Service Product Profit Model - FULL

Customer Lifecycle and The Service-Profit Chain Walter Adamson June, 2003 Version C Contact: [email_address] Tel: +61 403 345 632

Introduction
The Service Profit Chain
Customer Lifecycle
Profitably Serving Customers
Followed by:
Part One – Linking the Customer Lifecycle and Business Logic
Part Two – Developing the Customer Value Package
Part Three – Developing Service Products to fill the Value Package
Part Four – Understanding Service Pricing Strategies
Part Five – Improving Margins through the Service Value Chain

The Service Profit Chain 1 Focus of This Presentation Connected through Value Employee Productivity Internal Performance Employee Loyalty When we have this ..... Employee Satisfaction Profit & Growth 1 Customer Loyalty Customer Satisfaction 1 Customer Value 1 Service Value 1 External Performance

Customer Lifecycle
Represents the total potential touch-points and profit capture
The Customer Lifecycle Phase 1 Pre-sale Phase 5 Value Creation Phase 9 Disposing & Upgrading Phase 2 Value Identification Phase 7 Customer Value Gain Phase 8 Value Improvement Phase 3 Meeting Needs Phase 4 Obtaining Commitment Phase 6 Customer Learning

A systems thinking approach optimises:
Value creation for the customer
Value capture and sustainability for the provider
Customer Value Model Customer Value Package Whole Product Business Logic Customer Lifecycle Service-Profit Chain Profit & Growth Value Chain When we have this ..... $$

The Customer
From the market into the business strategy
Drives the business logic and value packages
Reflects industry trends and competitive forces
Without this analysis the business has no grounding
A value package is a customer-oriented offer
It includes a value proposition for specific customers
Without this offers will be only features or advantages
Requires an associated move to solutions selling
Understanding the Customer Value Model drives the development of the Customer Value Packages Customer Value Model Customer Value Package

The Service Product
The totality of what a customer buys
Includes all touch-points, resources, and emotions
Closely synchronised with the customer value package
Required to understand pricing, costing and competition
The lifecycle represents the lifecycle touch-points
Customer value packages must reflect different phases
Whole product and business logic link to lifecycle
Understanding required as a key part of solutions selling
Understanding the Whole Product concept allows business to be captured and value created through the full Customer Lifecycle Whole Product Customer Lifecycle

The Delivery
The process of delivering the whole product
Describes the activities and resources and interfaces
Closely synchronised with the customer lifecycle
Required to reduce inefficiencies and increase net profit
How the business operates and makes money
Driven from the strategy and customer value model
Measured by business targets and key result areas
Without clear understanding the business is suboptimal
Understanding the Whole Product concept allows business to be captured and value created through the full Customer Lifecycle Value Chain Business Logic

The Lifecycle Link to Profit Understanding the complete Customer Lifecycle is essential in order to the satisfaction required in the Service-Profit Chain Customer Lifecycle Service-Profit Chain
A satisfaction cycle
Reflects total costs and potential profit
If broken then breaks satisfaction
Customer satisfaction drives profit
Value package drives satisfaction
Solution selling meets value needs

Profitability and Sustainability Successfully delivering service profits requires an understanding and enablement of the linkages across the complete system Profitability Sustainability
Understand customer value
Sell value propositions that matter
Effective resource deployment
Efficient distribution of whole product
Satisfy customers and employees
Capture fair share of value created
Re-validate customer value & lifecycle

The Lifecycle Sales Approach - 1
Moving Sales from HOW & WHAT WHO & WHY
Solution (Why) Product (What) Advantages Promoter Transaction, Product Pusher Salesperson Needs Relationship, Value Provider Problem Solver Customer Needs (Who) Stages of Sales Maturity focus process 4 3 2 1

The Lifecycle Sales Approach - 2
The primary objective of the salesperson shifts
FROM : Close the sale, and
Sell the advantages and get through the process, TO:
Solve the problem of why the customer needs the product
Create customer value and capture a fair share of it
Solution (Why) Product (What) Advantages Promoter Transaction, Product Pusher Salesperson Needs Relationship, Value Provider Problem Solver Customer Needs (Who) focus process 4 3 2 1

The Service Profit Chain 1 Focus of This Presentation Connected through Value Employee Productivity Internal Performance Employee Loyalty When we have this ..... Employee Satisfaction Profit & Growth 1 Customer Loyalty Customer Satisfaction 1 Customer Value 1 Service Value 1 External Performance

The Service-Profit Model
Linking the Customer Lifecycle and Business Logic
Customer Lifecycle
Business Logic
Customer Value
Customer Value Model
Customer Value Package
Customer Value Audit
1

