Case 4: Dakota Office Products

Summary

The general manager of Dakota Office Products (DOP), John Malone was concerned about the financial results for the fiscal year 2000. The company had suffered a historic first loss in spite of sales increase from its prior year as noted in the income statement in (Exhibit 1). DOP distributes office supplies and offers a comprehensive product line. DOP had an excellent reputation for customer service and response time. It had operated several distribution centers with storage locations and shipments pending customer orders. DOP normally ships its orders through commercial truckers and had recently attracted new business by offering a “desk top” option by delivering the packages of supplies directly to individual locations at the customer’s site. The company charges a premium price percentage for the service with hopes of improving margins in its highly competitive business. Products are priced to its end-use customers by first marking up the purchased product cost by about 15% to cover the cost of warehousing, distribution, and freight. Then it adds another markup for general and selling expenses as well as for profit. Pricing is adjusted according to relationship and competitive situations. In the year 1999, Dakota has introduced electronic data interchange (EDI) and a new internet site in 2000, which allowed an automated ordering system that did not require a manual input of data. Even after those efforts, Dakota’s costs continued to increase. John Malone was concerned because the company could not make a profit. He wanted to take an action to regain profitability. John Malone turned to his controller, Melissa Dunhill, and the director of operations, Tim Cunningham to analyze the distribution centers and the facilities operations. Together, they identified four primary activities-process cartons in and out of the center, operating the new desk top delivery service, order handling and data entry. Space was dependent on the storage of cartons and turnover was dependent on the volume of cartons shipped in and out of the facility. Commercial freight for normal shipments, were based more on volume, regardless of the weight or distance. And any new desktop delivered items were not subject to the commercial shipping charges. Malone and his team continued to evaluate the expenses of data processing. Orders were manually keyed in, and system and internet generated orders came in automatically and there was no need for data entry. Company databases had generated ordering and shipping information for the year. The distribution centers has shipped out 80,000 cartons in year 2000, in which 75,000 cartons were shipped by commercial freight and the remaining 5,000 cartons were shipped under the desktop delivery option. In total, DOP had made 2,000 desktop deliveries for the year. The amount of handling, processing, and shipping was at full capacity according to the employees. The data entry personnel processed 16,000 manual orders and validated 8,000 EDI orders. Two small project teams were formed to review the distribution center and the data entry department activities. The distribution center team process 90% of the orders with 10% processing the desktop orders. The other warehouse expenses were associated with the operations not just in the current year, but from its prior year as well. The data entry team had worked 10,000 hours during the year, and these hours were distributed among each activity with the majority of hours going for entering individual order lines. Dunhill continued to analyze customer accounts to find the amount of sales generated was enough of contribution margin to cover the general and selling expenses and still for the company to be in profits as summarized in (Exhibit 2). Dunhill’s concern was the service demands for the second account that increased servicing for the orders that were requested. Exhibit 3 summarizes the actual ordering, delivery and payment statistics for the two customers. To address all the concerns a detailed analysis using activity-based costing analysis can help determine the actual costs of each product line. The costing system that was in place was inadequate because it did not account for all costs including interest paid in accounts receivable. Activity based costing (ABC) is an efficient tool that focuses on the total costs incurred to allow management to make a more informed decision. Implementing the ABC system can increase the overall efficiency of the company by identifying the areas that need to be improved.

|Exhibit 1 Dakota Office Products: Income Statement CY2000 |
| |
|Sales |42,500,000 |121.4% |
|Cost of Items Purchased |35,000,000 |100.0% |
|Gross margin |7,500,000 |21.4% |
|Warehouse Personnel Expense |2,400,000 |6.9% |
|Warehouse Expenses (excluding personnel) |2,000,000 |5.7% |
|Freight |450,000 |1.3% |
|Delivery Truck Expenses |200,000 |0.6% |
|Order entry expenses |800,000 |2.3% |
|General and selling expenses |2,000,000 |5.7% |
|Interest expense |120,000 |0.3% |
|Net Income Before Taxes |(470,000) |-1.3% |

|Exhibit 2 Customer Profitability Report (Current Method) |
| |
| |Customer A |Customer B |
|Sales |103,000 |121.2% |104,000 |122.4% |
|Cost of Items Purchased |85,000 |100.0% |85,000 |100.0% |
| | | | | |
|Gross margin |18,000 |21.2% |19,000 |22.4% |
|Warehousing, Distribution and Order Entry |12,750 |15.0% |12,750 |15.0% |
| | | | | |
|Contribution to general and selling |5,250 |6.2% |6,250 |7.4% |
|expenses, and profit | | | | |

