Activity-Based Management

Improving R&D Effectiveness While Better Managing Activities that Drive Up Costs

Activity-based management (ABM) is an approach to management in which work process managers—in this case, lab managers at all levels—are given the responsibility and authority to continuously improve the planning and control of operations. They do this by focusing on key operational activities. Each business activity is broken down into its fundamental processes for analysis. ABM strategically incorporates activity analysis, activity-based costing (ABC), activity-based budgeting, life-cycle and target costing, process value analysis, and value-chain analysis. As this list indicates, ABM often requires lab managers to work with other company functions, particularly finance, marketing and sales. Performing these analyses enables managers to determine the benefits and costs of each activity.

ABM requires a strong commitment from managers at all levels. They must communicate this commitment to their staff members. The goals of ABM include:

Determining key activities performed for each business or product line. One can also do this for each customer.
Determining cost drivers for each business, product line, or customer.
Grouping overhead and other indirect costs by activity, using clearly identified cost drivers.
Collecting data on activity demands (by product line and by customer).
Assigning costs to products and customers.
Using all this information as a basis for decision making.

Properly executed, ABM can improve R&D and technical service effectiveness while identifying and better managing activities that consume excessive resources and drive up operating costs. The focus for control is shifted away from financial measurement of company resources to activities that cause costs to be incurred. The ABM process provides managers with an understanding of each business’s or product line’s profitability and insight on how to increase profitability. This understanding and insight can result in repricing products to better reflect costs. It can also be useful when considering a new business opportunity.

ABM is particularly well suited to laboratory technical service work. For example, one of my former managers realized his technical service group was expending most of its time on small customers that in the aggregate provided a minor portion of its sales. The situation was a good example of the 80-20 rule: 80 percent of the lab work was supporting approximately 20 percent of the sales.1 Peter Turney, CEO of Cost Technology, presented a different but consistent analysis.2 He concluded that the best 20 percent of customers contribute profits equal to 500 percent of overall earned income. The worst 20 percent destroy 400 percent of overall earned income. The remaining 60 percent break even, at best.

My manager’s ABM analysis resulted in the sale of the part of the business focused on small customers. Because of the reduced technical service effort required for the remaining customers, the technical service staff was reduced, with some members transferred to other assignments.

ABM should not be regarded as a one-shot exercise. Rather, it should be repeated periodically. Trends can provide plenty of useful information. For example, they can indicate when an existing business is turning into a “cash cow” for which substantial laboratory expenditures are no longer justified.

Performing an ABM analysis

Several software firms provide activity-based management software. For instance, Oracle’s PeopleSoft Activity-Based Management and SAS Corp.’s Activity-Based Management software model business processes to determine cost, profitability and drivers. Using one of these sophisticated software packages enables lab and business managers to model processes to determine cost, profitability and drivers for both. Using such software enables managers to determine how cost accumulates. They can improve processes by identifying and then eliminating activities that don’t add value.

My own ABM work focused on lab activities plus customer-support activities by lab personnel, including trips with sales representatives to call on customers, participating in customer trials of our products and attending conferences. I found that spreadsheets I designed sufficed to give me the information I needed for ABM analyses at a low cost.

Adopt a unit operations perspective

Performing an ABM analysis is akin to performing chemical engineering unit operations analyses of multistep chemical manufacturing processes. First, one determines the unit operations of a business activity (Step 1). These unit operations include R&D; technical service; sales and marketing; intellectual property protection measures such as applying for and maintaining patents; and health, safety and environmental activities. This type of process breakdown is the core of ABM. Including non-laboratory operations means that lab managers must work with managers of other functions, such as manufacturing, sales and marketing, etc.

Then one determines the costs of each operation in the process (Step 2) and determines the benefits of each operation (Step 3). Each operation should be analyzed to determine how to reduce its costs and increase profits. This will identify the operations whose improvement or elimination will have the greatest overall effect on profitability. Implementing the results can increase overall profitability or result in terminating the business analyzed by dropping the product line or selling that business to another firm.

Step 2 requires an understanding of the costs involved in each operation of the business process. These costs include staff time to do the work and resources needed to enable lab staff to do the work, such as equipment, instruments and chemicals. Of course, non-laboratory costs also need to be considered. These include items such as the capital costs of plant construction, costs of borrowing money to build the plant and plant operating costs. Each of these costs includes staff time, materials, etc. Sales and marketing processes have costs beyond those of staff time. These include travel, advertising, registration fees for participating in trade shows, etc. All these various costs can be included in ABM analyses of each activity, such as participation in a trade show, and of the overall activity, such as sales and marketing.

