Service Product Profit Model - FULL

Customer Lifecycle and The Service-Profit Chain Walter Adamson June, 2003 Version C Contact: [email_address] Tel: +61 403 345 632

Introduction The Service Profit Chain Customer Lifecycle Profitably Serving Customers Followed by: Part One – Linking the Customer Lifecycle and Business Logic Part Two – Developing the Customer Value Package Part Three – Developing Service Products to fill the Value Package Part Four – Understanding Service Pricing Strategies Part Five – Improving Margins through the Service Value Chain

The Service Profit Chain 1 Focus of This Presentation Connected through Value Employee Productivity Internal Performance Employee Loyalty When we have this ..... Employee Satisfaction Profit & Growth 1 Customer Loyalty Customer Satisfaction 1 Customer Value 1 Service Value 1 External Performance

Customer Lifecycle Represents the total potential touch-points and profit capture The Customer Lifecycle Phase 1 Pre-sale Phase 5 Value Creation Phase 9 Disposing & Upgrading Phase 2 Value Identification Phase 7 Customer Value Gain Phase 8 Value Improvement Phase 3 Meeting Needs Phase 4 Obtaining Commitment Phase 6 Customer Learning

Profitably Serving Customers A systems thinking approach optimises: Value creation for the customer Value capture and sustainability for the provider Customer Value Model Customer Value Package Whole Product Business Logic Customer Lifecycle Service-Profit Chain Profit & Growth Value Chain When we have this ..... $$

The Customer From the market into the business strategy Drives the business logic and value packages Reflects industry trends and competitive forces Without this analysis the business has no grounding A value package is a customer-oriented offer It includes a value proposition for specific customers Without this offers will be only features or advantages Requires an associated move to solutions selling Understanding the Customer Value Model drives the development of the Customer Value Packages Customer Value Model Customer Value Package

The Service Product The totality of what a customer buys Includes all touch-points, resources, and emotions Closely synchronised with the customer value package Required to understand pricing, costing and competition The lifecycle represents the lifecycle touch-points Customer value packages must reflect different phases Whole product and business logic link to lifecycle Understanding required as a key part of solutions selling Understanding the Whole Product concept allows business to be captured and value created through the full Customer Lifecycle Whole Product Customer Lifecycle

The Delivery The process of delivering the whole product Describes the activities and resources and interfaces Closely synchronised with the customer lifecycle Required to reduce inefficiencies and increase net profit How the business operates and makes money Driven from the strategy and customer value model Measured by business targets and key result areas Without clear understanding the business is suboptimal Understanding the Whole Product concept allows business to be captured and value created through the full Customer Lifecycle Value Chain Business Logic

The Lifecycle Link to Profit Understanding the complete Customer Lifecycle is essential in order to the satisfaction required in the Service-Profit Chain Customer Lifecycle Service-Profit Chain A satisfaction cycle Reflects total costs and potential profit If broken then breaks satisfaction Customer satisfaction drives profit Value package drives satisfaction Solution selling meets value needs

Profitability and Sustainability Successfully delivering service profits requires an understanding and enablement of the linkages across the complete system Profitability Sustainability Understand customer value Sell value propositions that matter Effective resource deployment Efficient distribution of whole product Satisfy customers and employees Capture fair share of value created Re-validate customer value & lifecycle

The Lifecycle Sales Approach - 1 Moving Sales from HOW & WHAT WHO & WHY Solution (Why) Product (What) Advantages Promoter Transaction, Product Pusher Salesperson Needs Relationship, Value Provider Problem Solver Customer Needs (Who) Stages of Sales Maturity focus process 4 3 2 1

The Lifecycle Sales Approach - 2 The primary objective of the salesperson shifts FROM : Close the sale, and Sell the advantages and get through the process, TO: Solve the problem of why the customer needs the product Create customer value and capture a fair share of it Solution (Why) Product (What) Advantages Promoter Transaction, Product Pusher Salesperson Needs Relationship, Value Provider Problem Solver Customer Needs (Who) focus process 4 3 2 1

The Service-Profit Model Linking the Customer Lifecycle and Business Logic Customer Lifecycle Business Logic Customer Value Customer Value Model Customer Value Package Customer Value Audit 1

Customer Lifecycle The objective is to optimise the creation and capture of value The Customer Lifecycle Phase 1 Pre-sale Phase 5 Value Creation Phase 9 Disposing & Upgrading Phase 2 Value Identification Phase 7 Customer Value Gain Phase 8 Value Improvement Phase 3 Meeting Needs Phase 4 Obtaining Commitment Phase 6 Customer Learning

