Activity Based Accounting

Activity Based Accounting is the unbundling of costs and the rational assignment of those costs to the action that generated them.

In review, I seem to be fond of the word “proxy”.  In a management situation, proxies are used when the characteristic of interest (let’s assume “profit” or “true costs” for the remainder of the essay) is difficult or impossible to measure.

A common scenario is to choose a proxy that demonstrates good correlation to the characteristic of interest but is much easier to measure.  The production process evolves and the correlation becomes less strong over time.  Additionally, there are perverse forces in effect that actively try to split them.  In time, the proxy and the characteristic become completely decoupled and management fixates on whipping a dead horse, the continual improvement of the proxy while the characteristic of interest is in free-fall.

An example would be the use of “time card hours” to allocate fixed costs in a factory.  In the 1920s, direct labor was 80% of a typical factory’s cost.  Since people were sprinkled though the factory in a fairly uniform way, the “rent” for a specific product could be allocated on the basis of manhours required to make it.  And even if this induced inaccuracies, the “rent” was a small portion of the total cost and the inaccuracies were small.

Flash forward to the 1980s.  Direct labor was no longer 80% of the cost, it was closer to 20% of the cost.  Products were characterized by more fixed costs: more engineering, more sophisticated tooling, more compliance costs.  Facilities entered into death-spirals when they fixated on eliminated direct labor so-as to make other products produced within the facility absorb a larger share of the fixed costs.  Obviously, eliminating Joe Lunch-bucket eliminated a very small sliver of fixed costs but the GAAP pricing acted as if eliminating Joe Lunchbucket eliminated all of the fixed costs that had, hither-to-fore, been assigned to him. 

Taken to its logical extreme, the last direct labor employee carried a fixed cost burden of every salary employee associated with all products made within the building as well as the cost of the building.

The internet era

The internet era revealed another set of cost misallocations.

The business model (and I really hate that term, business model) for many service providers was to undercharge for the service but then make it back on product pricing associated with that service.  People who struggled to accept paying lots of money for an intangible, service, happily payed money for something they could carry out the door.

Vision

Examples include the optometrist.  I pay $83 for an exam which is not enough to keep the lights on.  The optometrists expect the patient to step into the next room and pay $400 for a pair of eyeglasses.  This was the norm when health insurance was more generous and there was no internet to shop on.  Now I can go to Zenni Optical and pay $9 for a pair of eyeglasses or go to Walmart and pay $35 a pair. 

Further, the on-line store has no way of verifying that my prescription is not over a year old.  I can use last year’s prescription if my eyesight has not drifted, thereby negating the need for another trip to the optometrist.  I can pay $13 ($9 plus shipping) when my lenses get scratched up as opposed to the $483 of the old model.

Many optometrists are locked into the failing business model and are riding a death spiral.  They are afraid to raise their rates to match the true economic costs of providing them.  They are loath to renegotiate their leases to dump the showroom floor. They are stuck.

Veterinarians

Other examples include Veterinarians.  They discount their services and expect to make it back selling worming products and specialty pet food.  Again, any person who is willing to read the back of the product can order products with the same active ingredients much more cheaply from Amazon or ValleyVet.com.

General Practice medicine

A third example is the GP medical practitioner.  Medicaid, Medicare and other health insurances cap the cost of an annual physical.  The $117 I pay does not come close to the cost of the doctor’s time for my annual physical.  The office has to make that back by spending a little bit less time on each chronic ear infection visit and from the hypochondriacs.  They need to make a little bit more on ancillary services like imaging (X-Rays) and allergy shots.

Two of the examples given above were driven by insurance.  Insurance separates customers, the cost of providing and prices.  The providers make a series of rational responses to those pressures which leaves them less seaworthy when faced with changes in the business climate.

Back to the lumber business

Tom Leep is sharp enough to realize that nearly all of the profit of timbering off a tract might be driven by just a few prime logs.  Most timber buyers are “lumpers”.  They will look at the total cost of harvesting a tract and the total, expected revenues.  That thinking causes them to underestimate the value of the highest value trees and overvalue the cost of the “trashy” trees.

This thinking is fostered by professional foresters.  They see their job as managing the woodlot.  They will advise the harvest of trees that are uneconomical to harvest because it will “release” the growth of trees with greater future value.  An example might be of an overstory of Box Elder overshadowing a stand of young Sugar Maple or oak.  The forester's advice  couples the cost of harvesting the tract with the cost of managing it for future profit.

Tom Leep’s business model separates out the harvesting costs and the management costs.  Further, by working on a percentage, he does not have to bid conservatively to protect himself against the vicissitudes of the market and Mother Nature.  Leep and the landowner share the impact of log(s) that might be hollow, be riddled with fencing wire or tree-stand steps or that the spot prices for timber take a dive.  Sharing those risks with the landowner usually resulted in the landowner getting a larger check.

The key enabler is that the property owner had to be able to trust Tom.  Trust is earned.