Customer Lifecycle
The objective is to optimise the creation and capture of value

Business Logic
To service customers you need operational business logic
‘ The logic that organises a business’s approach to things ’
Revenue Model Marketing & Sales Logic Service Product Design Delivery & Customer Support Business Strategy Customer Value Package Resources Customer’s Needs Customer Value Model Profit Targets Competition

Lifecycle and Business Logic
To maximise return on investment:
The customer lifecycle is supported by the Business Logic
Business Logic

Business Logic Basics
Describes how a business operates and how it makes money
Business Logic Value Creation Value Capture Value Chain Customer Value The Value Proposition Marketing Model Revenue Model Core Competencies Funds and Investment People Management Operations Model Systems Management

Business Logic and Strategy
Business Logic is the essential logic of the business
Needed in order to optimise value creation and capture
Expressed in terms of a major action premise that can:
Maximize market share, revenue, short-term-profit, ROI, or,
Whatever focus the Business Leaders have chosen
The Logic aligns the action premise and the people’s energies:
Marketing and Sales Logic
Revenue Model
Service-Product Development Logic
Customer Delivery and Support Logic

Business Logic and Strategy
Marketing & Sales – how to we gain access to our customers?
Niche, vertical, horizontal, alliances, distribution
Revenue Model – how do we use and make our money?
Market share, growth, acquisition, cost performance
Service-Product – what value package will we take to market?
Commodity, uniqueness, speed, trend, lifestyle, informational
Customer Delivery & Support – how do organise ourselves to make the other logics work together?
Product focus, geography, function, matrix, account
You need to test the total business logic to see that it makes sense!

Strategic Model
The Strategic Model drives the Business Logic and the Customer Value Package – using the Customer Value Model
Vision Customer Value Model Mission Business Logic and Strategy Business Targets Customer Value Package Core Values and Philosophy Operating Environment Key Result Areas

Customer Value Customer Value Model Customer Value Package Business Logic and Strategy Customer Value has three major components

Customer Value Model
A set of critical factors that define customer value
From the customer’s point of view
Requires detailed engagement and research
Input from the market
Drives the business logic
Drives the customer value package
Tells us what value we have to provide in order to win, and keep, the customer’s business over the complete lifecycle.

Competitive edge
Salespeople who understand their customer’s value model better than their competitors have a better chance to win the business
How do your customers define value?
Must be derived from the minds of the customer
Effective engagement
Communication
Develop Value Propositions
Must be validated in solid customer research
Who has best performance in the industry – key metrics, and why?
Must be able to implement the path to the customer’s ‘truth’
Building the Customer Value Model The customer value model is an ‘invisible truth’ used by the customer to evaluate the quality of outcomes you provide.

There is a hierarchy of customer value satisfiers:
Base value – the fundamental components of the customer value package you need in place just to stay in business
Expected value – what your customer considers ‘normal’ for you and your competitors
Desired value – added value features that customers know about but don’t necessarily expect because of the current level of performance of your competitors
Unanticipated value – going beyond the customer’s expectations and desires – provided that the customer really values these “surprises”
You must go beyond ‘base’ and ‘expected’ to make a difference
Hierarchy of Customer Value You must have mastered the first two levels in order to satisfy the customer on the higher levels. Failings in the first two levels will waste the effort and investment in the higher levels.

The enterprise infrastructure for value creation
PLUS , the Whole Product
Enterprise Components 1. Marketing & Sales Logic 2. Service Product Design 3. Delivery & Customer Support 4. Revenue Model 5. Branding & Reputation 6. Informational 7. Interpersonal

Enterprise capabilities are needed to deliver the Whole Product:
The Whole Product plus Enterprise Capabilities Post-Sales Support Life-Cycle Support Pre-Sales Support Integration Services Software Consulting Hardware The Product 1. Marketing & Sales Logic 2. Service Product Design 3. Delivery & Customer Support 4. Revenue Model 5. Branding & Reputation 6. Informational 7. Interpersonal

A multidimensional logic for managing the customer’s experience with your company, and with the value it creates
The customer value package must be right if you hope to build in the customer’s mind an impression of quality and value for money
Customers’ expectations vary enormously even in the same line of business

