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The ABCs of Activity-Based Costing

Oct. 1, 2010
Activity-based costing (ABC) can provide valuable insight to improving your company's financial performance.

Most successful electrical distributors have a firm handle on revenue sources and direct costs, but many don't have a good grip on how the products they distribute and the customers they serve consume support services and contribute to other indirect costs. Without detailed visibility into sales, logistics, fulfillment and administrative expenses, it's difficult to measure the financial performance of individual products and customers or to make informed decisions that reduce overall costs and optimize profitability.

Activity-based costing (ABC) can accurately determine the true cost of products and services by assigning costs based on services performed by distributor resources. It's a valuable tool for managing costs and improving performance. When conducted effectively, ABC can provide rich insight into a distributor's core business processes and help managers change inefficient business practices. ABC also helps distributors uncover and adjust the drivers of cost and profitability in their businesses and get real-time feedback on any changes they make in their business processes.

Optimizing profitability is a top-of-mind issue for many industry leaders. Dr. Barry Lawrence, director of the Industrial Distribution program and the Supply Chain Systems Lab at Texas A&M University, discusses the power of ABC in stratifying customers as one method of optimizing distributor profitability in the book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line.

To manage profitability effectively, distributors need to use the proper costing method and have the right information and analytical tools. Most distributors use some method of apportioning costs that lacks rigor and prevents them from understanding the real profitability of products and customers. Unfortunately, when they attempt to optimize their profitability, many distributors use an array of desktop spreadsheets rather than a dedicated application as a method of capturing costs. Spreadsheets can be extremely difficult to use for repetitive, collaborative tasks, and especially for analyses that involve complex sets of cost data. Relying on desktop spreadsheets can keep distributors from doing the kind of ABC needed to optimize profitability.

Technology is now available to assist distributors in applying ABC to drive improved financial performance. With profitability and cost management (PCM) applications, distributors can increase visibility into enterprise costs. PCM applications can help automate and enable the alignment of operational resources to increase revenues by focusing on the most profitable products and customers and reduce costs on those that are not.

PCM applications offer improved visibility into the drivers of cost and profitability with activity-centric, multi-dimensional modeling and analysis. Distributors can quickly build simple or complex ABC models that can truly reflect operational costs. Having the right cost information when they need it is critical to making smart, timely business decisions. PCM puts valuable data at the fingertips of users across the enterprise, enabling distributors to be agile and flexible. It can help identify areas for cost improvements such as instances of waste or high-cost activities and facilitate proactive decision making to rectify problems.

For example, a seemingly profitable high-volume customer may be unprofitable when a distributor considers the costs of all value-added services. Better understanding of customer profitability enables distributors to improve the structure of their sales terms and to align sales commissions to focus on more profitable sales. PCM allows distributors to become more agile and align their organizations better, gain visibility into their internal operations, and gain confidence in their abilities to control costs and their operations and build out new competitive advantage in this low-margin industry.


PCM offers electrical distributors a deep understanding of the levers affecting organizational costs and profitability. It allows for the identification of underlying causes of underperformance, testing of potential impacts of change and incisive actions to reduce costs and optimize profitability of products and customers.

ABC analysis doesn't come without some business challenges. Some distributors may have limited visibility into cost and profitability details; inefficient cost reporting that fails to provide insights for improving financial performance; a lack of transparency into cross-charges and insufficient insight into cost of value-added-services; or annual budgets disconnected from operational reality.

ABC analysis offers many profitability and cost management benefits, including visibility into key drivers affecting costs and profitability such as shared services; optimization of costs and profitability based on detailed understanding of multi-dimensional drivers such as products, services and customers; and more incisive decision making due to rapid identification of underlying causes of changes in cost and profitability, and the ability to test potential adjustments.

Applying a modern profitability costing methodology means a distributor has current information technology to ensure accuracy, efficiency and agility. Doing so enables distributors to model “what-if” decisions they make every day. Your first step to improve financial performance is a candid assessment of current capabilities and needs. Activity-based costing and the related profitability and cost management applications can help you do that.

Paul Pretko is an industry principal for wholesale distribution at SAP America. He focuses on enabling efficient distributor operations with SAP for wholesale-distribution solutions. For more information, contact him at [email protected] or visit

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