Business Logic To service customers you need operational business logic ‘ The logic that organises a business’s approach to things ’ Revenue Model Marketing & Sales Logic Service Product Design Delivery & Customer Support Business Strategy Customer Value Package Resources Customer’s Needs Customer Value Model Profit Targets Competition

Lifecycle and Business Logic To maximise return on investment: The customer lifecycle is supported by the Business Logic Business Logic

Business Logic Basics Describes how a business operates and how it makes money Business Logic Value Creation Value Capture Value Chain Customer Value The Value Proposition Marketing Model Revenue Model Core Competencies Funds and Investment People Management Operations Model Systems Management

Business Logic and Strategy Business Logic is the essential logic of the business Needed in order to optimise value creation and capture Expressed in terms of a major action premise that can: Maximize market share, revenue, short-term-profit, ROI, or, Whatever focus the Business Leaders have chosen The Logic aligns the action premise and the people’s energies: Marketing and Sales Logic Revenue Model Service-Product Development Logic Customer Delivery and Support Logic

Business Logic and Strategy Marketing & Sales – how to we gain access to our customers? Niche, vertical, horizontal, alliances, distribution Revenue Model – how do we use and make our money? Market share, growth, acquisition, cost performance Service-Product – what value package will we take to market? Commodity, uniqueness, speed, trend, lifestyle, informational Customer Delivery & Support – how do organise ourselves to make the other logics work together? Product focus, geography, function, matrix, account You need to test the total business logic to see that it makes sense!

Strategic Model The Strategic Model drives the Business Logic and the Customer Value Package – using the Customer Value Model Vision Customer Value Model Mission Business Logic and Strategy Business Targets Customer Value Package Core Values and Philosophy Operating Environment Key Result Areas

Customer Value Customer Value Model Customer Value Package Business Logic and Strategy Customer Value has three major components

Customer Value Model A set of critical factors that define customer value From the customer’s point of view Requires detailed engagement and research Input from the market Drives the business logic Drives the customer value package Tells us what value we have to provide in order to win, and keep, the customer’s business over the complete lifecycle.

Competitive edge Salespeople who understand their customer’s value model better than their competitors have a better chance to win the business How do your customers define value? Must be derived from the minds of the customer Effective engagement Communication Develop Value Propositions Must be validated in solid customer research Who has best performance in the industry – key metrics, and why? Must be able to implement the path to the customer’s ‘truth’ Building the Customer Value Model The customer value model is an ‘invisible truth’ used by the customer to evaluate the quality of outcomes you provide.

There is a hierarchy of customer value satisfiers: Base value – the fundamental components of the customer value package you need in place just to stay in business Expected value – what your customer considers ‘normal’ for you and your competitors Desired value – added value features that customers know about but don’t necessarily expect because of the current level of performance of your competitors Unanticipated value – going beyond the customer’s expectations and desires – provided that the customer really values these “surprises” You must go beyond ‘base’ and ‘expected’ to make a difference Hierarchy of Customer Value You must have mastered the first two levels in order to satisfy the customer on the higher levels. Failings in the first two levels will waste the effort and investment in the higher levels.

Customer Value Package The enterprise infrastructure for value creation PLUS , the Whole Product Enterprise Components 1. Marketing & Sales Logic 2. Service Product Design 3. Delivery & Customer Support 4. Revenue Model 5. Branding & Reputation 6. Informational 7. Interpersonal

Customer Value Package Enterprise capabilities are needed to deliver the Whole Product: The Whole Product plus Enterprise Capabilities Post-Sales Support Life-Cycle Support Pre-Sales Support Integration Services Software Consulting Hardware The Product 1. Marketing & Sales Logic 2. Service Product Design 3. Delivery & Customer Support 4. Revenue Model 5. Branding & Reputation 6. Informational 7. Interpersonal

Customer Value Package A multidimensional logic for managing the customer’s experience with your company, and with the value it creates The customer value package must be right if you hope to build in the customer’s mind an impression of quality and value for money Customers’ expectations vary enormously even in the same line of business

