We will help you better understand the origin of your profits.

We will help you better understand the origin of your profits.

The ABC method enables a realistic allocation of indirect costs of your various products/services and clients. The breakdown done by many companies between direct and indirect costs is rarely done correctly, and products or services may only be showing false profits when in reality they are losing money.
A similar analysis can be performed to identify the least profitable customers.

Trivial example:
Company VIVA ITALIA sells 2 types of products: industrial pasta and hand-made raviolis.

Industrial pasta costs 0.5€ per kilo to produce and is sold for 1€ per kilo. VIVA ITALIA diversified into hand-made raviolis filled with white truffles and entirely made by hand with superior ingredients. These raviolis cost 15€ per kilo to produce and are sold for 50€ per kilo.

VIVA ITALIA has a sales and marketing department which handles the sales for these two products and costs the company 200000€ per year. These structural costs are considered overheads and allocated according to the sales realized with each product.  
Last year VIVA ITALIA made a turnover of 1m€ (950000kg selling industrial pasta at 1€/kg = 950000€ and 1000kg selling raviolis at 50€/kg = 50000€). 95% of the overheads were allocated to the industrial pasta (190000€) and 5% (10000€) to the raviolis.

VIVA ITALIA’s management calculated the profitability of its 2 products as follows :

  • Industrial pasta:
    • Revenues: 950000€  Costs: 190000€+475000€=665000€
    • Profit: 950000€-665000€=285000€
    • Margin: 285000/950000=30%
  • Raviolis:
    • Revenues: 50000€
    • Costs: 10000€+15000€=25000€
    • Profit: 50000€-25000€=25000€
    • Margin: 25000/50000=50%

If VIVA ITALIA had applied the ABC Costing methodology to calculate its profitability the result would have been totally different.  An in-depth analysis revealed that the raviolis were more difficult to sell than the industrial pasta and that the sales and marketing department spent actually half of its time marketing and selling them. Therefore, applying the ABC method the reality was that 50% of the costs of the sales and marketing department thus (200000/2=100000€) should have been allocated to the raviolis and the profitability would have looked like this:

  • Raviolis:
    • Revenues: 50000€
    • Costs: 100000€+15000€=115000€
    • Profit: 50000€-115000€=-65000€
    • Margin: -65000/50000=-130%

The raviolis actually proved to be a very unprofitable product and VIVA ITALIA was losing money with it.

Although this example may seem trivial, we’ve applied ABC Costing for years in various settings and always discovered that some products, some services, some clients, were highly unprofitable and that our clients would be better off abandoning them.

When we perform an ABC Costing analysis we don’t look only at time spent by employees on selling products or services. We also analyze how goods or services are produced, which assets are used to produce them (machines or others) and their amortization time, what are the acquisition costs depending on the various distribution channels as well as the Customer Lifetime Value of the different market segments.

Although all calculations are unbiased because they are performed by two independent consultants in parallel, we never come up with exactly the results our clients were expecting. The more our clients are involved in each phase of the analysis the more they strengthen the credibility of our conclusion. There is always an unexpected surprise that our clients can immediately use to make their business more profitable. In one particular case, a customer of ours saw his profits increase 3-fold within 12 months.

Believe it or not, not all clients, products and services are profitable. Sometimes you are losing money with some of them and you are better off getting rid of some of them so that you can increase your profits. 

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