Clear View

I stopped by Evan Thomas Consulting Engineers to discuss the company’s performance. A secretary brought me a cup of coffee, and after a few moments Evan entered the boardroom. “I just received our quarterly results,” he said, “and they’re not very good.”

He tossed me a copy of the report and I glanced down the figures. “Your sales have increased, but your profit margins are down. For 2001 and 2002 you had margins of about 14%.”

“Exactly,” said Evan. “We’ve been running pre-tax profits of 13% to 15% for the last four years. But last quarter we were down to 12%. This quarter we’ve fallen to 10%.”

“Why do you think that’s happening?”

“We’ve underpriced some work. We hired Joe Gurney, a sales manager, about nine months ago. He’s very eager to prove his worth — and he’s been able to bring in a couple of very large clients. But I’m afraid he’s done that by lowering our prices too far.

“I had an analysis done by our controller,” Evan continued. “It shows that our large new clients generate only 7% profit compared to 11% for our traditional clients. You can see what I mean from this analysis of our last quarter. We billed $1 million — and we made just $100,000 pretax profit.”

“I’m a little confused,” I said. “You’ve dropped to 11% even for your traditional work. Something seems wrong.”

“We’ve suffered from some price erosion — but the main thing is our overheads have grown too much. We’ve pushed for greater capacity so we can deal with the new clients, and now I think it was a mistake. We shouldn’t have taken on the extra work.”

“Your cost allocation is based on professional hours spent,” I said. “It means that your overheads are distributed to the new clients based on the number of professional hours for the job.”

Evan nodded, “We’ve always done it that way.”

“That approach follows generally accepted accounting principles,” I explained, “but it may not be giving you the best information. Because your professional hours are above average for new client billings, those new clients are also being over-allocated overhead costs. That may be a distortion.”

“How else would you do it?”

“Allocating expenses using a formula is a simple and inexpensive way of dealing with a complicated problem. It’s fine as long as there are no issues. But if you’re going to make important decisions about your business, I’d prefer a more focused method — activity based accounting or ABA. Under ABA, all costs that are directly attributable to jobs are charged to them. The costs include your normal professional costs and also direct customer support.”

“I don’t see how that differs from what we do now.”

“There are two issues,” I said. “The first has to do with time put into WIP [work-in-progress] and the second with non-billable time. Most people erroneously believe that WIP is simply an inventory system for recognizing where time and money has been spent. If that were correct, your goal would be to collect every second of time that is allocable to a client.”

“That is what we do.”

“Not so. You actually use WIP primarily as a billing tool and secondarily for measuring performance. In particular, you focus on write-downs of WIP as a negative. As a result your staff learns to put their time where they are most likely to collect — rather than where it’s actually gone. Of course, 90% of WIP really does reflect the actual time spent on jobs. But to avoid write-downs, your staff learns to underestimate the time at the margin spent on difficult customers — and over-estimate the time spent on other clients. That’s the WIP issue.

“The second issue, ” I continued, “is that your difficult clients generally have lots of complaints that require time. The time might be spent by professionals, or administrative staff, or on lunches devoted to ironing out problems. Whatever the remedy, the solution is in terms of firm resources.

“To figure out what your costs are under ABA, I’d like to have one of our people interview your staff and come up with some numbers. Then we can meet next week. You might consider having your sales manager present. After all, if his work isn’t profitable, he should know about it.”

“All right,” Evan said. “Let’s do it.”

A week later the three of us met in the same boardroom. “What’s the verdict?” Evan said.

“It’s interesting,” I said. “Here’s an ABA version of your cost analysis. The sales and direct professional costs are the same as on your analysis. Our people discovered that the two new large clients Joe obtained do generate a higher ratio of professional costs to fees than your traditional work. That led you to suspect that their profitability was below normal. However the issues I raised about the accuracy of WIP and your non-billable time were correct. Apparently virtually all professional and administration fees are billed to the new clients. In addition they tend to be low maintenance in terms of unbilled time. In sum this means the actual gross profit from those jobs is actually higher than you had guessed.”

“Are you saying everything is O.K.? What about our diminished margins?” asked Evan.

“You do have a problem. But it’s not the one you believed you had. Your overheads are out of hand — but not because of your new clients. The expectation of more work led your controller to hire more staff. To that you can add training costs and the usual dislocation that occurs when new hires join the firm. It was a pretty expensive miscalculation — and it came as a result of depending too much on your accounting reports. There was no way anyone could discover from your system that your new clients were low maintenance — your overhead costs were simply averaged across the board.”

“But the decision to take a job or reject it should be done solely by analyzing incremental benefits,” Evan said.

“Precisely. And ABA is a useful tool for that reason.”

Hank Bulmash, MBA, CA is a principal of Bulmash Cullemore, chartered accountants of Toronto. E-mail: hbulmash@bulmashcullemore.com.

TRADITIONAL COSTING

ACTIVITY BASED COSTING