Customer Value Expectations Potential value expectations are broad e.g. a fashion store Customer Value Criteria Supplier reputation and experience Branding Warranty package Information Quality specification and control Parts and service coverage SECURITY Continuity of benefits and costs profile Continuity of supplier support RELIABILITY Cash flow Operating compatibility Operating flexibility Status/prestige ‘ Fashion’ currency PERFORMANCE AESTHETICS Style Design Conformance Longevity Design/style continuity CONVENIENCE Transaction facilities and process Product service and parts availabilities Warranty service processing Sales and service response Time Location Information ECONOMY Acquisition costs Installation costs Set up and training costs Maintenance costs Disposal value and costs Supplier information Opportunity costs

Customer Value Audit Does the design of your CVP reflect the customer’s value model? Or does it reflect just the convenience of your organisation? Cross-match Customer Value Model, to Customer Value Package CVM4 CVM3 CVM2 CVM1 Interpersonal Informational Branding & Reputation Revenue Model Delivery & Support Service Prod Design Marketing & Sales Logic Customer Value Factors Customer Value Package

Customer Value Audit Will these Customer Value Packages lead to success? Where are the gaps, how to fill them? CVM4 CVM3 CVM2 CVM1 Life-cycle Support Post-Sales Support Integration Services Consulting Hardware Software Pre-Sales Support Customer Value Factors Customer Value Package

Market Value Audit Determine the “defining features” by cross-referencing the value packages with the customer types – the market segment benefits Customers on one axis – cluster customers into sets Value packages on the other axis – cluster value packages The clusters (sets) represent meaningful defining features Customer Value Packages 5 4 3 2 1 Look for Niches     1 2 3 4 5 Customer Types

The Service-Profit Model Developing the Customer Value Package Understanding Value Developing a Value Proposition Integrating the VP into a Customer Value Package 1 2

Understanding Value Value is “mindware” created by the product/service you sell The end condition a customer deems worthy of their approval eMotion-Value End Condition Approval Emotional Reaction Value Package Customer’s Perception

Value is in the mind of a specific client Value = Benefits – Cost Benefits exist only with a particular client or set of clients in a particular business setting . Therefore, if there is no specific client and business setting you cannot promote value 1 . Features are an objective characteristic of the product or service. Advantages indicate how the features might help sets of clients . 1 In that case you will be promoting “features”, “advantages” or just technology . Understanding Value - 2 Advantages Lead To Features Benefits Lead To

Understanding Value - 3 Perception of value is tied to emotion , and personal values eMotion -Value = eMotion -Benefits – eMotion -Cost The outcomes, which are stated as benefits, are as much perception as measurable factual reality . Both facts and perception are reality. But interestingly, while facts belong to organisations, perceptions belong to individuals . The eMotion Value Proposition Model 1 explains: Why 'good' proposals stall Why high return (high ROI) proposals are blocked Why the 'best' proposal does not always win How personal distraction and effort mould perceptions of benefits How individual recognition and reward mould perceptions of value. 1 For full details of the eMotion VP Model go to www.digitalinvestor.com.au

Developing a VP - Asking Questions Start with good sense of the business situation Industry Company and its issues Personal (relationship) It is about the art of questioning and analysis What is the business’s perspective of the situation? What are they doing now and why? What are the tensions in what they are doing now? What is the ideal or “tomorrow state” as currently perceived? What barriers are faced in getting there? Which barriers have the biggest impact and where? What are their investment criteria? What is the decision-making process? What has been agreed to now and and in the past in IT initiatives? How do they perceive the value added by IT so far? Why? What is their ideal solution and how do they know when they achieve it?

Developing - Discovering Needs 1 The objective is to uncover the business’s specific needs Concentrate on identifying the real needs: Place yourself in their shoes Place yourself in their customer’s shoes Work on improving your questions and interaction Be aware of “knowing too much” - let the business talk! Then, move to offering a credible solution Float options, build and test your solutions Work in parallel to action the needs into an IT strategy Do not spend time or energy “ Selling” features, unqualified advantages, and technology Turning the needs analysis back to a generic IT solution Disparaging alternative IT solutions from the business Work to generate business ownership of the proposition

Developing – Discovering Needs 2 The most powerful tool is the “Day in The Life”: Live a day in the life of the business and their customers It is powerful because The business commits to spend time and energy You commit to contribute and report It brings ownership through joint generation of the VP It BUILDS WIDER RELATIONSHIPS Focus on your customer’s customers Workshop the outcomes to generate the VP Build a case which delivers “ladders of value” Also build ladders of compelling IT investment strategy

Developing – Generating the VP A useful technique When we have this ..... We will be able to do these things ... Which means this in business terms ...... And we’ll be able to measure the benefits this way .....

