Strategic Activity-Based Management: Product Mix and Pricing

Strategic Activity-Based Management:

Product Mix and Pricing

Dr. Nancy Mangold

California State University, East Bay

Strategic Activity-Based Management

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

Strategic Activity-Based Management -Decisions

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

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.

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.

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.

ABC Product Profitability:The 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

Cumulative ProfitabilityWhale Curve

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Product Profitability

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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

ABC Analysis: Whale Curve Cumulative profitability vs Cumulative sales volume

The profitable products(20%) generate 80% of sales and 300% of the unit’s profits.

The hump of the whale indicates the profits earned by the business unit’s most profitable products.

The remaining products generate 20% of sales and lose 200% of the units profits.

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.


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.


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).

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.

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.

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.

ABC Findings

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

ABC Findings

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

ABC Findings

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

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

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.

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)

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.

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

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

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.

ABC Costing for a New Order

Based on activities.

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.

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.

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.


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


Provides some stability to a company’s 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.

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.

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


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


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.


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.

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


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.


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.


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.

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.

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.

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.

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.

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.


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.


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.


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.

Improve Production Processes (1)

ABM involves continuous and discontinuous process improvement.


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.


Traditional costing system Obvious ways to reduce product costs:

– Lower materials purchase prices– Lower direct labor cost– Lower machine-related costs


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.


Lower direct labor costs.– Spent thousands of dollars on industrial engineering

studies to reduce a product’s direct labor content by tenths of hours

– Automate processes whenever possible and – Shifted labor-intensive processes to low-wage

countries.


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.


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


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.


ABC cost system retain the– Bill of materials structure

It adds a new dimension– A bill of activities


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.


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

Change Operating Policies and Strategy (1)

Several companies in view of Toyota’s 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.


Without any fundamental improvement in performing batch-level activities, frequent changeovers not only raised batch-level expenses, they also consumed valuable equipment capacity.


ABC bill of activities and associated classification by cost hierarchy provide a powerful connection to contemporary developments in operations management.


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.


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


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.


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.

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

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.


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.


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.

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.

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.


Such argument is based on demand curve, not their cost curves.

ABC is a cost-estimating model, says nothing about product demand curves.


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.


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


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.

Strategic Activity-Based Management: Product Mix and Pricing

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