Strategic Activity-Based Management: Product Mix and Pricing

1. Strategic Activity-Based Management:Product Mix and Pricing Dr. Nancy Mangold California State University, East Bay

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

3. Strategic Activity-Based Management -Decisions • Product mix and pricing • Customer relationships • Supplier selection and relationships • Product design and development

4. Cumulative Sales Curve Cumulative % of Sales Cumulative Percentage of Products

5. Cumulative Sales Curve

6. ABC Product Profitability • Cumulative sales curve • The normal 20-80 rule. • The highest volume 20% of products generate about 80% of sales.

7. 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.

8. 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.

9. 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

10. Cumulative ProfitabilityWhale Curve

11. 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

12. ABC Analysis: Whale CurveCumulative 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.

13. 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.

14. 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.

15. 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).

16. 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.

17. 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.

18. 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.

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

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

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

22. 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.

23. 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.

24. 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)

25. 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.

26. 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

27. 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

28. 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.

29. ABC Costing for a New Order • Based on activities.

30. 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.

31. 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.

32. 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.

33. Target ROI Pricing-Advantages • Provides a defensible price, permitting the company to cover its costs and earn a competitive return on its invested capital.

34. Target ROI Pricing-Advantages • 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.

35. 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.

36. 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

37. 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

38. 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.

39. 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.

40. 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

41. 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.

42. 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.

43. 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.

44. 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.

45. 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.

46. 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.

47. 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.

48. 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.

49. 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.

50. 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.