Testing the Value Proposition Is there a common understanding of the central need? Why should anyone want to use the proposed solution? What genuine business value does it return? Examples of things to consider: What problem does it solve for potential customers? Does it open a new market? Does it better exploit an existing market? Does it eliminate or reduce inefficiencies? Does it solve the same problem as competing systems but at less cost? How does the value proposition fit into the development of the Customer Value Package?

Integrating the VP into a CVP The VP guides development of a Customer Value Package: The Whole Product plus Enterprise Capabilities Value Proposition Post-Sales Support Life-Cycle Support Pre-Sales Support Integration Services Software Consulting Hardware The Product 1. Marketing & Sales Logic 2. Service Product Design 3. Delivery & Customer Support 4. Revenue Model 5. Branding & Reputation 6. Informational 7. Interpersonal

Integrating the VP into a CVP The Whole Product plus Enterprise Capabilities need optimisation: The Whole Product must be tailored to include the VP The Enterprise Capabilities have to support delivery of the VP This combines to produce a specific Customer Value Package Examples of things to consider How does the Whole Product mix need to be modified? How does the organisational infrastructure need to be modified? What role do channels and does distribution play? How does this CVP fit or blend with other CVPs which need support? What is the revenue model associated with this CVP? How can IT support and improve profitability of delivery of the CVP?

IT Support of the CVP How can systems support the Customer Value Package: What is the timing, sequence, priority and risk? Can they be built and implemented within a reasonable time? At an acceptable cost? Examples of things to consider Are the necessary skill sets available, and the technology? Should it be insourced or outsourced? How do they fit the current systems architecture? Do they have to be integrated with other systems and data? Do they improve the underlying technology fabric? Do they improve the company’s overall operations?

The Service-Profit Model Developing Service Products to fill the Value Package Service-Product Development Whole Product Concept Whole Product Value Technology Adoption Lifecycle 1 3

Service-Product Development The fundamental elements of service-product formulation are coordinated market value propositions and delivery at a profit Customer Service Product Design Service Delivery Value Proposition Activity Costing/Profit Go to Market

Which Customer? The model points to a customer, but which customer? This requires market segmentation including technology lifecycle Integration Logic Customer? Service Product Design Service Delivery Value Proposition Activity Costing/Profit Go to Market

Service Product Design Audit The Customer Value Models are customer pulls Match those pulls to the Service-Product Design Elements CVM4 CVM3 CVM2 CVM1 Integration Logic Activity Costing/Profit Go To Market Service Delivery Value Proposition Customer Value Factors Lifecycle Adoption Phase

Whole Product Definition Service-Products are complex - they have many dimensions The Whole Product is the totality of what a customer buys A whole product is the physical object, software or service from which customer gets direct utility, plus other factors, services and perceptions that make the product: Useful Desirable Convenient People Brand attractiveness - “Intel Inside” For example Computer Operating System is: Software + development + environment (hardware and software) + documentation to use it + training program + reseller’s service & troubleshooting capabilities + availability of hardware drivers + suppliers enhancement plans, + reliability + interface design appeal + brand appeal (Mac) etc.

Whole Product Concept The “whole product” gives the customer value satisfaction The cost of creating a complete product is often many times the cost of developing the generic product or service Generic Product Expected Product Augmented Product Potential Product Value

The Expected Product A step above the Generic Product The Expected Product represents the customer’s base expectations Delivery conditions, installation services, post-sale services, spare parts, training, packaging conveniences Other examples of the minimum expectations: The bank: the loan officer who is cooperative The realtor: who is on your side The lawyer: who protects you The retailer: who sells you products which work and are reliable The expected attributes vary by customers and industries They could be sources of product differentiation Depending on how well vendors implement their value packages

The Augmented Product Augmentations are means of product differentiation Customers may be offered more than they expect: Computer that comes with “Office 2000” already installed Optical store that replaces customer’s lost contact lenses nights & weekends and delivers them to customer’s home Augmentations can also bring about customer dependency They can educate customers about what it is reasonable to expect This raises the competitive bar since augmented benefits may turn into customer expectations (and move into the inner circle) Not all customers can be attracted by an ever-widening circle of augmented benefits

The Potential Product The Potential is everything feasible to get and keep customers what can be feasibly done with the existing product & service what is possible in the future what is needed in the future Suppliers, and customers, can compete more effectively with the Potential Product in the changed conditions of future In high tech markets, customers desire extendibility for the product so that the platform and basic technology can last over several generations of technology lifecycles e.g. semiconductor technology cycles Building and maintaining a Product Roadmap is important

