Eighteen years ago, Team 1 Plastics, a plastic injection molding company for the automotive industry, began using the Activity-Based Cost (ABC) Accounting model for quoting new jobs. The company is now in the fifth generation of the model, having updated it last year to reflect current systems and processes, and it remains one of the competitive advantages for Team 1 Plastics, according to Craig Carrel, President.
“It takes a lot of work to develop an ABC quote model, but once you have it set up, it pays huge dividends. It makes your quoting process easier and very consistent. You do not have to make any guesses or estimates in anything. You quote the part as you believe it will run. The only variable you adjust is your profit level. When negotiating with your customers to win parts, you know clearly, like Kenny Rodgers, ‘When to Walk Away’ from a bid because a part will not be profitable for you. You let your competitors win those unprofitable parts.”
The ABC model is different from traditional Cost Accounting because it calculates Indirect costs (overhead) differently, said John Daly, management consultant and author of Pricing for Profitability. Both accounting methods calculate direct material and direct labor the same, but the difference is how overhead is calculated. “Traditional costing methods fail in many pricing situations because they arbitrarily allocate the indirect costs. Today, indirect costs such as rent, depreciation, utilities, and supervision are often a significant portion of the company’s cost structure … Activity-based costing provides the tools to understand indirect costs.”
With the ABC model, Daly said that a company identifies “buckets of costs, like supervisory cost, quality inspection costs, even things you do in the office, such as invoicing the customer and trying to figure out what it costs per invoice.”
Team 1 Plastics began by examining the cost to launch a new product. This included quoting, engineering, layout, PPAP, selling costs, and other activities that occur before the company produces the first saleable unit of a product. They discovered that the launch costs in 1998 typically ranged from $5,000 to $15,000. One of the advantages of ABC model, Daly said, is that it “helps us differentiate between high-volume and low-volume. For a high volume product, launch costs per piece may be trivial. However, for a low volume product, launch costs may be the most significant element of cost.”
Knowing your company’s buckets of costs, said Daly, gives you a competitive advantage over your company. “Traditional [cost accounting] thinks in terms in three categories of cost: material, labor and overhead. If you were to take time to learn five categories of cost, such as launch costs and set up costs, you would have a competitive advantage over a company that used only the three categories. If you took time to learn seven categories, you would have a competitive advantage over a company that had five. If you understood 12, you have a competitive advantage over a company that knows seven. But the law of diminishing returns applies. Once you’ve looked at about twelve categories of costs for your company’s major activities, then you’ve probably looked at over 95% of your company’s cost structure. So a company that looked at 20 categories would not have a competitive advantage over a company that looked at 12.”
According to Carrel, Team 1 Plastics has identified 12 categories of costs. “Our first model went from three categories to five categories. We’ve evolved, working with John Daly, and we’re up to about 12 variables. The key is to really identify your main cost drivers.”
Carrel admitted that he was skeptical at first when Team 1 Plastics begin using the ABC model. “In particular, I was worried that many of the parts quoted would be close to our breakeven point, and we would have to then negotiate around a loss to win any new work. In reality, our pricing is either competitive with a profit margin or we are 20+% high. Since we have a deep understanding of our costs we do not believe we are that far off (20+%) and we again let our competitors win those unprofitable parts. It also has allowed us to have a deep understanding of all of our costs and be able to discuss with customers what areas are driving the pricing, such as launch, set up, material handling, etc. When customers have questions about our quotes and why certain areas are higher, we can have a very detailed conversation of why this is the case.”
Carrel said that Team 1 often gets questions about why their quotes look very different from their competitors. “Even though we have been using ABC for over 15 years, our competition is not. The vast majority of them use the traditional costing model of machine/labor rates with an overhead and profit markup. This is simpler for our customers to understand and makes our quotes look very different than our competitors which leads to lots of conversations explaining the differences. This is especially true with newer customers until they get a better understanding of our ABC quoting process.”
Using the ABC model does take a major commitment said Carrel. “It has to be updated every three to five years, because you are constantly improving and changing your systems and processes and the ABC model has to reflect these changes. The key is to have a high level of confidence that your ABC model is accurately reflecting your costs and what it takes to produce each part so that you can provide the customer with the most accurate and competitive quote every time.“
For Team 1 Plastics, the commitment to the ABC model is worth the effort. “I truly believe it has helped our profitability by winning parts that are profitable while avoiding parts that have no chance to be profitable and will be loss leaders."