ABM and outsourcing

Analyses of various activities required to operate their laboratories can aid lab managers in deciding which operations could be performed at lower cost if outsourced. Ideally, such activities should provide at least equal benefits compared with performing the activities in-house. For example, some sophisticated laboratory analyses and the skilled professionals and instruments required to perform them may be needed too infrequently for laboratories to perform this work themselves. Consequently, lab managers may use analytical service laboratories to perform this work.

Some energy and chemical companies have sold analytical departments to outside firms because ABM analyses indicated they were not earning a sufficient return on their investment in highly trained personnel and expensive laboratory instruments. For instance, Intertek is pursuing a business strategy that takes advantage of low utilization of staff members and instruments at some corporate analytical laboratories. Intertek has taken over operation of oil refinery and chemical plant laboratories in the U.S, Canada and Western Europe for major oil and chemical companies. By combining existing in-house analysis work with new business from other firms, Intertek increases lab utilization while providing oil and chemical company staff members with continued employment and career opportunities.

For instance, chemical company DSM outsourced laboratory services performed by its Polychem Lab unit to contract laboratory Intertek Group. Approximately 175 employees were transferred to Intertek. In pharmaceuticals, Eli Lilly Company sold its Greenfield Laboratories facility to Covance, a major drug development services company. Covance assumed responsibility for Lilly’s toxicology testing and other R&D support activities at the site and hired many of the Lilly employees. It may not make sense for small companies to operate their own patent and advertising departments. The level of service required is insufficient to provide full-time work for the highly paid professionals in this industry. As a result, small firms outsource this work to law firms and advertising agencies.

The same is true of other aspects of small companies’ business.

Limitations of ABM

It is difficult, if not impossible, to assess the benefits of many lab activities, although determination of their costs may not be difficult. One example is the participation of laboratory staff members in technical and trade association conferences. It is difficult to assess the financial benefits of the continuing education that occurs when staff members attend conferences. In addition, lab staff members often interact with customers and potential customers at these conferences. These interactions may have an immediate effect, with benefits fairly easily quantified. Alternatively, benefits such as making a sale to a new customer occur over several conferences and are harder to quantify.

While ABM customarily does not include the interfaces between various processes, it should. For example, the competitive advantages of a highly effective R&D department can be lost if transfers of newly developed products to the marketing and manufacturing departments for commercialization are slow and poorly organized. I saw an example of this when working for a former employer. Fearing that failure of new products in customer trials might result in negative consequences for the department and his own career, a manager blocked the release of newly developed products at a time when the company desperately needed new business. Eventually, a higher-level manager broke the logjam and the newly developed products were successfully released, resulting in new business. (The situation resulted in the manager being transferred to a nonsupervisory position and losing his job less than two months later.)

Another example of an interface between processes occurs between performing technical service work for a customer and communicating the results to the customer. If this process is slow and poorly organized, sales can be lost and the customer can even decide to change suppliers. In addition, besides communicating the results to a single customer, communication of results to other customers, without disclosing the name of the original customer, should be considered. This can leverage the technical service work to a larger market, further increasing sales.

Another limitation is that some business processes, such as compliance with government regulations, must occur regardless of their impact on profitability. Still, factoring in the costs in an ABM analysis of the overall business can result in the decision that compliance is simply too costly for the organization and the business in question should be terminated or sold to another firm that can operate that business at lower cost.

The ABM process does not do a good job of measuring intangible benefits such as public goodwill created by a business program. For example, some lab managers have a budget line that permits such activities as research staff members spending small amounts of time in schools talking about science or judging science fairs.

Wrap-up

ABM can be used as a tool for continuous process improvement. It will not itself reduce costs, but it can help managers understand them better so they can make intelligent decisions when cutting costs. Lab staff members should understand the ABM analyses of their work. Working with their managers and fellow team members, they should view ABM findings as opportunities to improve efficiency and reduce costs and then take appropriate steps to do so. They shouldn’t view them as threats. R&D and technical service work can play an important role in capitalizing on ABM findings.