Product Lifecycle Products are marketing inventions Product invention / definition is a continuous process Starts at the intersection of new technology capability and perceived market opportunity Continues past product introduction thru to discovery of new applications (not envisioned by the original developers) Continues further As product marches down the Technology Adoption Life Cycle and it is redefined for new groups of customers As the company diversifies into new market segments to capture more market share

Whole Product Value To the potential customer, value satisfaction is the “product” The generic “thing” or “device” is not itself the product. It is the minimum necessary to get into the “game” Whole Product value has meaning only from the viewpoint of the customer or the ultimate user - only they can assign value Customers’ needs and wants define whole product value Depending on the targeted market segment, the whole product offer must change to meet different value expectations When positioning against competition, it is important to compare complete whole product customer value packages The whole product must be defined differently in different phases of the Technology Adoption Life Cycle

Technology Adoption Lifecycle The Customer Value Package must be different for each stage At different stages customers buy and perceive value differently Time 2.5 % Innovators 13.5% Early adopters 34% Early majority 34% Late majority 16% Laggards

Technology Lifecycle Value Audit Rate the Customer Value Packages against the adopter stage Look for gaps and misalignments in the offer and the adopter CVP4 CVP3 CVP2 CVP1 Laggards Late Majority Early Majority Early Adopters Innovators Customer Value Factors Lifecycle Adoption Phase

Customer and Technology Lifecycle Effort and resource expenditure through the customer lifecycle needs to be optimised against the technology adopter lifecycle These buyers 1 need less selling and more confidence that you will support the product they are willing to try These buyers 2 need more selling and confidence that others have bought the product and are satisfied Customer Lifecycle 2 1 1 2 1 1 2 2 1 Early adopters Early majority Late majority Laggards

The Service-Profit Model Understanding Service Pricing Strategies Service Pricing Strategies Price-Value Perceptions Value Strategies for Service Pricing Service Costing Activity-Based Costing 1 3 4

Pricing Strategies Begin with costs and work towards selling price Begin with selling price and work towards costs Cost factors Price Customer Value Competition Cost-based Pricing Demand-based Pricing Combination Pricing Competition-based Pricing Begin with Competitors’ Pricing Above The Market Below The Market At The Market

General Pricing Challenges Pricing strategies and challenges Demand-Based Cost-Based Competition- Based Cost-based problems: 1. Costs difficult to trace 2. Labor more difficult to price than materials 3. Costs may not equal value Competition-based problems: Small firms may charge too little to be viable Heterogeneity of services limits comparability Prices may not reflect customer value perception Demand-based problems: 1. Monetary price must be adjusted to reflect the value of non-monetary costs 2. Information on service costs is less available to customers, hence price may not be a central factor

Service Pricing Strategies What makes it difficult and different? Hard to calculate financial costs of creating an intangible High ratio of fixed to variable costs - cost to serve one extra customer may be minimal (but must still recover fixed costs) Variability of inputs and outputs - how to define a “unit of service” and establish basis for pricing? Many services hard for customers to evaluate--what price can they put on the ‘value’ which is delivered? Importance of time factor - same service may have more value to some customers when delivered faster Use of physical or electronic channels - may create differences in perceived value

Pricing Strategies Choice of strategy depends on: The technology, refer to the technology lifecycle (part three) The market and your customer power Your cost structure The competitive environment Threat of substitution Threat of new entrants Keys to Demand-based Pricing: Set prices consistent with customer perceptions of value Prices are based on the whole product value package

Incorporating Value into Pricing You must fully understand what value means to customers: What benefits does the whole product package provide? How important is each of these benefits as to the others? How much is it worth to the customer to receive a particular benefit in a service product’s value chain? At what price will the service be economically acceptable to potential buyers? In what context is the customer purchasing the service? What is the customer’s perception of ‘value’?

Price-Value Perceptions Four customer-definitions of value: Value is low price. Value is everything I want in a service. Value is the quality I get for the price I pay. Value is all that I get for all that I give.

Value Strategies for Service Pricing Pricing strategies to reduce uncertainty service guarantees benefit-driven (pricing that aspect of service that creates value) flat rate (quoting a fixed price in advance) Relationship pricing--incentives to patronize one supplier non-price incentives discounts for volume purchases discounts for purchasing multiple services Low-cost leadership Convince customers not to equate price with quality Must keep economic costs low to ensure profitability at low price

Pricing Questions - Services How do you calculate the total potential profit of offerings? Can you rank service-products by margin, by total profit? Can you rank service-products in the technology lifecycle? What does each function and process contribute to profit? How can you reduce costs by 20% in the service-product chain? What mix of service-products yields the highest profits? What new blends of services yield the potential best profits? What is your maximum possible revenue given the resources? What are the key ingredients of the offers that drive profits up? What continuing investment is needed to support current offers? What investments are needed to create new offers? Can costs be better distributed through a channel strategy?