Customer Value Expectations
Potential value expectations are broad e.g. a fashion store
Customer Value Criteria
Supplier reputation and experience
Branding
Warranty package
Information
Quality specification and control
Parts and service coverage
SECURITY
Continuity of benefits and costs profile
Continuity of supplier support
RELIABILITY
Cash flow
Operating compatibility
Operating flexibility
Status/prestige
‘ Fashion’ currency
PERFORMANCE
AESTHETICS
Style
Design
Conformance
Longevity
Design/style continuity
CONVENIENCE
Transaction facilities and process
Product service and parts availabilities
Warranty service processing
Sales and service response
Time
Location
Information
ECONOMY
Acquisition costs
Installation costs
Set up and training costs
Maintenance costs
Disposal value and costs
Supplier information
Opportunity costs

Does the design of your CVP reflect the customer’s value model?
Or does it reflect just the convenience of your organisation?
Cross-match Customer Value Model, to Customer Value Package
CVM4 CVM3 CVM2 CVM1 Interpersonal Informational Branding & Reputation Revenue Model Delivery & Support Service Prod Design Marketing & Sales Logic Customer Value Factors Customer Value Package

Will these Customer Value Packages lead to success?
Where are the gaps, how to fill them?
CVM4 CVM3 CVM2 CVM1 Life-cycle Support Post-Sales Support Integration Services Consulting Hardware Software Pre-Sales Support Customer Value Factors Customer Value Package

Market Value Audit
Determine the “defining features” by cross-referencing the value packages with the customer types – the market segment benefits
Customers on one axis – cluster customers into sets
Value packages on the other axis – cluster value packages
The clusters (sets) represent meaningful defining features
Customer Value Packages 5 4 3 2 1 Look for Niches     1 2 3 4 5 Customer Types

Developing the Customer Value Package
Understanding Value
Developing a Value Proposition
Integrating the VP into a Customer Value Package
1 2

Understanding Value
Value is “mindware” created by the product/service you sell
The end condition a customer deems worthy of their approval
eMotion-Value End Condition Approval Emotional Reaction Value Package Customer’s Perception

Value is in the mind of a specific client
Value = Benefits – Cost
Benefits exist only with a particular client or set of clients in a particular business setting . Therefore, if there is no specific client and business setting you cannot promote value 1 .
Features are an objective characteristic of the product or service.
Advantages indicate how the features might help sets of clients .
1 In that case you will be promoting “features”, “advantages” or just technology .
Understanding Value - 2 Advantages Lead To Features Benefits Lead To

Understanding Value - 3
Perception of value is tied to emotion , and personal values
eMotion -Value = eMotion -Benefits – eMotion -Cost
The outcomes, which are stated as benefits, are as much perception as measurable factual reality .
Both facts and perception are reality. But interestingly, while facts belong to organisations, perceptions belong to individuals .
The eMotion Value Proposition Model 1 explains:
Why 'good' proposals stall
Why high return (high ROI) proposals are blocked
Why the 'best' proposal does not always win
How personal distraction and effort mould perceptions of benefits
How individual recognition and reward mould perceptions of value.
1 For full details of the eMotion VP Model go to www.digitalinvestor.com.au

Developing a VP - Asking Questions
Start with good sense of the business situation
Industry
Company and its issues
Personal (relationship)
It is about the art of questioning and analysis
What is the business’s perspective of the situation?
What are they doing now and why?
What are the tensions in what they are doing now?
What is the ideal or “tomorrow state” as currently perceived?
What barriers are faced in getting there?
Which barriers have the biggest impact and where?
What are their investment criteria?
What is the decision-making process?
What has been agreed to now and and in the past in IT initiatives?
How do they perceive the value added by IT so far? Why?
What is their ideal solution and how do they know when they achieve it?

Developing - Discovering Needs 1
The objective is to uncover the business’s specific needs
Concentrate on identifying the real needs:
Place yourself in their shoes
Place yourself in their customer’s shoes
Work on improving your questions and interaction
Be aware of “knowing too much” - let the business talk!
Then, move to offering a credible solution
Float options, build and test your solutions
Work in parallel to action the needs into an IT strategy
Do not spend time or energy
“ Selling” features, unqualified advantages, and technology
Turning the needs analysis back to a generic IT solution
Disparaging alternative IT solutions from the business
Work to generate business ownership of the proposition

Developing – Discovering Needs 2
The most powerful tool is the “Day in The Life”:
Live a day in the life of the business and their customers
It is powerful because
The business commits to spend time and energy
You commit to contribute and report
It brings ownership through joint generation of the VP
It BUILDS WIDER RELATIONSHIPS
Focus on your customer’s customers
Workshop the outcomes to generate the VP
Build a case which delivers “ladders of value”
Also build ladders of compelling IT investment strategy

Developing – Generating the VP
A useful technique
When we have this ..... We will be able to do these things ... Which means this in business terms ...... And we’ll be able to measure the benefits this way .....

