Moving from Fixed Charge to Transaction-based Pricing

Posted: 07/09/2012

When ABB China decided to consolidate the accounting operations of four companies in Hong Kong, it realized that unless accounting processes were standardized and optimized at the time of transfer, transaction-processing cost would vary among the companies, with lower processing costs for companies with more efficient processes, and vice versa. Similarly, an inappropriate charging scheme would penalize efficient companies and deter them from participating in the program.

Background

ABB China started implementing Shared Services in the year 2000, by transferring the accounting activities of four Hong Kong companies to a newly set up SSC, also located in Hong Kong. A feasibility study was done to estimate the potential savings of this arrangement. In the feasibility study, cost of accounting activities in each company was determined and a charging scheme proposed to charge back the cost.

Deciding on a Suitable Charging Scheme

For Shared Services to achieve its cost-reduction objective, the service fee paid by companies had to be lower than the original cost of keeping the activities within the companies. When Shared Services was proposed to the four ABB companies in Hong Kong, three questions were raised by the management of each company:

1. What is the current cost of processing the transactions in my company?
2. How much is the service fee to be charged by the SSC to my company?
3. How much is the saving to my company?

Cost of Accounting Activities

The real cost of accounting activities in a company is more than headcount-related cost. Accounts processes and their interfaces with other processes in the company, if not managed properly, will generate work that extends beyond the accounts department itself.

Having standardized processes among companies helps to ensure scalability and facilitates implementation of best practices. For example, if all companies are on a common web-based travel and expense platform, an improvement made in travel and expense workflow can rapidly be rolled out to all ABB companies operating in China (including Hong Kong).

In the Shared Services feasibility study, we had limited the cost of accounting activities to headcount-related cost for pragmatic reasons. The full cost of account staff comprised of:

1. payroll and related cost;
2. staff training;
3. ERP license fee;
4. depreciation charge;
5. workspace rental; and
6. internal allocated cost.

Of the above, some were variable and would cease to exist in the company after the staff were transferred to the SSC. Costs numbers 1, 2 & 3, above, were variable costs. Others were fixed and could only be regarded as realized savings to companies if the resources were being utilized, e.g., vacated workspace being used for other business purpose. If business volume was flat and vacated empty space or equipment remained unutilized, those cost would have to be taken into consideration when formulating the business case.

Deciding on a Suitable Charging Scheme

The SSC had to charge back the cost to the four companies as a service fee. We considered different ways of doing this, each with its own pros and cons, to determine if there were savings to the four companies in question.

In general, charging schemes fall into two broad categories: fixed charge, to be negotiated periodically; and transaction-based charge, with monthly service fees varying, depending on transaction volume. Charging scheme options include:

1. fixed charge;
2. benefits-sharing: could be fixed or transaction-based;
3. cost allocation: fixed charge;
4. benchmark-based: could be fixed or transaction-based;
5. activity-based charge: transaction-based.

In transaction-based charging, the cost of each accounting function would be calculated and divided by the estimated transaction volume to derive the unit transaction price. A price would be set for each unit of transaction processed, for the following accounting functions: accounts payable, accounts receivable, fixed assets, travel & expenses, and general accounting. During the start-up phase of the Hong Kong SSC, accounting processes were not standardized and the efficiency level of each company varied. Pooling the accounting activities in the SSC averaged out the cost of each accounting function. As a result, the unit transaction price of the consolidated functions in Shared Services was high for efficient companies and low for less efficient companies. There would, therefore, be no savings for efficient companies if this charging scheme were adopted.

To ensure that companies were not worse off as a result of Shared Services , the fixed charge scheme was adopted. This meant that the service fee charged was the same as the original ‘cost of account functions’ within the four companies, less a discount factor.

How Much is the Savings to My Company?

Having determined the cost of accounting activities in each of the four companies and having decided on the charging scheme, the difference between the cost and the service fee represented the savings to the companies.