Service Costing Service costing is an application of strategic cost analysis, for: Modifying product mix and pricing Repricing customer value packages Substituting services and offers Eliminating elements and resulting excess capacity Improving service-product design and development Redesigning service-products Improving delivery and whole product support processes Investing in technology support Improving customer relationships Changing operating policies and strategy Improving channel relationships

Strategic Cost Analysis Strategic cost analysis uses activity costing to: Identify distorted service-product costs Determine unprofitable Customer Value Packages Highlight areas for different channel strategies Explain undercosting and overcosting of products and services Give management insight into the cost structures for making and selling diverse products Particularly, it must focus on whole product and the value chain: Assigning activity costs to whole product customer value packages: calculating the activity cost per unit of activity driver preparing a bill of activities for each whole product

Strategic Cost Analysis Benefits Particular benefits relate to service-product development: Management can identify and evaluate new service-products to improve performance by evaluating how service and process designs affect activities and costs. Companies can work with their customers to evaluate the costs and prices of alternative value packages.

For Service Firms The general approach is very similar to that in manufacturing : Costs are divided into homogeneous cost pools and classified as output unit-level, batch-level, product- or service-sustaining, and facility-sustaining costs The cost pools correspond to key activities: Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause-and-effect relationship with the cost in the cost pool Resources CVP 1 CVP 2 CVP 3 Activities Activities Activities

Service Costing - 1 Service costing is a critical element of performance management Identify the processes for each CVP value chain Allows you to answer key questions: What does it cost to deliver these services? Are we delivering our services cost-effectively? How do our service costs compare? How much should we charge for these services? Is there is an alternative, less costly, way to deliver these services?

Service Costing - 2 How do you find the processes to analyse? Organisations are managed vertically, however: Work gets done horizontally via business processes Processes cut across functions and layers of the organisation Processes consume all types of the resources of an organisation Process measures help resolve friction and take out costs Processes provide feedback for continuous improvement Process measures enable customers of the processes to be served more effectively and efficiently Processes consist of activities measure through activity-based costing

The Logic of Activity Costing Products and Services are consumed by customers Activities are consumed by products and services Resources are consumed by activities It is the Customers That buy our Services Which makes us conduct Activities That consume our Resources

Basic Activity Cost Allocation The costing process is simple in theory: Fundamental Cost Objects Activities Costs of Activities Assignment to Other Cost Objects Product Lines Individual Products Customers Distribution Channels

Implementing Activity Costing Follow four stages to assign overhead costs to products: Calculate a cost-driver rate for each activity. Assign activity costs to customer value packages using the cost-driver rate. Identify and classify cost objects (activities). Customer Value Package 1 Customer Value Package 2 Identify cost drivers relevant to each activity in a whole product value package: Marketing & Sales Corporate Services Lifecycle Support Step 1 Step 2

Activity-Based Costing The logic of ABC is simple: It is a methodology to calculate the cost of activities (such as train employees), and cost objects (such as products and services) It assumes that services create needs for outputs which create the demand for activities which, in turn, consume resources. By tracing costs to services/outputs according to the activities required to provide them , ABC provides a more accurate picture of costs and performance.

Cost Drivers Knowing the cost drivers is an integral part of ABC Drivers apply to activities or factors that cause costs to be incurred There are volume-based drivers and non-volume-based: Volume-based cost drivers Assumes all costs are driven, or caused, by the volume of production (or sales) Non-volume-based cost drivers Costs are not directly related to production volume

Activity–Based Costing - 1 The key principles are that: Cost are assigned to activities Costs driven by volume are at ‘unit level’ Cost drivers are identified for batch-level and product-level costs, but not for facility-level costs Unit, batch and product-level costs vary proportionally with their cost drivers Managers need to see “whole product” costs as an integral part of the firm’s effort to create value for customers.

