in Profitability Analytics
Some organizations have strict rules to determine the acceptance for proposals to invest and spend money on equipment or projects. Sometimes the administration of these is called the capital investment justification process. Senior management may not authorize any spending unless the business proposal exceeds a certain return on investment (ROI) level – often referred to as the hurdle rate. Management wants to assure itself that any money re-invested in itself will greatly exceed the level of return that its shareholders could achieve in other investments.
Organizations that are skeptical of activity-base costing (ABC) regularly ask, “What is the ROI from ABC?” My blunt reply from what I have learned is that calculating ROI on ABC/M is not possible to do. Here is why.
In the early 1990s CAM-I commissioned Professor Kay Silvester of University of Maryland to research this same question. She based her research on several successful ABC implementations in various industries. Her conclusion was that each company had several parallel improvement change initiatives (e.g., TQM, BPR, JIT) occurring simultaneously with their ABC implementation. As a result, it was nearly impossible for her to trace benefits, such as cost savings, directly back to each program (This is like re-assembling a broken egg yoke to be whole). Since the ABC data served each company as an enabler to turbo-charge the improvement programs, the contribution to profits coming from the ABC data was even more impossible to measure than the returns from the change initiative programs.
My reply to this question about the ROI from ABC is somewhat sarcastic, but I am trying to first catch the questioner’s attention in order to make an important point about what ABC is and is not. I first answer with this, “The ROI from ABC is often 1,000%!” However, there is some merit to this reply. As an example, after some two-day ABC Rapid Prototyping sessions, executives who see these early results may conclude to abandon certain losing products & service-lines or to terminate (“fire”) a large but unprofitable customer. That single decision can ultimately realize a substantial amount of money in future cost avoidance that converts directly into profits. That type of financial return is a large payback from a small fraction and investment in employees' time and the relatively minor cost of commercial ABC software.
That argument, however, may not be sufficiently convincing. Some managers may not believe that kind of opportunity is applicable to their organization. So I next pose this question back to the requestor: “I will answer the ROI on ABC relative to your estimate of the ROI you are already getting on something else. OK? What is the ROI from your general ledger accounting system?”
What we are discussing is actually “What is the incremental benefit from having better data to make better decisions?” As discussed in this book’s outset, the general ledger is so structurally deficient that it is at best useless and at worst dysfunctional and misleading. When an organization considering implementing an ABC system has to think about the ROI from what they have today, ABC data is multiples of their current cost data. It is likely that the financial return from an ABC system is well above the ROI of 99% of the capital expenditures and investments that the questioning organization has already pursued.
In short, you can not put a measure on the benefits of better data. An organization considering an ABC/M implementation first needs to ask itself, "Given what we see our more fierce competitors doing, how long do we want our company to perpetuate making decisions with the flawed and incomplete financial data that our users are already grumbling about?"
I am not suggesting that a company pursue an ABC system based on blind faith, but there is a bit on conviction required that ABC just makes good sense to do to provide better data. The flip side to doing ABC is to take no risk and keep using the same old costing method. Reluctance to act may be what is separating the stronger from the weaker economies and nations.
For example, the economy of the USA, particularly Silicon Valley, continues to boom for one reason. The people there are risk takers. They are not waiting for consensus and 99% proof and evidence that something works. They do not keep asking about whom else is doing it because they are nervous that if they fail, they may lose face. The risk-taking people in the businesses and governments in the USA look at something, judge if it makes sense, and then go for it if it does make sense. ABC is a no-brainer if you can articulate the comparison of ABC to what an organization already has. The challenge for advocates of ABC is to be able to articulate this.
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This article is an excerpt from the final chapter of Gary Cokins John Wiley & Sons book on pages 368-369. Here is the link to the book:
Activity-Based Cost Management: An Executive's Guide | Wiley