Testing the Value Proposition
Is there a common understanding of the central need?
Why should anyone want to use the proposed solution?
What genuine business value does it return?
Examples of things to consider:
What problem does it solve for potential customers?
Does it open a new market?
Does it better exploit an existing market?
Does it eliminate or reduce inefficiencies?
Does it solve the same problem as competing systems but at less cost?
How does the value proposition fit into the development of the Customer Value Package?

Integrating the VP into a CVP
The VP guides development of a Customer Value Package:
The Whole Product plus Enterprise Capabilities Value Proposition Post-Sales Support Life-Cycle Support Pre-Sales Support Integration Services Software Consulting Hardware The Product 1. Marketing & Sales Logic 2. Service Product Design 3. Delivery & Customer Support 4. Revenue Model 5. Branding & Reputation 6. Informational 7. Interpersonal

Integrating the VP into a CVP
The Whole Product plus Enterprise Capabilities need optimisation:
The Whole Product must be tailored to include the VP
The Enterprise Capabilities have to support delivery of the VP
This combines to produce a specific Customer Value Package
Examples of things to consider
How does the Whole Product mix need to be modified?
How does the organisational infrastructure need to be modified?
What role do channels and does distribution play?
How does this CVP fit or blend with other CVPs which need support?
What is the revenue model associated with this CVP?
How can IT support and improve profitability of delivery of the CVP?

IT Support of the CVP
How can systems support the Customer Value Package:
What is the timing, sequence, priority and risk?
Can they be built and implemented within a reasonable time?
At an acceptable cost?
Examples of things to consider
Are the necessary skill sets available, and the technology?
Should it be insourced or outsourced?
How do they fit the current systems architecture?
Do they have to be integrated with other systems and data?
Do they improve the underlying technology fabric?
Do they improve the company’s overall operations?

Developing Service Products to fill the Value Package
Service-Product Development
Whole Product Concept
Whole Product Value
Technology Adoption Lifecycle
1 3

Service-Product Development
The fundamental elements of service-product formulation are coordinated market value propositions and delivery at a profit
Customer Service Product Design Service Delivery Value Proposition Activity Costing/Profit Go to Market

Which Customer?
The model points to a customer, but which customer?
This requires market segmentation including technology lifecycle
Integration Logic Customer? Service Product Design Service Delivery Value Proposition Activity Costing/Profit Go to Market

Service Product Design Audit
The Customer Value Models are customer pulls
Match those pulls to the Service-Product Design Elements
CVM4 CVM3 CVM2 CVM1 Integration Logic Activity Costing/Profit Go To Market Service Delivery Value Proposition Customer Value Factors Lifecycle Adoption Phase

Whole Product Definition
Service-Products are complex - they have many dimensions
The Whole Product is the totality of what a customer buys
A whole product is the physical object, software or service from which customer gets direct utility, plus other factors, services and perceptions that make the product:
Useful
Desirable
Convenient
People
Brand attractiveness - “Intel Inside”
For example Computer Operating System is:
Software + development + environment (hardware and software) + documentation to use it + training program + reseller’s service & troubleshooting capabilities + availability of hardware drivers + suppliers enhancement plans, + reliability + interface design appeal + brand appeal (Mac) etc.

Whole Product Concept
The “whole product” gives the customer value satisfaction
The cost of creating a complete product is often many times the cost of developing the generic product or service
Generic Product Expected Product Augmented Product Potential Product Value

The Expected Product
A step above the Generic Product
The Expected Product represents the customer’s base expectations
Delivery conditions, installation services, post-sale services, spare parts, training, packaging conveniences
Other examples of the minimum expectations:
The bank: the loan officer who is cooperative
The realtor: who is on your side
The lawyer: who protects you
The retailer: who sells you products which work and are reliable
The expected attributes vary by customers and industries
They could be sources of product differentiation
Depending on how well vendors implement their value packages

The Augmented Product
Augmentations are means of product differentiation
Customers may be offered more than they expect:
Computer that comes with “Office 2000” already installed
Optical store that replaces customer’s lost contact lenses nights & weekends and delivers them to customer’s home
Augmentations can also bring about customer dependency
They can educate customers about what it is reasonable to expect
This raises the competitive bar since augmented benefits may turn into customer expectations (and move into the inner circle)
Not all customers can be attracted by an ever-widening circle of augmented benefits

The Potential Product
The Potential is everything feasible to get and keep customers
what can be feasibly done with the existing product & service
what is possible in the future
what is needed in the future
Suppliers, and customers, can compete more effectively with the Potential Product in the changed conditions of future
In high tech markets, customers desire extendibility for the product so that the platform and basic technology can last over several generations of technology lifecycles
e.g. semiconductor technology cycles
Building and maintaining a Product Roadmap is important

