Profitability modeling and analysis is one of the most important areas of financial analysis. The modeling options and possible modeling approaches are many. Here, we’ll look at a few of the drawbacks of traditional allocations and profitability modeling approaches, and how to overcome them.
The problem with traditional profitability modeling solutions
Traditional allocation solutions either implicitly derive allocation rates via the solution’s defined allocation procedures or require the allocation percentage to be input directly into the allocation procedure line items. In the first case, where allocation percentages are implicitly derived, the allocation logic and cost breakdown are hidden in the metadata behind the allocation instruction. The allocation process and underlying business logic therefore suffer from a lack of transparency and often become unwieldy.
In the second case, where allocation percentages are entered directly, the cost breakdown becomes more transparent, yet the high number of required allocation instructions will still cause a lack of transparency. Because of that lack of transparency, traditional cost allocation process solutions are often manageable only by highly trained and experienced financial analysts, and often limited to use within the context of a financial close cycle.
That means that traditional cost allocation processes are not well suited for ongoing, activity-based costing purposes and pricing exercises. While it is conceptually possible to achieve ‘activity-based costing’ through a traditional cost allocation process, the underlying costing approaches will stay hidden behind the allocation metadata. The allocation process thus becomes an abstract interpretation of the costing methodology.
Applying activity-based costing methodologies with modern profitability modeling solutions
Activity-based costing methodologies, on the other hand, provide transparency into the costing methodologies, approaches and concepts applied by the user because rates are derived based on ‘activities.’ Via rate management and analysis capability, these methodologies provide insight into the costing approaches taken, for example by answering “Which activities drive what costs and how?” or “How should a costing rate be derived — what are its data-drivers?” They also provide insight into the effects of the costing approaches on profitability as measured by the business.
Activity-based costing, which by its nature requires transparency, is therefore typically achieved via a rate-based costing approach and model. Yet, rate-based costing models cannot be easily applied to determine and analyze related causes and effects on a larger scale, such as during a financial close cycle or to analyze outcomes or restructuring changes.
An actionable, activity-based costing approach hence should be based on cost rates and an underlying data model that manages the entire process, from setting the rate logic to rate calculation and analysis. Such a rate-based costing model can then very effectively be leveraged by a cost allocations process for scenarios where cost is not directly aligned with the cost drivers. In the presence of a rate-based costing methodology and a corresponding solution that provides transparency into the costing methodologies, the allocations process needs to be able to simply ‘pick up’ the rate(s) that are to be applied to an allocation cycle. Rather than interpreting the costing methodology, the allocation process directly applies the costing methodology. The outcome is a transparent and simpler allocations process, driven and supported by a transparent and comprehensive rate-based costing solution.
The best of both worlds: IBM Planning Analytics
The IBM Planning Analytics Solution for Allocations and Profitability Modeling enables companies to combine the flexibility of a traditional financial allocation process engine with the financial and procedural transparency of an activity-based profitability modeling approach. The solution offers the following core features:
- Waterfall allocations, with an unlimited number of allocation cycles and instructions
- Modeling and configuration by end-users (no IBM TM1 development skills required)
- Out-of-the-box support for standard allocation and apportionment methods.
- Integration with existing IBM Planning Analytics models
- Rapid integration of external fact-, master and metadata
- Cube/model-specific allocations
- Traceability for the automatic creation and updating of:
- Validation modules (to analyze over/under)
- Allocation trace and narrative modules (to allocate transactions by source, target and offset line items or allocation target transaction ‘narrative’)
- Allocation lineage modules (to analyze and filter allocations by allocation type, driver, sources, targets, offsets, etc.)
- Fast performance and high scalability: leverage parallel allocation processing algorithms and a multi-threaded query engine for the speedy processing and analysis of millions to billions of records
- Allocation processing statistics and verbose logging
- What-if profitability modeling
- Traditional and activity-based (driver-based) profitability modeling
With a configurable and scalable allocation engine at its core, and leveraging the capabilities of the IBM TM1 in-memory multi-cube architecture, this IBM solution allows the deployment of comprehensive financial allocation, costing and profitability solutions within a matter of days or weeks, without requiring IT development skills. And it does so at a lower total cost of ownership (TCO) than most traditional profitability modeling solutions.