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Compaq claims that activity-based costing (ABC) now supplies a powerful analy-
tic tool for measuring and controlling manufacturing costs better than its com-
petitors can. "It is by far the best financial weapon we have." Thanks in large
measure to ABC, Compaq now lays claim to being the low-cost producer in the PC
industry. Convinced they were already producing computers more efficiently than
anyone else back in 1989, Compaq executives were mystified how competitors
could sell comparable equipment for less and still make money. They learned
that accounting experts long criticized conventional cost systems for allocat-
ing overhead on the basis of labor, when direct labor content in today's high-
tech factories is only a small portion of total product costs. The result is
that product costs are distorted. High-volume, commodity-type products are fre-
quently overcosted, "subsidizing" low-volume custom-made products. ABC analysis
confirmed that. Compaq was able to slash overhead by 75% per unit and drop SG&A
by 14% so far. "You ain't seen nothin' yet"............................... Alan
COMPAQ'S SECRET WEAPON - Behind Compaq's rise to leadership in the PC industry
{S.L. Mintz, CFO, 10/94, pp93-97}
Recent price cuts by red-hot Compaq Computer Corp. reflect more than business
as usual in an industry prone to knee-jerk pricing decisions. Instead, the
Houston-based computer maker claims that activity-based costing (ABC) now
supplies a powerful analytic tool for measuring and controlling manufacturing
costs better than its competitors can. Since last January, Compaq executives
have had access to thorough ABC analysis to assist them in setting prices.
"It is by far the best financial weapon we have," says chief financial officer
Daryl J. White.
This ringing endorsement is a strong case for a cost management tool that took
Compaq four painstaking years to install. In most industries, four years is
a long time; in the computer industry, it's several product generations. But
insofar as competitive pricing contributes to results, the investment of time
and resources has paid off. In the first half of 1994, Compaq's unit sales of
personal computers streaked past all of its competitors, including IBM for
the first time. Sales jumped 50 percent, to $4.8 billion, while profits more
than doubled, to $423 million from $204 million a year earlier. With gross mar-
gins of 26 percent, Compaq could well afford August's across-the-board price
cuts of up to 22 percent.
Thanks in large measure to ABC, Compaq now lays claim to being the low-cost
producer in the PC industry. "This effort is just beginning to bear fruit,"
says White. "It could not come at a better time."
STRONG MEDICINE
Such impressive performance, and the patience required to achieve it,
illustrate why many of White's counterparts consider ABC management
worthy--but too difficult to implement. But it is also difficult these days
to look at Compaq and decide not to take the same medicine, especially when
traditional cost management often doesn't measure up any more.
That's the clear message from the results of a recent survey conducted by the
Cost Management Group of the Institute of Management Accountants (IMA), in
Montvale, New Jersey.
Nearly half of the respondents described current cost management systems as
"less than adequate" or "poor." A year earlier, only one in four gave the same
response. Meanwhile, the percentage of replies ranking cost management
systems "good" or "excellent" slid in the latest survey, to 25 percent from 33
percent.
Compaq, back in 1989, could see that conventional cost management wasn't doing
the job, as a growing field of competitors began stealing market share. "We
were providing price and performance umbrellas for the rest of the industry to
slip under," says White. Convinced they were already producing computers more
efficiently than anyone else, Compaq executives were mystified how com-
petitors could sell comparable equipment for less and still make money. "We
were in a denial mode in those early years," White admits.
White tapped Tim Harris, then worldwide controller for manufacturing
operations and now vice president and controller for the desktop PC division,
to find a solution--and not a moment too soon. Compaq's sales slipped from $3.6
billion in 1990 to $3.3 billion in 1991, while profits dove from $455 million
to $ 131 million. "It became pretty obvious that our accounting systems and
financial systems were not providing information that helped drive
manufacturing decisions," Harris says. Rounds of payroll cuts followed, and
even chief executive officer Rod Canion lost his job, in October 1991.
White and Harris decided that a new approach was needed to help their
manufacturing colleagues get a tighter handle on costs. They set themselves
three broad objectives: to provide operational cost information reflective of
real operations processes; to provide tools for continuous cost improvement
and containment; and to provide a foundation for activity-based costing and
management efforts.
AHEAD OF THE CURVE
By now, ABC has gained wide acceptance as a cost management tool. The notion
that product costs can be usefully analyzed in terms of activities is no longer
controversial; "value-added activities" and "activity cost pools" have entered
the up-to-date controller's lexicon. Twenty-nine percent of respondents to
another IMA survey reported they were using ABC systems to replace their
existing traditional cost systems; another 56 percent said they were using ABC
as an off-line analytic tool (as Compaq now does).
In 1989, however, Compaq was ahead of the curve with ABC. In November of that
year, Harris named Joe Ottaviano, financial manager of the desktop PC division,
to manage the ABC project on a day-to-day basis. The pair spent most of 1990
gathering data, deciding on a strategy, and securing support from top
management.
In the first quarter of 1991, Harris and Ottaviano got the green light to
proceed with a two-phased program. Phase one was to establish the value of
activities that are eventually "consumed" by finished products--what
Ottaviano refers to as "activity-based management," or ABM. Phase two was to
translate that into meaningful cost data for individual products. (Consultants
would call both phases ABC, reserving ABM to describe changes made to business
processes based on ABC-type activity analyses.)
The translation of activity values into cost data is where most ABC projects
fall down, says Ottaviano, who studied similar attempts in the course of
devising Compaq's approach. Companies either skip the time-consuming ABM phase
or take ill-advised short-cuts. "You have to have ABM first to get accurate
product costs," he maintains.