Product Lifecycle
Products are marketing inventions
Product invention / definition is a continuous process
Starts at the intersection of new technology capability and perceived market opportunity
Continues past product introduction thru to discovery of new applications (not envisioned by the original developers)
Continues further
As product marches down the Technology Adoption Life Cycle and it is redefined for new groups of customers
As the company diversifies into new market segments to capture more market share

Whole Product Value
To the potential customer, value satisfaction is the “product”
The generic “thing” or “device” is not itself the product. It is the minimum necessary to get into the “game”
Whole Product value has meaning only from the viewpoint of the customer or the ultimate user - only they can assign value
Customers’ needs and wants define whole product value
Depending on the targeted market segment, the whole product offer must change to meet different value expectations
When positioning against competition, it is important to compare complete whole product customer value packages
The whole product must be defined differently in different phases of the Technology Adoption Life Cycle

Technology Adoption Lifecycle
The Customer Value Package must be different for each stage
At different stages customers buy and perceive value differently
Time 2.5 % Innovators 13.5% Early adopters 34% Early majority 34% Late majority 16% Laggards

Technology Lifecycle Value Audit
Rate the Customer Value Packages against the adopter stage
Look for gaps and misalignments in the offer and the adopter
CVP4 CVP3 CVP2 CVP1 Laggards Late Majority Early Majority Early Adopters Innovators Customer Value Factors Lifecycle Adoption Phase

Customer and Technology Lifecycle
Effort and resource expenditure through the customer lifecycle needs to be optimised against the technology adopter lifecycle
These buyers 1 need less selling and more confidence that you will support the product they are willing to try These buyers 2 need more selling and confidence that others have bought the product and are satisfied Customer Lifecycle 2 1 1 2 1 1 2 2 1 Early adopters Early majority Late majority Laggards

Understanding Service Pricing Strategies
Service Pricing Strategies
Price-Value Perceptions
Value Strategies for Service Pricing
Service Costing
Activity-Based Costing
1 3 4

Pricing Strategies Begin with costs and work towards selling price Begin with selling price and work towards costs Cost factors Price Customer Value Competition Cost-based Pricing Demand-based Pricing Combination Pricing Competition-based Pricing Begin with Competitors’ Pricing Above The Market Below The Market At The Market

General Pricing Challenges
Pricing strategies and challenges
Demand-Based Cost-Based Competition- Based Cost-based problems: 1. Costs difficult to trace 2. Labor more difficult to price than materials 3. Costs may not equal value
Competition-based problems:
Small firms may charge too little to be viable
Heterogeneity of services limits comparability
Prices may not reflect customer value perception
Demand-based problems: 1. Monetary price must be adjusted to reflect the value of non-monetary costs 2. Information on service costs is less available to customers, hence price may not be a central factor

Service Pricing Strategies
What makes it difficult and different?
Hard to calculate financial costs of creating an intangible
High ratio of fixed to variable costs - cost to serve one extra customer may be minimal (but must still recover fixed costs)
Variability of inputs and outputs - how to define a “unit of service” and establish basis for pricing?
Many services hard for customers to evaluate--what price can they put on the ‘value’ which is delivered?
Importance of time factor - same service may have more value to some customers when delivered faster
Use of physical or electronic channels - may create differences in perceived value

Pricing Strategies
Choice of strategy depends on:
The technology, refer to the technology lifecycle (part three)
The market and your customer power
Your cost structure
The competitive environment
Threat of substitution
Threat of new entrants
Keys to Demand-based Pricing:
Set prices consistent with customer perceptions of value
Prices are based on the whole product value package

Incorporating Value into Pricing
You must fully understand what value means to customers:
What benefits does the whole product package provide?
How important is each of these benefits as to the others?
How much is it worth to the customer to receive a particular benefit in a service product’s value chain?
At what price will the service be economically acceptable to potential buyers?
In what context is the customer purchasing the service?
What is the customer’s perception of ‘value’?

Price-Value Perceptions
Four customer-definitions of value:
Value is low price. Value is everything I want in a service. Value is the quality I get for the price I pay. Value is all that I get for all that I give.

