Many years ago, I attended a workshop hosted by IBM that fundamentally reshaped how I viewed costs and profitability in business. The workshop introduced me to two concepts that were game changers: Activity-Based Costing (ABC) and Customer Profitability Analysis (CPA). These tools, while powerful individually, become transformative when combined. ABC opened my eyes to the true drivers of costs within my organization, and CPA helped connect these insights to customer relationships and decision-making.
At its core, ABC isn’t just a method for allocating costs; it’s a lens through which you can see the real mechanics of your business. I came to realize that traditional costing methods could obscure valuable insights, lumping indirect costs into broad categories that fail to tell the whole story. ABC cuts through that fog, illuminating the specific activities that drive costs and enabling precise, actionable insights.
When I attended the IBM workshop, I was managing the documentation and training division within Interleaf, a service-based enterprise. Interleaf had recently acquired my documentation and training company along with two other documentation companies, and our main deliverables included user manuals, service guides, and training courses for Interleaf’s customers. Like many service businesses, I struggled to identify which customers were genuinely profitable.
The Challenge of Costing in a Service Business
Service businesses often struggle to allocate costs accurately. Unlike manufacturing, where you can point to raw materials or machine hours, service costs are tied to less tangible elements, such as people’s time, varied skill sets, and different support functions. In my documentation and training division, I thought I understood my costs. I knew how much I paid my team, how much time we spent on client projects, and what it cost to run the office. But I couldn’t shake the feeling that some clients and projects were far more profitable than others – and that I wasn’t capturing this difference in my pricing.
At the workshop, the instructor posed a simple question to me, “Do you really know what it costs to deliver your services?” At the time, I thought I did. Like many in the class, I assumed that as long as revenue exceeded direct costs, the rest was just a matter of covering overhead. But as the session unfolded, I realized how wrong I was. My assumptions about profitability were based on broad averages that hid the nuances of my operation. This is where ABC came in.
Understanding Activity-Based Costing
ABC is more than just a costing method; it’s a way to see your business operations with precision and clarity. Instead of lumping overhead costs into broad categories and allocating them across all billable hours, ABC identifies specific activities that drive costs and assigns those costs based on actual consumption.
For my business, breaking down our operations into discrete activities was essential, particularly because the costs varied significantly depending on the type of customer and deliverable. Each deliverable had unique cost drivers, and identifying these activities allowed me to uncover the real dynamics of resource usage.
In the following example, we will be examining how to allocate costs for a technical writer using Activity-Based Costing (ABC). While the focus here is on technical writer hours, the same principles apply to other roles in a documentation and training business, such as editors, graphic designers, instructional designers, course developers, and programmers. Each role would have its own direct costs, general overhead allocations, and project-specific adjustments.
1. Establishing the Direct Cost for Technical Writer
The first step was to identify the baseline rate for the function.
Direct Cost
The direct cost of a technical writer includes:
- Average base salary: $75,000/year
- Payroll taxes: $6,000/year
- Fringe benefits: $20,000/year
Total annual compensation: $101,000/year
Hourly direct cost: $101,000 ÷ 2,080 hours = $48.56/hour, rounded to $50/hour.
G&A Allocation
General and Administrative (G&A) costs include:
- Sales and Marketing: $100,000/year
- Administrative Support and Management Salaries: $150,000/year
Total G&A costs: $250,000/year
Total billable hours (all roles): 45,000 hours
G&A overhead per hour: $250,000 ÷ 45,000 = $5.56/hour.
Baseline Rate
Adding G&A to the direct cost:
$50/hour (direct cost) + $5.56/hour (G&A overhead) = $55.56/hour, rounded to $56/hour.
This $56/hour is the baseline rate applied to all technical writer hours before office or project-specific allocations are added. The baseline rate is a ‘peanut butter’ allocation that is spread evenly across all billable hours for writers. Be mindful that this would be developed for all roles, such as editors, graphic designers, instructional designers, course developers, and programmers.
2. Allocating Office Overhead Costs
Office-specific costs are allocated to all hours worked on site, as off-site projects do not consume office resources.