Harris and Ottaviano spent the next two years honing the ABM portion of the
program. There was more than one false start along the way. One early approach,
for instance, attempted to examine individual piece parts listed in a product's
bill of material, with an eye to predicting what quantity of each piece
manufacturing would require in the next six months. The idea was to apportion
overhead to each of dozens of parts. "Conceptually it made sense," says
Ottaviano. But in practice, after several months of evaluation, it proved far
too complex. "It was a nightmare," Ottaviano admits.
(Wary of unworkable solutions, CFO White's dictum is "Keep It Simple." "It's
a red flag when a manager says, 'Please explain this to me again,"' says White,
who squashed an elaborate, time clock-based overhead allocation scheme soon
after he joined Compaq in 1983.)
Harris and Ottaviano chose the materials function of Compaq's U.S. operations
to implement ABM on a trial basis. Because of the function's size, complexity,
and strategic importance, says Ottaviano, "We felt that if we could do
materials, we could do any organization--that was the true test." The pilot
program assembled team members from the whole spectrum of manufacturing and
finance functions: product planning, development engineering, packaging,
warehousing, testing, cost accounting, general accounting, and internal
auditing, to name about two-thirds of the categories represented. Together,
members settled on methodologies for ABM and ABC.
Begun in May 1991, the pilot program took just four months to complete.
Encouraged by their success, Harris and Ottaviano were now ready to implement
ABC throughout the company.
HOMEWORK REQUIRED
Training was critical. ABM entailed a five-week schedule requiring about two
hours of formal training plus light homework, followed by six hours over three
weeks in the ABC phase. The training was largely self-directed. Managers
trained supervisors, then supervisors trained workers. Harris and Ottaviano
made themselves available, even to the point of picking up the workloads of
managers distracted by the training process, but they remained in the
background as much as possible. After the second training session, workers
listed every task they did each day on separate three-by-five Post-it notes and
brought them to the first workshop, during week three. Working from a list of
hundreds of separate tasks, Harris, Ottaviano, and the team leaders eventually
merged the tasks into a handful of activity pools, such as testing, packaging,
warehousing, and assembly, then costed those activities. In December 1992,
three years into the project, Compaq was ready to implement phase two--ABC.
Once the companywide cost contribution by each activity pool was measured, it
became possible to impute that information into the cost of individual
products that represented the sum of component activities. The result l was a
whole new way for managers to assess the costs of products, and a road map for
attacking indirect labor costs that didn't add value to the production
process.
3 THE LOWDOWN ON COSTS
Accounting experts have long criticized conventional cost systems for
allocating overhead on the basis of labor, when direct labor content in today's
high-tech factories is only a small portion of total product costs. The result,
they maintain, is that product costs are distorted. High-volume,
commodity-type products are frequently overcosted, "subsidizing" low-volume,
custom-made products.
That, in a nutshell, was the case at Compaq. ABC analysis confirmed what Harris
and Ottaviano had suspected all along: high-volume, low-cost computers were
subsidizing low-volume, customized machines (see chart, page 94). The result:
Compaq was being underpriced in the fastest-growing segment of the industry.
With a brand new cost matrix to steer by, Compaq. says CFO White, has been able
to slash overhead by 75 percent per unit while steadying margins--despite
precipitous price declines. Weeding out non-value-added activities has driven
tens of millions of dollars from product costs, according to Harris, who
declines to be more specific.
The job is far from done, however. At present, the effects of ABM and ABC
reach only the gross profit line. In the next two years, White wants to
introduce these methods at the SG&A and engineering levels. "What I want to get
to," he says, "is our ability to cost a product all the way through the bottom
line."
He has a head start. Through December 1993, a nominal 14 percent drop in
Compaq's SG&A over the past three years led the computer and office machines
industry, according to a survey of comparative SG&A costs conducted exclusively
for CFO magazine by Andersen Consulting. White sounds prepared to seize the
momentum until ABM and ABC become religion at Compaq. "You ain't seen nothin'
yet," he declares. -
S.L. Mintz is New York bureau chief of CFO.
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| We are using Activity Based Management in Shared Engineering Services,
and if it's being considered for all of Digital, then I would contend
that the topic is valid for discussion here in the Digital notes file.
Perhaps the management focus on labor vs overhead is warranted.
Certainly, no one in software engineering really knows what the budget
is being spent on and how that relates to the price of the product. So
maybe it's a valid issue. But I don't know how ABM is going to solve
any problems.
For SES, I believe a lot of data will be gathered, and maybe 10% of it will
be really useful information. (Most people just enter activity
codes and hours because it's required...not really actual hours.) The
process of introducing the system was rather sloppy, in my opinion.
The biggest obstruction to getting real data is that the activity codes
were based on sample processes, which do not reflect reality. Another
obstruction is lack of attention to those activities that really
are time and money wasters...If I have to spend two hours backing
up and upgrading my PC, I put it down under the code "Other" because
there is no code for "wasting time backing up and upgrading my PC."
And how would management solve this problem of my wasting time
this way? Hire more system management? I have been asking for that
since long before we got activity-based management. No great
revelations there!
So, can Digital at large use activity-based costing? I think we will
have to learn a lot more about our processes, and the work each person
does, before ABM can be introduced. And then, at the end of the first
fiscal year, lots of data! So what do you do with lots of data? Need
to interpret it and summarize it for management. Finally, management
has to be open to making changes in the processes that bring
budgets into line. Only then can the savings being reflected in lower
product costs for our customers. Today, Digital product prices have
almost nothing to do with the cost of producing the product.
I guess my point, though, is that activity-based management is not a
solution, it's just another tool. If your diagrams are poor, your
materials unavailable or not up to spec, your location is not ideal,
and it rains every time you try to start building your new home, well,
a new hammer just isn't going to fix it.
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