Real savings could be higher, in fact, since we had limited the cost of accounting activities to headcount-related cost.

One might argue that Shared Services result in additional coordination work between the companies and the SSC, which could be costly. This is true if such co-ordination work is not managed properly, but there are ways to improve such co-ordination work to keep the cost minimal.

Changing the Charging Scheme

When the scenario that had justified a fixed charge scheme at the Hong Kong SSC changed, the charging scheme was reviewed to assess its ongoing suitability.

During the first two years of Hong Kong SSC operations, efforts were made towards standardizing processes using the model of the SSC at ABB China (Beijing).* Productivity tools already deployed in China were also rolled out at the SSC in Hong Kong. Through such standardization and optimization efforts, efficiency levels at the Hong Kong SSC improved and it became appropriate to convert from fixed charge to transaction-based charging.

Why Transaction Based Charging?

As business volume increased, processing work and manpower at the SSC in Hong Kong also increased. With the fixed charge scheme, the SSC had to negotiate new service fees with the companies every year. What was visible to the individual company was the request for a higher service fee. Information on productivity improvement, however, was not transparent to them.

In a transaction-based charging scheme, a unit price was set for each type of account transaction processed. A service fee is calculated by multiplying the unit transaction price with transaction appropriate volume.

When business volume increased, charges increased accordingly – something that companies can accept. Also, productivity data is captured in the unit price. A reduction in unit transaction price implies an improvement in the productivity of SSC.

Keeping it Simple

To avoid having an overly complicated costing/pricing scheme which would be administratively difficult to maintain, only one unit price was set for each of the following accounting functions: accounts payable, accounts receivable, travel and expenses, fixed assets and general ledgers.

The cost of the SSC was divided into five cost groups, each representing the cost of accounting functions. Transaction volumes of each accounting function were also determined. Taking the cost of an accounting function and dividing it by the transaction volume of that function gave us the unit transaction price. This could be done using a typical spreadsheet program.

Summary and Conclusion

Importance of costing & pricing

Because the ultimate objective of Shared Services is cost-reduction, costing and pricing have become important aspects of the program. A company needs to be able to compare the cost of running its accounting services itself, compared to paying a SSC to run them. Pricing has to be done properly in order to fairly allocate appropriate savings back to the companies. A poorly designed charging scheme will cross-subsidize cost and penalize efficient companies.

Fixed or transaction- based charging?

The fixed charge was easy to understand and more readily accepted by the companies; this was also ABB China’s preferred charging scheme at its SSC’s start up. Transaction-based charging, if not properly implemented, may become complicated to maintain. Such schemes avoid the need to negotiate for fee increases since an increase in transaction volume automatically results in an increase in the service fee. Productivity information is also captured in unit transaction price and becomes transparent to companies. A reduction in unit transaction price is strong evidence of productivity improvement.

Cost of accounting activities not easy to measure

The full cost of accounts staff will not accurately reflect the cost of running accounting activities in the companies. Business processes transcend across departments and business functions. An inefficient accounting workflow will create a workload and costs outside the accounting functions and those cost are not easy to quantify. Accounting process standardization work becomes important and is best achieved via Shared Services, as each company, being a separate independent entity, lacks the incentive to adopt the processes of another company.

Follow Through

With increased in business volume and changes in the charging scheme, whether Shared Services delivers results could be a difficult question to answer.

It is, therefore, important to ensure proper follow-up work. The feasibility study, which started the program, must be updated. As the basis of estimating cost and determining savings were stipulated in the feasibility study, they must be measured, adjusted and compared with the actual situation as we proceed with the Shared Services program.

* When SSC Hong Kong started operations, ABB China also started setting up a SSC in Beijing. Although Hong Kong started operation earlier than Beijing, several productivity tools were rolled-out first in Beijing, then transfered to Hong Kong. This is because Lim is based in Beijing.

Posted: 07/09/2012

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