Value Strategies for Service Pricing
Pricing strategies to reduce uncertainty
service guarantees
benefit-driven (pricing that aspect of service that creates value)
flat rate (quoting a fixed price in advance)
Relationship pricing--incentives to patronize one supplier
non-price incentives
discounts for volume purchases
discounts for purchasing multiple services
Low-cost leadership
Convince customers not to equate price with quality
Must keep economic costs low to ensure profitability at low price

Pricing Questions - Services
How do you calculate the total potential profit of offerings?
Can you rank service-products by margin, by total profit?
Can you rank service-products in the technology lifecycle?
What does each function and process contribute to profit?
How can you reduce costs by 20% in the service-product chain?
What mix of service-products yields the highest profits?
What new blends of services yield the potential best profits?
What is your maximum possible revenue given the resources?
What are the key ingredients of the offers that drive profits up?
What continuing investment is needed to support current offers?
What investments are needed to create new offers?
Can costs be better distributed through a channel strategy?

Service Costing
Service costing is an application of strategic cost analysis, for:
Modifying product mix and pricing
Repricing customer value packages
Substituting services and offers
Eliminating elements and resulting excess capacity
Improving service-product design and development
Redesigning service-products
Improving delivery and whole product support processes
Investing in technology support
Improving customer relationships
Changing operating policies and strategy
Improving channel relationships

Strategic Cost Analysis
Strategic cost analysis uses activity costing to:
Identify distorted service-product costs
Determine unprofitable Customer Value Packages
Highlight areas for different channel strategies
Explain undercosting and overcosting of products and services
Give management insight into the cost structures for making and selling diverse products
Particularly, it must focus on whole product and the value chain:
Assigning activity costs to whole product customer value packages:
calculating the activity cost per unit of activity driver
preparing a bill of activities for each whole product

Strategic Cost Analysis Benefits
Particular benefits relate to service-product development:
Management can identify and evaluate new service-products to improve performance by evaluating how service and process designs affect activities and costs. Companies can work with their customers to evaluate the costs and prices of alternative value packages.

For Service Firms
The general approach is very similar to that in manufacturing :
Costs are divided into homogeneous cost pools and classified as output unit-level, batch-level, product- or service-sustaining, and facility-sustaining costs
The cost pools correspond to key activities:
Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool
Resources CVP 1 CVP 2 CVP 3 Activities Activities Activities

Service Costing - 1
Service costing is a critical element of performance management
Identify the processes for each CVP value chain
Allows you to answer key questions:
What does it cost to deliver these services?
Are we delivering our services cost-effectively?
How do our service costs compare?
How much should we charge for these services?
Is there is an alternative, less costly, way to deliver these services?

Service Costing - 2
How do you find the processes to analyse?
Organisations are managed vertically, however:
Work gets done horizontally via business processes
Processes cut across functions and layers of the organisation
Processes consume all types of the resources of an organisation
Process measures help resolve friction and take out costs
Processes provide feedback for continuous improvement
Process measures enable customers of the processes to be served more effectively and efficiently
Processes consist of activities
measure through activity-based costing

The Logic of Activity Costing
Products and Services are consumed by customers
Activities are consumed by products and services
Resources are consumed by activities
It is the Customers That buy our Services Which makes us conduct Activities That consume our Resources

Basic Activity Cost Allocation
The costing process is simple in theory:
Fundamental Cost Objects Activities Costs of Activities Assignment to Other Cost Objects Product Lines Individual Products Customers Distribution Channels

Implementing Activity Costing
Follow four stages to assign overhead costs to products:
Calculate a cost-driver rate for each activity.
Assign activity costs to customer value packages using the cost-driver rate.
Identify and classify cost objects (activities). Customer Value Package 1 Customer Value Package 2 Identify cost drivers relevant to each activity in a whole product value package: Marketing & Sales Corporate Services Lifecycle Support Step 1 Step 2

Activity-Based Costing
The logic of ABC is simple:
It is a methodology to calculate the cost of activities (such as train employees), and cost objects (such as products and services)
It assumes that services create needs for outputs which create the demand for activities which, in turn, consume resources.
By tracing costs to services/outputs according to the activities required to provide them , ABC provides a more accurate picture of costs and performance.

Cost Drivers
Knowing the cost drivers is an integral part of ABC
Drivers apply to activities or factors that cause costs to be incurred
There are volume-based drivers and non-volume-based:
Volume-based cost drivers
Assumes all costs are driven, or caused, by the volume of production (or sales)
Non-volume-based cost drivers
Costs are not directly related to production volume

Activity–Based Costing - 1
The key principles are that:
Cost are assigned to activities
Costs driven by volume are at ‘unit level’
Cost drivers are identified for batch-level and product-level costs, but not for facility-level costs
Unit, batch and product-level costs vary proportionally with their cost drivers
Managers need to see “whole product” costs as an integral part of the firm’s effort to create value for customers.

