred to where they might be needed elsewhere in the organization.) Influencing Trading Partner Behavior
Initially some trading partners will exclusively and perhaps selfishly use their activity-based costing data for their own private benefit. They will use it for in- cremental price and cost trade-off analysis. For example, to entice a customer to reduce its current level of services, they may offer the customers a reduced unbundled price incentive. Assuming the customer accepts the new arrangement, an organization must know in advance how much of the resulting costs will be available and realizable for savings. The critical test equation comes from basic economics:
For service reductions, the incremental change in price and revenues must alwaysbe
less than
the incremental change in cost (and vice-versa for service increases, where changes in revenues must alwaysexceed changes in costs).
If this condition is not satisfied, the supplier loses profit if the customer elects to select the option.
Figure 4.1 shows a case in which an unprofitable service is converted into a profitable one by reducing both the service level and price—but the change in cost must decline more than the change in price and revenues for a positive profit impact.
This is a very different and important use of ABC/M data. Note that the data are not used in this application for internal productivity improvement but rather to influence external demand. The key for the supplier is to somehow alter the be- havior of its customers in harmony with its own cost structure. The supplier is brilliant if it can do this. The supplier must have a very good understanding of its own cost structure and how it varies with changes. ABC/M data are essential for this.
The trade-off of price and cost can go in both directions. The service level can be raised, but presumably the price and resulting revenues will rise even more than the incremental costs to yield incremental profit. In the Internet twenty-first century customer order entry process, progressive companies will provide their customers with online access to select their own options using web-based pricing.
Suppliers may communicate with customers in several ways. Some might proac- tively “push” their promotions at customers by offering various product and ser- vice-level options. Suppliers can also wait for customers to visit and shop at their websites. But with Internet auction sites, exchanges, and e-bidding, suppliers
will be forced to have cost estimating and profit margin acceptance testing capa- bilities that are far more advanced than what they have today.
Forget the past methods of pricing and quoting. When a customer asks the sales or order entry function of a supplier what the price might be for a personal- ized order with various options and features, the reply from a clerk or tele-sales person cannot be, “I will get back to you in a day or two after our operations, cost estimating, and pricing people have given this a look.” The information must be calculated at Internet speed. The calculation will require rule-based logic lever- aging ABC/M data. Suppliers without this automated and web-based capability risk selling orders at a loss or unwittingly pricing too high and losing customers.
It will not be sufficient for a supplier to have a “static” web-catalog that is pe- riodically updated, such as annually or quarterly. A supplier’s web-catalog must be near dynamic and include product features, options, pricing, and availability data. Figure 4.1 illustrates how Internet exchanges can expose buyers to more suppliers. Supplier auctioning systems will be commonplace to match the buyers’
bidding systems. Figure 4.2 further illustrates why a supplier’s host system will require a more robust, rule-based predictive cost system than what suppliers have today.
In short, price quoting and customer order acceptance testing cannot be a back-of-an-envelope exercise. It must leverage rule-based models that reflect a supplier’s cost structure.
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Cost
Price (loss)
profitable Money
Time
Increasingly, organizations will drive “desired” customer demand by offering lower prices for less service (or vice-versa). Knowing the incremental cost trade-off is critical to assure that profits increase.
Example: Providing incentive to a customer via a lower price to receive weekly rather than daily shipments will require keen understanding
as to which and how much activity costs change.
Change in service level
FIGURE 4.1 Influencing Customer Behavior
Big Risks from Flawed Thinking
One of the risks the supplier will encounter will be the assumptions it makes about the inclusion or exclusion of the business sustaining costs that can opti- mally be absorbed in calculating the costs to be used for the profit margin accep- tance test of each customer order:
• If too much of the business sustaining or presumably near-term fixed costs is excluded, there will be a temptation to opportunistically offer low pricing.
This creates a risk that repetition of similar orders will gradually replace the company’s pricing structure below the level required to fully recover its business sustaining cost structure.
• If too little of the business sustaining costs is excluded, meaning that too much of fixed costs are included in the assumption, there is a risk that selec- tive reduced pricing may not be tried to attract a new customer or prevent an existing customer from switching to a competitor.
As the Internet spawns the digital market via website auctioning, some be- lieve that companies will start to do things typically reserved to commodity ex- changes, such as soybeans, wheat, sugar, and cocoa. There will be opportunities to do things that only commodity traders or brokers have done in the past. With Internet exchanges, every business becomes a broker in a free-floating market with what appears to be a transparent pipeline (transparent to supplier prices, but not to their profit margins, which are still undisclosed except in rare seller-buyer relationships). Others believe that buying and selling in most businesses is much more complex than what occurs in commodity market trading.