Activity-Based Costing - 2 The ABC process relates activities to the resources they consume Classifies costs into four levels: Unit level Activities performed for each service-product unit Batch level Activities performed for a group of service-product units Product level Activities performed for service-product families Facility level Costs incurred to support the whole enterprise

Activity-Based Costing - 3 Other costing factors to consider are: Customer Lifecycle Costs Customer-level costs -- things like preparing bids, processing orders, answering questions, expediting rush orders, designing products, providing support Net Margin Realized Difference between the revenue and unit and batch level costs of manufacturing the item. The profit on the actual goods sold, without consideration of the specific costs to selling them to the customer Influenced by the price demanded by the customer (related to their bargaining power) as well as the inherent profitability of the item

When to Use ABC - 1 An option when one or more of the following conditions exist: Indirect costs are significant in proportion to direct costs and use only one or two cost-drivers Goods are complex, requiring many inputs and processes. Simple, high-volume products perform more poorly than complex, low-volume products Different departments believe costs are assigned inaccurately. The company loses bids it thought were low, and wins bids it thought were high Operations have changed significantly, but the costing system has not changed

When to Use ABC - 2 When organizations find themselves on a crisis course: Selling (funding) the wrong products or services Serving the wrong customers Designing costly products Instituting cost cutting programs that fail, and/or Obtaining the wrong (unnecessary) parts from outside suppliers

Strategic Cost Analysis Benefits ABC benefits will be greatest where : Overhead costs are a significant proportion of total cost, and a large part of overhead is not directly related to production volume The business has a diverse product range, and individual product’s use of support resources differs from their use of volume-based cost drivers Production activity involves diverse batch sizes and product complexity There are likely to be high ‘costs’ associated with making inappropriate decisions, based on inaccurate product costs The cost of designing, implementing and maintaining the ABC system is relatively low due to sophisticated IT support

Typical Revelations The application of strategic cost analysis typically reveals: Higher-volume products/services are overcosted Lower-volume products/services are undercosted Unexpected differences in customer profitability Opportunities to improve processes 25-35% of activities don’t contribute to organizational goals 80% of costs are consumed by 20% of the activities

Limitations However, ABC can be difficult to implement in service firms: High levels of facility costs cause problems with costing services Individual activities are difficult to identify because they are non-repetitive A non-repetitive production environment makes it difficult to identify service outputs Challenge: ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools.

The Service-Profit Model Improving Margins through the Service Value Chain Customer Lifecycle and Profitability Lifecycle Sales Approach Increasing Net Value 1 3 4 5

Customer Lifecycle Costs The lifecycle incurs costs in delivering through the value chain The Customer Lifecycle Phase 1 Pre-sale Phase 5 Value Creation Phase 9 Disposing & Upgrading Phase 2 Value Identification Phase 7 Customer Value Gain Phase 8 Value Improvement Phase 3 Meeting Needs Phase 4 Obtaining Commitment Phase 6 Customer Learning

Whole Product Value Chain The Customer Value Package offer is a value chain Is each extension feasible, achievable, sustainable? Investment and resource allocation? Market competitiveness and positioning? Ability to make a profit? Value/Cost D Value/Cost C Value/Cost B Generic Product Value/Cost A Expected Product Total Solution

Value Chain Analysis Value chain analysis helps to understand (at a high level) how each of your business activities adds value to your company The objective of value chain analysis is to maximise the profitability of your business activities in a sustainable manner Value chain analysis can also be applied to the Whole Product offer to understand the value offered to the customer and your costs associated with each element of that offer The chain comprises the activities and functions performed by a company to deliver value to its customers. Are you profitably delivering value to your customers?

Value Chain Consider a value chain for the "Recruitment" business activity The links in the value chain could be: Identify - a list of all of the candidates that applied Select - those candidates that meet the basic criteria Screen - identify the best two/three for the vacancy Interview - determine who should be offered the job Offer - the job to the best candidate Train - the new employee when they join the company Each step in the chain adds value and adds costs

Value Chain Analysis - 1 A Value Chain Analysis: Summarises your customer value package activities as distinct value chains - one for each package Outlines and analyses the key links in each of your customer value packages Defines the metrics you will measure to determine performance of your customer value packages Identifies opportunities to improve the profitability of your customer value packages

Value Chain Analysis - 2 Distributors’ and forward channels partners’ value chains: Change costs and margins of distributors and forward channel partners influence price paid by ultimate consumers Therefore these activities must be analyzed as part of the chain: The quality of activities performed by distributors and forward channel partners influence the quality of products/services of the company to the end-user The activities have a direct impact on the profitability of the customer value packages and the lifetime customer value

