Strategic Activity-Based Management: Product Mix and Pricing

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Strategic Activity-Based ManagementProduct Mix
and Pricing

• Dr. Nancy Mangold
• California State University, East Bay

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Strategic Activity-Based Management

• Strategic ABM works by shifting the mix of
  activities away from costly and unprofitable
  applications to more profitable ones.

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Strategic Activity-Based Management -Decisions

• Product mix and pricing
• Customer relationships
• Supplier selection and relationships
• Product design and development

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Cumulative Sales Curve
Cumulative of Sales
Cumulative Percentage of Products
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Cumulative Sales Curve
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ABC Product Profitability

• Cumulative sales curve
• The normal 20-80 rule.
• The highest volume 20 of products generate about
  80 of sales.

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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.

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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.

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ABC Product ProfitabilityThe 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

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Cumulative ProfitabilityWhale Curve
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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

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ABC Analysis Whale Curve Cumulative
profitability vs Cumulative sales volume

• The profitable products(20) generate 80 of
  sales and 300 of the units profits.
• The hump of the whale indicates the profits
  earned by the business units most profitable
  products.
• The remaining products generate 20 of sales and
  lose 200 of the units profits.

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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.

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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.

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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).

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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.

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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.

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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.

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ABC Findings

• Sony eliminated several models sizes of
  televisions, and Mitsubishi is cutting back on
  its 30 different varieties of fax machines.

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ABC Findings

• Japanese electronics will eliminate 25 models of
  video-cassette recorders and 10 models of
  televisions.

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ABC Findings

• Matsushita is scaling back from its 220 types of
  televisions and 62 types of VCRs recognizing that
  only 10 sold well

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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 companys whale curve indicates the need for
  it to address the issue of whether customers
  truly value the wide range of products it
  currently provides.

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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.

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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)

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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.

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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

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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

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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.

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ABC Costing for a New Order

• Based on activities.

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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.

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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.

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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.

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Target ROI Pricing-Advantages

• Provides a defensible price, permitting the
  company to cover its costs and earn a competitive
  return on its invested capital.

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Target ROI Pricing-Advantages

• Provides some stability to a companys 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.

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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.

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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

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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

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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.

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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.

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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

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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Improve Production Processes (1)

• ABM involves continuous and discontinuous process
  improvement.

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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.

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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

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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.

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Improve Production Processes (5)

• Lower direct labor costs.
• Spent thousands of dollars on industrial
  engineering studies to reduce a products direct
  labor content by tenths of hours
• Automate processes whenever possible and
• Shifted labor-intensive processes to low-wage
  countries.

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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.

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Improve Production Processes (7)

• All these actions appeared sensible when viewed
  through the lens of
• The materials
• Labor and
• Machine hour costs.

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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.

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Improve Production Processes (9)

• ABC cost system retain the
• Bill of materials structure
• It adds a new dimension
• A bill of activities

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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.

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Improve Production Processes (11)

• The insights from a bill of activities as well as
  an analysis of the costs of products stimulate
  process improvements.

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Change Operating Policies and Strategy (1)

• Several companies in view of Toyotas 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.

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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.

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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.

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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.

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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

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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.

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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.

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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

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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Eliminate Products (5)

• Make shifts in the incentive structure by
  awarding commissions and incentive pay based on
  profitability not sales.

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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.