Activity-Based Costing - 2
The ABC process relates activities to the resources they consume
Classifies costs into four levels:
Unit level
Activities performed for each service-product unit
Batch level
Activities performed for a group of service-product units
Product level
Activities performed for service-product families
Facility level
Costs incurred to support the whole enterprise

Activity-Based Costing - 3
Other costing factors to consider are:
Customer Lifecycle Costs
Customer-level costs -- things like preparing bids, processing orders, answering questions, expediting rush orders, designing products, providing support
Net Margin Realized
Difference between the revenue and unit and batch level costs of manufacturing the item. The profit on the actual goods sold, without consideration of the specific costs to selling them to the customer
Influenced by the price demanded by the customer (related to their bargaining power) as well as the inherent profitability of the item

When to Use ABC - 1
An option when one or more of the following conditions exist:
Indirect costs are significant in proportion to direct costs and use only one or two cost-drivers
Goods are complex, requiring many inputs and processes.
Simple, high-volume products perform more poorly than complex, low-volume products
Different departments believe costs are assigned inaccurately.
The company loses bids it thought were low, and wins bids it thought were high
Operations have changed significantly, but the costing system has not changed

When to Use ABC - 2
When organizations find themselves on a crisis course:
Selling (funding) the wrong products or services
Serving the wrong customers
Designing costly products
Instituting cost cutting programs that fail, and/or
Obtaining the wrong (unnecessary) parts from outside suppliers

Strategic Cost Analysis Benefits
ABC benefits will be greatest where :
Overhead costs are a significant proportion of total cost, and a large part of overhead is not directly related to production volume
The business has a diverse product range, and individual product’s use of support resources differs from their use of volume-based cost drivers
Production activity involves diverse batch sizes and product complexity
There are likely to be high ‘costs’ associated with making inappropriate decisions, based on inaccurate product costs
The cost of designing, implementing and maintaining the ABC system is relatively low due to sophisticated IT support

Typical Revelations
The application of strategic cost analysis typically reveals:
Higher-volume products/services are overcosted
Lower-volume products/services are undercosted
Unexpected differences in customer profitability
Opportunities to improve processes
25-35% of activities don’t contribute to organizational goals
80% of costs are consumed by 20% of the activities

Limitations
However, ABC can be difficult to implement in service firms:
High levels of facility costs cause problems with costing services
Individual activities are difficult to identify because they are non-repetitive
A non-repetitive production environment makes it difficult to identify service outputs
Challenge:
ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.

Improving Margins through the Service Value Chain
Customer Lifecycle and Profitability
Lifecycle Sales Approach
Increasing Net Value
1 3 4 5

Customer Lifecycle Costs
The lifecycle incurs costs in delivering through the value chain

Whole Product Value Chain
The Customer Value Package offer is a value chain
Is each extension feasible, achievable, sustainable?
Investment and resource allocation?
Market competitiveness and positioning?
Ability to make a profit?
Value/Cost D Value/Cost C Value/Cost B Generic Product Value/Cost A Expected Product Total Solution

Value Chain Analysis
Value chain analysis helps to understand (at a high level) how each of your business activities adds value to your company
The objective of value chain analysis is to maximise the profitability of your business activities in a sustainable manner
Value chain analysis can also be applied to the Whole Product offer to understand the value offered to the customer and your costs associated with each element of that offer
The chain comprises the activities and functions performed by a company to deliver value to its customers.
Are you profitably delivering value to your customers?

Value Chain
Consider a value chain for the "Recruitment" business activity
The links in the value chain could be:
Identify - a list of all of the candidates that applied
Select - those candidates that meet the basic criteria
Screen - identify the best two/three for the vacancy
Interview - determine who should be offered the job
Offer - the job to the best candidate
Train - the new employee when they join the company
Each step in the chain adds value and adds costs

Value Chain Analysis - 1
A Value Chain Analysis:
Summarises your customer value package activities as distinct value chains - one for each package
Outlines and analyses the key links in each of your customer value packages
Defines the metrics you will measure to determine performance of your customer value packages
Identifies opportunities to improve the profitability of your customer value packages

Value Chain Analysis - 2
Distributors’ and forward channels partners’ value chains:
Change costs and margins of distributors and forward channel partners influence price paid by ultimate consumers
Therefore these activities must be analyzed as part of the chain:
The quality of activities performed by distributors and forward channel partners influence the quality of products/services of the company to the end-user
The activities have a direct impact on the profitability of the customer value packages and the lifetime customer value

Growing the Bottom Line
Value chain analysis and activity-based costing are tools to grow the bottom line and the quality of earnings:
Activities Costs of Activities Product Lines Individual Products Customers Distribution Channels Value/Cost D Value/Cost C Value/Cost B Generic Product Value/Cost A Expected Product

