Driving Improved Profitability With Activity-Based Costing

Executive Summary

For a large majority of U.S. printing companies, profits are becoming increasingly difficult to earn. The annual ratio studies compiled by Printing Industries of America show that, from a financial performance standpoint, the U.S. printing industry is actually two industries – one composed of a relatively small number of firms that are performing fairly well, and one made up of a much larger number of printing companies that are producing little, if any, profits. In its ratio studies, PIA provides financial statistics for both the average company and for the average "profit leader." Profit leaders are the best performing 25% of companies, measured by net pre-tax profits as a percentage of value added. For the ten-year period from 1992 through 2001, the average profit leader earned annual profits of about 9.7% of sales. During that same time period, the average profit "lagger" – firms in the bottom 75% of profitability – earned profits of about 0.7% of sales. Profit leaders were, therefore, over ten times more profitable than profit laggers.

This Executive White Paper seeks to address three important topics. First, it identifies and describes one of the primary causes of the huge and persistent profit gap that exists between profit leaders and profit laggers. Second, the paper explains why the traditional budgeted hourly rate (BHR) cost systems used by most U.S. printing companies actually help create and sustain an information "blind spot" that makes it difficult for printing company owners and managers to significantly improve profitability. And, third, this paper describes and discusses a costing system that does provide printing company owners and managers with the information they need to produce higher profits.

Profit leading printing companies achieve superior financial results in large part because they spend far fewer dollars on "support expenses" for each dollar of earnings produced than average firms of the same size (measured by sales). Support expenses are operating expenses that relate to the performance of support activities, and support activities include all work activities that a printing company performs except direct production activities. In many cases, more than half of the profitability gap between profit leaders and average firms can be attributed to this difference in support expense levels. Profit leaders spend less on support expenses because they perform support activities more efficiently. For an average printing company to improve its support activity efficiency, the company’s management team must be able to identify what specific support activities the company is performing, describe in detail how the company is performing those activities, and establish how much the company is spending to perform those activities. For many printing companies, determining the cost of support activities can be almost impossible, because traditional BHR-based cost systems provide little, if any, insight into the cost of specific support activities and processes.

Traditional BHR-based cost systems actually contain three flaws that can impede significant improvements in profitability. Two of these shortcomings relate specifically to the treatment of support expenses, while the third concerns the equally important issue of capacity cost measurement. The first major problem with traditional BHR-based systems is that they make no attempt to identify, define and assign costs to support activities. This means that printing company owners and managers cannot see what activities and business processes are causing specific support costs to exist. This absence of information also means that printing company managers have no way of prioritizing support activity improvement projects to achieve the greatest economic benefits and no way of measuring the progress of those projects once they are underway. The second major problem with traditional BHR-based cost systems is that they "force" all operating expenses, including support expenses, to be allocated to the print jobs and other services sold by a printing company. This distorts economic reality because many support costs have no direct cause and effect relationship to the jobs and other services sold by the company. The third major problem with traditional BHR-based systems relates to capacity costs. By using estimated utilization rates to calculate hourly cost rates, traditional BHR systems not only fail to measure the cost of unused capacity, they actually conceal such costs from printing company managers.

These shortcomings of traditional BHR-based cost systems point to the pressing need for a new cost system for U.S. printing companies. Fortunately, a time-tested and proven cost system does exist that can enable printing company managers to make sound, profit-enhancing decisions. Since the mid-1980’s, activity-based costing (ABC) systems have been implemented in an extraordinarily wide variety of organizations, both large and small. A well-designed ABC system provides an economic map of a company’s expenses and profitability that is linked to and based on the company’s activities. For printing companies, well-designed ABC systems solve the major problems associated with traditional BHR-based cost systems. They trace and assign operating expenses to support activities based on "real world" cause and effect relationships, they avoid arbitrary allocations of operating expenses that distort economic reality, and they provide critically important information regarding the cost of excess capacity.

Activity-based costing provides printing company owners and managers with a powerful tool for improving profits. Implementing an activity-based costing system is not all that is required to produce long-term success, but it is an important first step.