Office Costs
- Annual office rent and utilities: $100,000
- Annual computer, Internet, and office equipment costs: $50,000
- Total office-specific costs: $150,000
- Total on-site hours: 41,000 hours (45,000 total billable hours – 4,000 hours for two writers working off-site at the client’s offices)
Office overhead per on-site hour:
$150,000 ÷ 41,000 = $3.66/hour, rounded to $4.00/hour
- Off-site Projects (e.g., Project A):
$56/hour (baseline), as no office overhead is applied = $56/hour - On-site Projects (e.g., Project B and others):
$56/hour (baseline) + $4.00/hour (office overhead) = $60/hour.
3. Allocating Software Costs (Usage-Based Allocation)
Certain tools, like version control systems, are used exclusively by specific projects, and their allocation varies based on the project. For Project A, the customer required that the software cost be invoiced separately as a monthly line item, ensuring clear visibility. In contrast, for Project B, the software cost is integrated into the hourly rate, streamlining billing while still reflecting usage.
Software Costs
- Annual software license cost: $10,000
- Project A usage: 4,000 hours
- Project B usage: 2,000 hours
- Total software usage hours: 6,000 hours
Monthly Invoice for Project A
- Total software cost for Project A:
$10,000 × (4,000 ÷ 6,000) = $6,667. - Monthly invoice amount for Project A:
$6,667 ÷ 12 = $556/month.
Per Hour Allocation for Project B
- Software cost per hour for Project B:
$10,000 × (2,000 ÷ 6,000) ÷ 2,000 = $1.67/hour, rounded to $2/hour
Project-Specific Fully Burdened Rates
- Project A (Off-site):
$56/hour (baseline rate)
Software invoiced separately at $556/month. - Project B (On-site):
$60/hour (onsite rate) + $2.00/hour (software) = $62/hour. - Other Projects that do not use the version control software (On-site):
$60/hour (on-site rate).
Summary of Fully Burdened Rates
Cost Component | Project A (Off-site) | Project B (On-site) | Other Projects (On-site) |
Direct Cost | $50/hour | $50/hour | $50/hour |
G&A Overhead | $6.00/hour | $6.00/hour | $6.00/hour |
Office Overhead | N/A | $4.00/hour | $4.00/hour |
Software (Version Control) | $556/month, Invoiced Separately | $2.00/hour | N/A |
Total Fully Burdened Rate | $56/hour + $556/month | $62/hour | $60/hour |
ABC allowed me to assign costs to these specific activities based on their consumption of resources, such as staff time, software, or physical infrastructure.
By breaking down operations in this way, ABC not only revealed the true cost of each deliverable but also highlighted why these costs existed. This clarity empowered me to make more informed decisions and better align pricing with the value delivered to clients.
How ABC Works with Customer Profitability Analysis (CPA)
The workshop also introduced me to Customer Profitability Analysis (CPA), which builds on ABC’s foundation. CPA examines the profitability of individual customers or customer segments, taking into account not just revenue but also the costs of serving them.
For my business, ABC provided the granular cost data I needed to perform CPA. By linking activities and costs to specific clients, I could calculate the actual profitability of each account.
This analysis transformed my approach to client relationships. Instead of focusing solely on revenue, I began evaluating clients based on their overall contribution to profitability.
Lessons Learned
One of the most valuable lessons learned from the IBM workshop was the importance of looking beyond surface-level metrics. Traditional costing methods had masked the true dynamics of my business, leading me to underestimate the costs of certain activities and overestimate the profitability of some clients. ABC changed that.
Another key takeaway was the value of data. Implementing ABC required detailed tracking of activities and costs, but the insights gained were well worth the effort. I learned to view data not as an administrative burden but as a strategic asset.
ABC and CPA are often seen as tools for large corporations, but my experience proves their value for businesses of all sizes. By shedding light on the hidden drivers of cost and profitability, these methodologies empower businesses like mine to make smarter decisions.
In the years since that workshop, I’ve continued to refine how my clients can use ABC in their business. Whether I’m evaluating a new client, planning a project, or reviewing my own operations, ABC ensures that every decision is grounded in reality.
How can you use ABC in your business?