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As easy as ABC: Activity-based costing

TORONTO, Ont. - When it comes to providing an effective means for costing a company's products or services, Kenneth Manning, president and co-founder of the Transportation Costing Group (TCG), said it...

TORONTO, Ont. – When it comes to providing an effective means for costing a company’s products or services, Kenneth Manning, president and co-founder of the Transportation Costing Group (TCG), said it can be as easy as ABC – activity-based costing, that is. Manning spoke to a group at the Ontario Trucking Association’s annual conference in Toronto Nov. 18.

With more and more companies looking for ways to increase efficiency and improve profitability, many are using new information, processes and technology tools to achieve their goals. One method is the use of ABC to determine load costs and customer profitability.

According to Manning, ABC is a method of costing products and services based on the activities required to produce the product or service. ABC is used to identify and associate the resources (and their costs) required to perform each activity.

“The idea behind activity-based costing is to get away from average costs and get on that red line,” Manning said.

ABC can be used as a flexible pricing tool for simulation or “what if” analysis. Since freight is dynamic, Manning said there is a constant need to evaluate both new and existing business. He said when companies get in a rut, there’s a tendency to think that trends will continue that way for years to come – but this is not the case in a dynamic market.

Manning first outlined the use of ABC in a Less-Than-Load (LTL) market, using “McClucking Trucking” as a fictitious company. In his overview, McClucking is a company which gives good, consistent on-time service and has established a satisfied customer base. It also has average to above average productivity, good growth over the last few years, but it still has an unacceptable level of profitability. The company realizes it’s doing the right things, but profits aren’t where they should be, so McClucking increases its rates.

Manning said McClucking’s actions mirror a common misconception that says if sales aren’t that profitable, the rates must be too low. In reality, an increase in revenue doesn’t necessarily increase profit, Manning said.

“Some shipments are money-makers and some are money-losers,” he said. “The losers sometimes outweigh the winners.”

But Manning stressed that unless the company’s activities are analyzed, there’s no way to be sure where money is being made and lost.

First of all, Manning said McClucking needs to ask itself a few questions: Does it know the profitability of each customer it does business with? Does its current system highlight opportunities for cost improvement? Does it understand the various activities performed in its company? Does it have the tools needed to estimate the profitability of prospective customers?

The basic premise for ABC is that providing a service (in this case freight transportation) consumes activities. Activities in turn consume resources and the consumption of resources is what drives cost. When analyzed properly, Manning said companies will find that each activity has independently associated overhead costs.

Traditional costing tends not to be as accurate, especially since the system tends to work in averages. Using a “real life” model, Manning reminded the group that it’s impossible for a family to have the average “two and a half kids.”

In this way, a company needs to get away from average costs and find what their “true” costs are. One key element is finding out the details. According to Manning, by showing more details of a load (more than simply the weight), it’s possible to discover opportunities for cost improvement, improve strategic decision-making, and identify money-makers and losers. Details of the load might include things as simple as how dense the load was; whether it was loose or on a pallet; how many cubic feet it was; and whether the shipment was booked with an appointment.

However, Manning warned that McClucking would have to be “real” with its analysis. He said the ABC system must be able to associate different handling characteristics to the cost of providing service. As well, he said it may not be practical to allocate all costs to activities and the allocation must be based upon use of resources, not functional expenses..

Moving from the LTL model, Manning moved to a Truck Load (TL) scenario. He spoke specifically about carriers with irregular routes where drivers might have multiple stops in one trip.

In the traditional costing method used for this model, the total number of miles for a trip is calculated by added loaded miles and assigned empties.

Using that same traditional model, the cost of the load is found by multiplying the total miles by the unit cost per mile. But Manning said the unit cost is irrelevant because cost equals the total cost of material less the value of the “leftover” (ie. waste, scrap or byproduct).

In actuality, the round trip is the cost. With Manning’s new “balance” concept, cost is incurred for the entire trip required to serve the customer. He said that cost is not divisible using cost per mile and that round trip cost must be jointly allocated to specific loads based on contribution. Essentially, if a company is not making money on the round trips run to serve a customer, it’s not making money on that customer. By analyzing a company’s operating ratio, one can discover the best routes possible to maximize profit, or if nothing else, break even on the round trip.

Overall Manning said averaging things out is not an appropriate measure to determine a company’s profitability and encouraged people to solicit the help of experts.

“You can’t do this with a pencil and paper,” he said.

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