Increasing Net Value
Reduce resource expenditure at each stage of the value chain
Minimize interpersonal blockages
Optimize informational sharing and transfer
Decrease intra-enterprise engagement friction
Understand the Whole Product cost and value chain!
Share a common intent about the customer value package
Value/Cost D Value/Cost C Value/Cost B Generic Product Value/Cost A Expected Product Total Solution

Margin Improvement
Margins can be improved through process improvement:
Time and motion studies (1940s)
Workflow analysis (1960s)
Technology-based approaches (1970s)
Business process reengineering ( 1980s)
Process mapping (late 1980s)
Differences between activity-based and processed-based approach:
The activity-based view reveals how resources have been consumed
The process-oriented view cuts across the entire organization and reveals all resources and costs expended on producing a process output e.g. a customer value package

Service Process Chain - 1
The CVP is delivered by a “process” chain, or value chain:
xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx Service Product Marketing & Sales Support Customer Value & Your Profit xxxxx Process Activity A Customer Value Package Determining Service-Product Mix Determining Marketing & Sales Effort Support & Lifecycle Effort

Service Process Chain - 2
There is a different chain for each part of the customer lifecycle:
xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx Service Product Marketing & Sales Support 1 5 9 2 7 8 3 4 6

What To Measure
Process improvement uses many measures:
Activity-Based Cost – the cost of resources consumed by each activity performed
Rework – the cost of non value-added activities to correct things not done right the first time
Cycle Time – length of time it takes to get an outcome for a process
Touch Points – number of times an item is touched as it moved through a process
Cost per Process Output – process cost divided by a volume of items produced by a process
Customer Satisfaction – the degree to which customers are satisfied with the performance of the process

Service Process Improvement - 1
A methodical approach is required, focused on processes:
Firstly, identify the activities behind the customer value package
Determine the cost of resources used to perform each activity - some allocation may be required using resource drivers (labor, capital, materials, energy)
Allocate secondary activity costs to primary activities if needed
Combine activities with similar drivers/behavior into cost pools based on process, activity level, consumption ratio
Identify a cost driver for activities
Calculate the budgeted cost per unit of the cost driver for each activity
Collect information about cost driver usage for value package
Allocate costs to customer value package

Service Process Improvement - 2
Analyze the process chain for the total Customer Value Package:
The Whole Product plus Enterprise Capabilities Value Chain - Processes Post-Sales Support Life-Cycle Support Pre-Sales Support Integration Services Software Consulting Hardware The Product 1. Marketing & Sales Logic 2. Service Product Design 3. Delivery & Customer Support 4. Revenue Model 5. Branding & Reputation 6. Informational 7. Interpersonal

Customer Profitability - 1
The most common problem in determining customer profitability:
Selling, marketing, distribution and administrative costs are not assigned to products or customers
This is not necessary for financial reporting
Management considers them ‘fixed’
It is considered too expensive to do so
As a result, the behavior of these costs is not well-understood and cannot be easily managed
Value-chain analysis identifies and allocates these costs
Costs are allocated to each customer value package

Knowing the customer-profit profile determines value packages
A mismatch between the value package and customer profile:
Erodes profits
Misses the chance to capture extra profits
Consumes resources managing the mismatch
The matching of value packages and customers is step one
Value chain analysis, and profitability analysis are step two
From there margins can be improved

Types of Customer-Profit Profiles
Aggressive
Leverage their buying power
Low price and lots of customized service and features
Sensitive Price-sensitive and few special demands Impressive Costly to service, but pay top dollar
Passive
Product is crucial
Good supplier relationship
Net Margin Realized Low High Low High Cost to Serve

Gaining Internal Balance
There are often significant disagreements between staff about the costs and profitability of products and services.
1 3 2 4 1 1 1 1 2 2 2 3 3 3 4 4 4 4 3 2 Profit Top-line Quality Technology CEO & Finance Sales Consulting Delivery Products & R&D

Summary – Improving Margins
By following the value chain analysis process:
The profitability of each Customer Value Package is known
The Value Packages are matched to the customer profiles
Margins will be improved for each value package
Alignment will be gained between all parties to the value chain and service product about its contribution to profit

Contact:
Walter Adamson
Digital Investor Pty ltd
5/45 William St, Melbourne 3000
Office: 0500-500-321, Cell: 0403 345 632
[email_address]
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Service Product Profit Model - FULL

by Walter Adamson on Oct 25, 2007

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Service Product Profit Model - FULL — Presentation Transcript