Customer Selection (3 of 4) – Activity-Based Costing

In his Are You Selecting Your Customers…Or Are They Selecting You?  presentation at CSIA 2010, Dean Streck, CEO of V I Engineering, encourages the use of Activity-Based Costing (ABC) to identify, describe, assign costs to, and report on operational performance. A more accurate cost management system than traditional cost accounting; ABC identifies opportunities to improve business process effectiveness and efficiency by determining the “true” cost of a product or service. ABC principles are used:

1. To focus management attention on the total cost to produce a product or service, and
2. As the basis for full and accurate cost recovery.

Support services are particularly suitable for activity-based resourcing because they produce identifiable and measurable units of output.

4 Steps to Knowing Your ABCs

Dean goes on to recommend some basic steps to implementing your Activity-based Costing system.

Identify activities—perform an in-depth analysis of the operating processes of each responsibility segment. Each process may consist of one or more activities required by outputs.

Assign resource costs to activities—this is sometimes called “tracing.” Traceability refers to tracing costs to cost objects to determine why costs were incurred.

Identify outputs—identify all of the outputs for which an activity segment performs activities and consumes resources. Outputs can be products, services, or customers.

Assign activity costs to outputs—assign activity costs to outputs using activity drivers. Activity drivers assign activity costs to outputs based on individual outputs’ consumption or demand for activities. For example, a driver may be the number of times an activity is performed (transaction driver) or the length of time an activity is performed (duration driver).

As also discussed in my project cost accounting post, this is a vital step in an integrator’s ability to maximize the profitability. It becomes impossible to run the business from macro-level – simply tracking overall receivables and payables versus the total labor cost. You must be able to account for your finances on a project-by-project basis.

Customer Lifetime Value

By performing Activity-Based Accounting, you can ultimately assign a customer lifetime value(CLV) for your accounts. The CLV is the present value of the future cash flows attributed to the customer relationship. Use of customer lifetime value as a marketing metric tends to place greater emphasis on customer service and long-term customer satisfaction, rather than on maximizing short-term sales.

Customer Selection (Part 4-4) – Customer Migration Techniques

Financial Management

Technical success as an Alliance Partner is great, but ultimately you need to be financially successful to run and grow a business. In the end, financial management is just as important as good project management. And, failure to do so is often the primary reason for the demise of a small services business.

Show Me the Money - Tom Cruise

So, you need to implement adequate processes to manage, control, report, and plan your finances. They may not need to all be automated, but there at least needs to be defined business practices to ensure that they are handled consistently.

We’ve talked about a couple of the most important in the past:

1. Project Cost Accounting – a vital step in an integrator’s ability to maximize the profitability. As your business grows, it becomes impossible to run the business from macro-level – simply tracking overall receivables and payables versus the total labor cost. You must be able to account for your finances on a project-by-project basis.
2. Managing Cash Flow – perhaps, the most important financial practice. This is particularly true for smaller system integration companies that often operate business that are fairly low-margin and a large payroll. You can actually have a profitable business with significant revenue, still run out of the cash required to operate the business. And, that’s not to mention the cash needed to finance the growth of the business.

Over the next few weeks, we touch on other basic financial practices required to run a successful system integration business.

Project Cost Accounting

Project tracking ultimately leads to individual project cost accounting. And, this is a vital step in an integrator’s ability to maximize the profitability. It becomes impossible to run the business from macro-level – simply tracking overall receivables and payables versus the total labor cost. You must be able to account for your finances on a project-by-project basis.

Quoted versus Budgeted

The first step in the process is to understand that there is a difference between the quote for a project versus the budget for a projects. The quoted price is simply what you were able to sell the project for; the budget is what you have allotted to actually get the project done. In some cases that may be the same. But, in others, you may expect to complete project for less than the quoted price. Or, you may even expect it to take more (and therefore less profit). But, don’t make a habit of it.

Getting the Complete Picture

Next, ensure that your project accounting system includes all labor, not just developer time. Be sure to accounts for management costs, project support, customer engagements, sub-contracting, …. To get a complete picture, your project cost accounting system should include hardware and equipment utilization. For instance, you may be able to save labor by using better tools.

Eventually, some integrators will go so far as to include sales, marketing, and other overhead to the projects. At first this may be a simple percentage calculation, but eventually you may find that it is worth noting which projects require more upfront marketing and sales costs.

Don’t forget about non-billable projects. These may include internal projects or lost opportunities. For some, these are just tracked as ‘negative’ projects which the other projects must counter-balance. But others figure out ways to ‘charge’ their projects for use of these non-billable activities.

Project reviews and audits

Once you have your project cost accounting system in place, it becomes easier to incorporate into your project reviews. You can look at total project cost and profitability rather than just labor costs and schedules. Issues can be raised and addressed as they occur rather than at the end.

In addition, you can perform financial audits of your projects. Take a look at the real costs and where you are actually making money. You may be able to improve your budgeting process, and even identify customers that you may want to ‘fire’.