Growing the Bottom Line Value chain analysis and activity-based costing are tools to grow the bottom line and the quality of earnings: Activities Costs of Activities Product Lines Individual Products Customers Distribution Channels Value/Cost D Value/Cost C Value/Cost B Generic Product Value/Cost A Expected Product

Increasing Net Value Reduce resource expenditure at each stage of the value chain Minimize interpersonal blockages Optimize informational sharing and transfer Decrease intra-enterprise engagement friction Understand the Whole Product cost and value chain! Share a common intent about the customer value package Value/Cost D Value/Cost C Value/Cost B Generic Product Value/Cost A Expected Product Total Solution

Margin Improvement Margins can be improved through process improvement: Time and motion studies (1940s) Workflow analysis (1960s) Technology-based approaches (1970s) Business process reengineering ( 1980s) Process mapping (late 1980s) Differences between activity-based and processed-based approach: The activity-based view reveals how resources have been consumed The process-oriented view cuts across the entire organization and reveals all resources and costs expended on producing a process output e.g. a customer value package

Service Process Chain - 1 The CVP is delivered by a “process” chain, or value chain: xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx Service Product Marketing & Sales Support Customer Value & Your Profit xxxxx Process Activity A Customer Value Package Determining Service-Product Mix Determining Marketing & Sales Effort Support & Lifecycle Effort

Service Process Chain - 2 There is a different chain for each part of the customer lifecycle: xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx Service Product Marketing & Sales Support 1 5 9 2 7 8 3 4 6

What To Measure Process improvement uses many measures: Activity-Based Cost – the cost of resources consumed by each activity performed Rework – the cost of non value-added activities to correct things not done right the first time Cycle Time – length of time it takes to get an outcome for a process Touch Points – number of times an item is touched as it moved through a process Cost per Process Output – process cost divided by a volume of items produced by a process Customer Satisfaction – the degree to which customers are satisfied with the performance of the process

Service Process Improvement - 1 A methodical approach is required, focused on processes: Firstly, identify the activities behind the customer value package Determine the cost of resources used to perform each activity - some allocation may be required using resource drivers (labor, capital, materials, energy) Allocate secondary activity costs to primary activities if needed Combine activities with similar drivers/behavior into cost pools based on process, activity level, consumption ratio Identify a cost driver for activities Calculate the budgeted cost per unit of the cost driver for each activity Collect information about cost driver usage for value package Allocate costs to customer value package

Service Process Improvement - 2 Analyze the process chain for the total Customer Value Package: The Whole Product plus Enterprise Capabilities Value Chain - Processes Post-Sales Support Life-Cycle Support Pre-Sales Support Integration Services Software Consulting Hardware The Product 1. Marketing & Sales Logic 2. Service Product Design 3. Delivery & Customer Support 4. Revenue Model 5. Branding & Reputation 6. Informational 7. Interpersonal

Customer Profitability - 1 The most common problem in determining customer profitability: Selling, marketing, distribution and administrative costs are not assigned to products or customers This is not necessary for financial reporting Management considers them ‘fixed’ It is considered too expensive to do so As a result, the behavior of these costs is not well-understood and cannot be easily managed Value-chain analysis identifies and allocates these costs Costs are allocated to each customer value package

Customer Profitability - 2 Knowing the customer-profit profile determines value packages A mismatch between the value package and customer profile: Erodes profits Misses the chance to capture extra profits Consumes resources managing the mismatch The matching of value packages and customers is step one Value chain analysis, and profitability analysis are step two From there margins can be improved

Customer Profitability - 3 Types of Customer-Profit Profiles Aggressive Leverage their buying power Low price and lots of customized service and features Sensitive Price-sensitive and few special demands Impressive Costly to service, but pay top dollar Passive Product is crucial Good supplier relationship Net Margin Realized Low High Low High Cost to Serve

Gaining Internal Balance There are often significant disagreements between staff about the costs and profitability of products and services. 1 3 2 4 1 1 1 1 2 2 2 3 3 3 4 4 4 4 3 2 Profit Top-line Quality Technology CEO & Finance Sales Consulting Delivery Products & R&D

Summary – Improving Margins By following the value chain analysis process: The profitability of each Customer Value Package is known The Value Packages are matched to the customer profiles Margins will be improved for each value package Alignment will be gained between all parties to the value chain and service product about its contribution to profit

Profitably Serving Customers Contact: Walter Adamson Digital Investor Pty ltd 5/45 William St, Melbourne 3000 Office: 0500-500-321, Cell: 0403 345 632 [email_address] 1 2 3 4 5

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