Market Exchange
Customer
Customer
Customer
Customer
Customer Rule-based
order acceptance
test (ABC/M)
Buyer’s view
Offer options and price
Work demands
Supplier Host Server
Suppliers need predictive costing that reflects the customer.
FIGURE 4.2 How Suppliers Counter the Shift of Power to Buyers
Technology is no longer an inhibitor for suppliers to economically capturing true costs, estimating costs for quotes, and testing profit margins. Businesses now face a thinking problem. They must really understand their assumptions about fixed and variable costs—and the implications of each assumption.
The supplier’s option of altering the behavior of its trading partners is not commonly pursued because many organizations haven’t adequately considered it yet. Most organizations are habitually inward-focused and concentrate on how they should manage their internal costs. Many companies do not adequately un- derstand how much of their cost structure is in fact a consequence of the collec- tive suppliers’ and customers’ demands-on-work. Costs measure effects. The thought of influencing a customer or supplier to behave differently to lessen the organization’s employee workload is often outside the realm of many organiza- tions’ thinking. Supply chain management will force organizations to truly un- derstand their inter-firm costs. To understand inter-firm costs, one has to measure inter-firm costs (see “Measuring Supply Chain Profits and Costs: ABC/M to the Rescue” in this chapter.)
Altering trading partner behavior requires trust among suppliers and cus- tomers. Businesses have historically been wary of releasing information to trad- ing partners even when that information will aid mutual understanding, and one area where disclosure is needed is regarding an organization’s cost structure. Yet
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Perils of Throughput Accounting
Regardless of how auctioning will work, organizations will need much better predictive financial data to understand the profit impact outcome of their de- cisions compared to what they have today. Some companies will find the logic of a relatively new costing method, called throughput accounting, ap- pealing. However, one must be careful when using this approach. Companies can be lulled into thinking that every exchange event is similar to spot- purchasing of a commodity. Throughput accounting treats momentary lapses of idle capacity as being free, and therefore it excludes their cost from the profit margin acceptance test of an order.
If an increasing number of customer orders rely on throughput account- ing for profit margin acceptance testing, the company risks creating a perma- nent price structure level that is well below what is required to sustain an ongoing economic profit. In short, throughput accounting is very process and capacity-centric, but it can create myopia for companies that think inwardat their production capacities and not outward at their customers and share- holders.
Throughput accounting and predictive cost estimating is discussed in Chapter 8. The risks of using suppliers using so-called process optimization, dis- guised by names like “profit optimizers” and “profit velocity,” are also discussed in that section.
many organizations mistrust their own cost data. As previously mentioned, they operate with a resigned acceptance that their cost accounting data are “a bunch of lies—we all agree to.” Understanding true and actual costs is not the entire solu- tion, but it is a part of the solution to increase inter-firm trust and better manage costs and profit margins.
What Role Will ABC/M Play in E-Commerce and Supply Chain Management?
Today buyers are increasingly dictating terms, conditions, and pricing. Mega- digital marketplaces continue to be under construction as cyber-exchanges con- solidate the place where consumers and producers go to buy information, products, and computing capability as well as to process transactions. Suppliers face additional risks from exposing more of themselves on their websites. How can suppliers recover the power they are losing to buyers? They do have options, but suppliers will need to be savvy. Information technology is the wild card. Ac- tivity-based costing will be part of the supplier’s solution.
Information technology is enabling the trading partners along the value- creation chain to better coordinate and collaborate for mutual benefit. But trad- ing partners will require cost accounting systems, including activity-based costing, that are superior to the accounting systems they all struggle with today.
E-commerce is causing major changes in two of the major core processes of any commercial or public sector organization:
• The Generate Requests and Ordersprocess (the “front office” where mar- keting and sales reside)
• The Fulfill Requests and Orders process (The “back office” where opera- tions reside)
The “Front Office”
The revolution in the supplier’s “front office” is that the buyers themselves can now directly participate in specifying, selecting, and acquiring goods and ser- vices with little or no assistance from their suppliers. To the experienced shopper, securing a bank loan or specifying options and purchasing a new automobile may be as natural as retrieving cash from an automated teller machine (ATM).
I previously alluded to the ability of sellers to influence and alter (i.e., ma- nipulate) the buyers’ behavior by offering various service level options with as- sociated higher or lower prices. This tactic may be the supplier’s best defense to minimize the shift in power from the seller to the buyer. Supplier auctioning will be commonplace to match buyers’ bidding systems. ABC/M will play an impor- tant role in assisting sellers to understand and test the profitability of their deci- sions. Those suppliers without an ABC/M calculation engine risk motivating a customer to change purchasing habits and potentially buy goods and services where the seller loses money as a result. The impact of ABC/M in the front of-