|Exhibit 3 Services Provided in Year 2000 to Customers A and B |
| |
| |
| |Customer A |Customer B |
|Number of cartons ordered |200 |200 |
|Number of cartons shipped commercial |200 |150 |
|freight | | |
|Number of desktop deliveries |- |25 |
|Number of orders, manual |6 |100 |
|Number of line items, manual |60 |180 |
|Number of EDI orders |6 |- |
|Average accounts receivable |$9,000 |$30,000 |
| | | |

Question 1: Inadequate pricing system The existing pricing system was inadequate for its current operating environment for Dakota Office products because it did not take into account the additional resources that were used by different ordering and shipping methods for different customers which has led to wrong cost determination for individual customers. This made some customers much more profitable than others.

Question 2: Activity Based Costing Systems
|Activity Based Costing and Drivers | | |
|Cost Items |Annual Cost |Cost Driver |Estimated Value |Cost per | | |
| | | | |Driver Unit | | |
|Warehouse Personnel |2,160,000 |Number of Cartons |75,000 |$28.80 | | |
|Expense (freight) | | | | | | |
|Warehouse Personnel |240,000 |Number of Cartons |5,000 |$48.00 | | |
|Expense (desktop) | | | | | | |
|Warehouse Expense |2,000,000 |Number of Cartons |80,000 |$25.00 | | |
|(Excluding Personnel) | | | | | | |
|Freight |450,000 |Number of Cartons |75,000 |$6.00 | | |
|Delivery Truck Expense |200,000 |Number of Cartons |5,000 |$40.00 | | |
|Order Entry Expense |76,000 |Line Items |150,000 |$0.51 | | |
|EDI Order Expense |4,000 |Orders |8,000 |$0.50 | | |
|General and Selling Expense |2,000,000 |Number of Cartons |80,000 |$25.00 | | |
|Interest Expense |120,000 |$ Owed in Accts Receivable |1,200,000 |$0.10 | | |
|Order Entry Cost |8 | | | | | |
|Divided up by hours | | | | | | |

Activity based costing (ABC) is a way for a company to break up costs into cost pools and then allocate these costs based on cost drivers. This systems give DOP a more extensive view of different how different cost pools are performing for comparisons and improvements. ABC will also DOP to analyze the profitability of customers based on the services they use. The above activity base cost and drivers are based on the operations and tasks handled by DOP employees to fill order requests from customers and an estimated cost.

Question 3: Profitability
|Activity Based Costing Expenses for Customers A and B |
| |Customer A |Customer B |
|Number of Cartons Ordered |200 |200 |
|Cartons Shipped Freight |200 |150 |
|Desktop Deliveries | |50 |
|Manual Order Lines |60 |180 |
|EDI Orders |6 | |
|Average Accounts Receivable |9000 |30,000 |
| | | |
| |Customer A |Customer B |
|Warehouse Personnel |5760 |4320 |
|Expense (freight) | | |
|Warehouse Personnel | |2400 |
|Expense (desktop) | | |
|Warehouse Expense |5000 |5000 |
|(Excluding Personnel) | | |
|Freight |1200 |900 |
|Delivery Truck Expense | |2000 |
|Order Entry Expense |30 |91 |
|EDI Order Expense |3 | |
|Warehouse, Distribution and Order Entry Expense |$11,993.40 |$14,711.20 |
|General and Selling Expense |5000 |5000 |
|Interest Expense |900 |3000 |
|Total Expense |$17,893.40 |$22,711.20 |
| | | |
| |Customer A |Customer B |
|Sales |103,000 |104,000 |
|Cost of Items Purchased |85,000 |85,000 |
|Gross Margin |18,000 |19,000 |
|Warehouse, Distribution and Order Entry Expense |$11,993.40 |$14,711.20 |
|Contribution to General and Selling Expenses and Profit|$6,006.60 |$4,288.80 |

DOP looked at two customers, Customer A and Customer B to determine why the profitability between the two customers is different when they had the same amount of cartons shipped during the year. Using the ABC system it was calculated out what the actual profitability of each customer is related to the costs of providing services to them.

