Opinion: The big four A's in logistics pricing

By: Kim Hassall


The four big As in logistics pricing – the stepping stones to efficient pricing?

Opinion: The big four A's in logistics pricing
Kim Hassall

 

There is a particular group of costing/pricing schemes that, if calculated properly and applied to your operations, can be highly beneficial so you don’t go broke. In this the sixth instalment in a series of logistic pricing schemes, we will examine "the Big Four A’s" of the operations pricing world. These are:

1. Activity-based costing

2. Attributable costing

3. Avoidable costing

4. Allocated pricing

Firstly, know your costs

Knowing your costs is the basis for any effective, or even efficient, pricing scheme. Sounds so simple, yet surprisingly many operators make mistakes and underestimate their full costs. Well, I have been a believer in a logistics world look at the activities that are attributable to an operation. Which of these operations and their overheads are actually avoidable if I close down a particular division, and of what is left, how do I allocate the costs to the remaining operations?

This process does also work in reverse. When I win a new contract, what joint or common costs should be allocated to this new contract? What corporate overheads for human resources, accounting, legal and purchasing should be allocated to this new contract? This is a common question.

Activity and attribution

Activity-Based Costing (ABC) is a sensible first cut at calculating your basket of costs to cover your operations. Grouping activities is logical and generally there is a good mapping of costs to basic activities/operations. Using an ABC, costs can now be attributed to an operation. For the most part, attributable divisional costs will also incur overheads, as well as the actual operational costs, and so particular proportions of overheads are levied to the field or warehouse operational logistics costs. Full and efficient attribution to an operation is very important across multi-product lines.

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Avoidability – a must to understand this one

When a General Manager looks at a product profitability analysis and decides to close down a product line, then usually what is actually saved is never what the product analysis cost or profitability statement actually is. Why so? Because a large percentage of the overheads and, often, plant, equipment, IT systems and property, can’t be gotten rid of at the stroke of a pen. That is, in the short-term, all costs related to a product are not ‘avoidable’ if that product line or contract is closed. In the long-term a greater percentage of avoidable costs can be saved but possibly not all of those costs either. It is always better to have a few contracts pending in order to take up this slack and allocate some of the new contracts some of the old overhead services.

Avoidability example: A GM gets a product report and this states that the attributed HQ property cost for his office floor at headquarters is, say, $100,000. He grumbles and argues that he can rent property space cheaper. He wants to move his division. Luckily the CEO tells him he is not exactly smart, as any new office space will be an extra cost to the corporation as the GM’s floor cannot be sub-leased and any new office rental will be an extra cost to the company. His current HQ property rental is not avoidable and so go and concentrate on beating up revenue and saving on field operating costs instead!

Cost attribution and allocation

There can be some disastrous pricing decisions made by getting attribution and allocation wrong. For example, imagine a supermarket stating: "We are primarily here to sell milk and bread. Therefore, we allocate the supermarket’s costs to milk and bread, and other revenue is incidental. Wow milk and bread are really unprofitable!" Similarly, a national

Post Office decrees that Post Offices are there to sell stamps and wow what a loss there is on stamps! If Post Offices were there only to sell stamps, then use a vending machine like in the old days. The same argument applies as is true for the supermarket. In a multi-product environment, a joint facility cannot be charged to a single product. These would be examples of totally erroneous costing and pricing attribution and allocation techniques.

Smoke and mirrors

How to play the corporate product costing system:

A new GM announces that if he/she is employed then he/she can improve the profitability of all current existing products. The GM is hired. Step 1, introduce a new large revenue-generating product at a very low margin. After two years, the new product is generating significant revenue but it’s a break even product. The CEO asks, "Didn’t you say you could introduce a new profitable product?"

The GM says "No, you misunderstood, I said that I could make all your CURRENT products more profitable, and I have!"

"How so?" asks the CEO.

"Well," says the GM, "the new product is not profitable, but it does not make a loss. However, it covers all of its attributable and allocated costs. In doing so it has lowered the attributable overhead costs by a considerable amount for all the other overheads in your initial product range at the time I was employed. Those initial products are now more profitable due to corporate allocated overheads being partially absorbed by my new product. See, your old products are now more profitable! Isn’t that what I said I would do for you?"

Dr Kim Hassall is chair CILT-Australia and director of the Industrial Logistics Institute

12 FREIGHT PRICING STRATEGIES SERIES

Part 1: Network link (density) pricing

Part 2: Moving club pricing

Part 3: PAYGO

Part 4: Price escalations

Part 5: Transfer pricing

 

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