Question 4: Differences in Profitability There is a difference in profitability between customer A and customer B and there could be several reasons for that. The most likely reason in this case is the cost associated with providing services to the two customers. The methods in which they place orders and what they order in each turn are associated with the overall profitability of the customer to Dakota. For customer A, around half of their orders arrived using the new electronic system set up, which saved on processing order costs that are usually related to manual entry. Customer A also made fewer orders with large amounts of items in every order, so less processing costs overall when handling the amounts of orders placed. Customer B placed all orders manually, either by phone or paper, which increases the time and costs to process the orders and costs are incurred for every line item. Customer B placed many smaller quantity orders and around 25% of their orders requested the desktop delivery option, which puts more strain on resources in the distribution center and is more expensive. Overall, even though the amount of cartons ordered was the same and the costs of the items purchased were the same between the two customers, the methods used to place orders and the costs of the services required to process those orders were different and contributed to the difference in profitability of customer A versus customer B.

Question 5: Limitations to Profitability The limitations to determining the profitability are that you can only measure the data you have on hand with the customers and direct costs associated with services and products provided. It is difficult or challenging to determine or trace indirect costs associated with serving the customers back to them. Because of this it will be difficult to try and calculate and determine every single indirect cost associated with an individual customer. The amount of cost pools and cost drivers used to calculate costs of services provided should be limited to the amount that makes sense in determining profitability. Having 100 cost pools and associated drivers in an attempt to determine indirect costs associated with serving a customer can get complicated and too costly to evaluate and maintain in the long run.

Question 6: Additional information Relative Profitability There could be some additional information obtained to further define the profitability of Customer A and Customer B. The analysis so far takes into account the processing of manual orders versus electronic orders, method of shipping from the distribution centers, amount of line items per order and markups to each of the customers. Another aspect of the customer that could be valuable are any processing of rush orders that take more time to process or any returns made by the customers. These are two additional factors that could have an effect on the profitability of the customers to Dakota.

Question 7: Increase Company Profits Every company has customers that are more profitable than others. Earlier we examined how Customer A was far more profitable to Dakota Office Products than Company B. The difference in profitability is due to the difference in warehousing, distribution, amount of accounts receivable and order entry between the customers. For example, the warehouse labor expense and shipping expense for desktop deliveries is $88 per carton, while freight orders have a cost per create of only $34.80. Also manual orders are significantly more costly to process $.51 per line item as opposed to EDI orders that are only $.50 per order. The final determinant is the interest expense (10%) that DOP is charged for outstanding accounts receivable. If Dakota managers were able to analyze every customer based on the services they choose, they can reveal which customers are most profitable. Customers that are more profitable will use freight shipments, use EDI order entry and have low accounts receivable. Customers who use desktop shipping, manual order entry and hold high accounts receivable are less profitable for DOP. Customers who are determined to be less profitable or unprofitable, DOP can adjust the mark-up percentage on that customer’s orders. Customers who are create more expense for Dakota, will be paying for the extra expense or will be incentivized to use the more efficient methods.

Question 8: Switching order methods If a major customer switched from placing manual orders to placing electronic orders, it will have favorable effects on that customer’s profitability for DOP. The customer moving to EDI ordering will switch the cost driver for that customer from number of line items to number of orders. Assuming this customer had an average amount of line items per order (10) and average cost in terms of manual order entry, the activity cost driver rates for both manual and EDI orders should not very much. However, the cost of the order will move from manual to EDI and the cost driver will be orders instead of line items. Assuming each manual order has on average 10 line items, it costs DOP $5.07 to process, but EDI orders only cost $.50 to verify. For every order the major customer places, DOP will save $4.57 in order processing. Since the EDI order method is significantly cheaper than the manual entry, this will save the company time and money on every order the customer places.

Conclusion In conclusion, the ABC system method has advantages and could assist DOP in several different ways. It will allow DOP to determine services costs per customers based on their methods of order entry, manual versus electronic, and their methods of delivery, for example. For electronic advantages and less paper the EDI will be a definite tool for DOP. Of course the cost driver changes in each method. Using the ABC method DOP is able to determine the more profitable customers that they could concentrate on and allows them to assign service fees for the more costly methods in order to receive better profit margins for servicing less profitable customers and encourage them to change or adapt to those methods that are less in service fees and costs for DOP.

References:
Jiambalvo, James. (2010). Managerial Accounting, 4th Ed., John Wiley & Sons Inc, NJ.
Kaplan, Robert S., Dakota Office Products, Harvard Business School, February 18, 2005.