Executive Summary – Allied Office ProductsIncreased competition in the forms manufacturing business motivates companies to create ways to increase sales and maximize profits. As a corporation in the forms manufacturing business, Allied Office Products strives to develop, create, and offer new value-adding services to its clients in order to differentiate itself from competitors. In 1988, the company expanded into the business forms inventory service line. This new line of service was offered through the Total Forms Control (TFC) branch. Four years later, TFC achieved sales of $60 million. Its services focused primarily on: warehousing, form distribution, inventory control, and form usage reporting. Although the branch is growing and TFC’s return on investment is six percent, the Business Forms Division’s return on investment is twenty percent.
Thus, TFC’s return on investment seems to be less than exceptional.Upon the realization of the company’s short comings, upper management has turned to TFC Controller, Melissa Dunhill, and Director of Operations, Tim Cunningham, to assist in upper management understanding customer profitability. Currently, the company uses a normal cost system. Normal cost systems apply direct materials and direct labor and then apply predetermined overhead rates in determining costs of activities. (Hansen ; Mowen, 2013) In exhibit 1 of the case, the calculation for the predetermined overhead rate displays how product sales at cost are used as the cost driver and the overhead accounts are broken down into percentages of sales at cost. Cost drivers are factors that measure the demands placed on an activity. (Hansen ; Mowen, 2013) With the current strategy, the standard price for the product services is the same no matter the level of services required.
Although this approach does allocate the expenses to the clients, it does not result in an effective pricing strategy or a fair profitability per client analysis.With the objective of raising the profit margin, many companies are switching to Activity Based Costing (ABC) systems. ABC systems trace costs to particular activities and then trace these activities to the products/services offered. (Hansen ; Mowen, 2013) If Allied could utilize an ABC system for its TFC department, then clients could be charged by both the services rendered and the product costs. This would result in better pricing strategies and expense allocation for the company overall.
To obtain the primary activities and the associated cost drivers for each activity, upper management visited the distribution center and interviewed warehouse supervisor, Rick Fosmire, and data entry operator, Hazel Nutley. After gathering data, a conclusion was made that it is not fair for clients with similar sales amounts to be charged the same amount of money regardless of the level of services obtained. It was also determined that this is the primary area of responsibility for profitability issues.
Upon these conclusions, upper management contacted our team to help with the cost system issues of TFC. By examining the information discovered from onsite observations and the costing systems currently in place, the purpose of this analysis is to examine whether or not an ABC costing system would result in effectively allocating expenses; thus, resulting in improved pricing methods that would in return raise company profits.ABC System AnalysisWhen constructing an ABC system, the first task is to identify the activities. From the interviews and observations that were completed, upper management disclosed six primary value adding activities including: storage, requisition handling, basic warehouse stock selection, “pick-pack” activity, data entry, and desk top delivery. Additional costs relating to clients include: freight out, inventory financing, and inactive inventory storage costs. Exhibit 2 in the case shows how each activity’s total cost is calculated using a sample of five distribution warehouses.
The sample used for the costing analysis consists of five distribution centers with combined inventories of 350,000 cartons. Total annual requisitions are 310,000 and since each requisition averages 2.5 lines, total lines processed is 775,000.
Out of the 775,000 lines, 90% of them will need pick packing, resulting in 697,500 pick packed lines. Lastly, the cost of storing inventory is 13%.Figure 1Resources – Storage ExpensesSecurity DepreciationUtilitiesRent$3$208$187$1,424100% 85%15%85% 15% 85%15%ActivitiesStoring CartonsHandling Requisitions$X= $1,550,000$Y= $273,000=$1,550,000/350,000 cartons =$273,000/310,000 requisitions=$4.43 per carton =$.88 per requisitionCustomers350 Cartons 700 Cartons 364 requisitions 790 requisitionsCustomer ACustomer BFigure 1 is an in depth cost allocation for the storage expense activity. In the figure, one resource driver is appointed, Storage Expenses.
A resource driver measures the consumption of resources by activities. (Hansen & Mowen, 2013) The activity, storing cartons, is then calculated by allocating the determined portion of overhead. Pulling from Exhibit 2, all of security and 85% of depreciation, utilities, and rent are allocated to storage expenses.
The remaining 15% of overhead costs are thrown into the requisition handling expenses activity. Since this figure focuses on storage expenses, the requisitions handling is not complete and only shows the relationship of overhead. Having allocated all of the costs related to storage, the storing cartons expense is determined to be $1,550,000. For this activity, cartons are the cost driver and the sample has 350,000 cartons. To find the unitcost, take the total cost, $1,550,000 and divide by the driver volume, 350,000 cartons, to get storage expenses of $4.43 per carton per year. By figuring the amount of storage expenses related to each carton, the storage expenses can be distributed fairly to clients by the number of cartons in inventory.
For example, since customer A has an average of 350 cartons of inventory, the associated storage costs would be $1,554. To accurately calculate all of the activity costs related to customers, every activity needs to be broken down to a unit cost rate.Figure 2Value Added ActivityCost driverTotalDriver UnitCostVolumeCostA.
Storage ActivityCartons$1,550 /350K =$4.43B. Requisition HandlingRequisitions$1,801 / 310K =$5.81*Carton Lines775K$2.32C.
Warehouse ActivityRequisitions$761 /310K =$2.45*D. Pick Packing ActivityPick Packed Lines$734 /697.5K** =$1.05E. Entering DataCarton Lines$612 /775K =$.
79F. Desk top delivery servicesNumber of times$250 /8.5K =$29.41* Using requisitions rather than carton lines for calculations ** = 775K carton lines x 90%Figure 2 displays all six activities and each activity’s associated cost, cost driver, and unit cost. For requisition handling, either requisitions or carton lines can be used as cost drivers. However, since we have a specific “pick-packing” activity pertaining to carton lines, requisitions will be used as the primary cost driver. Therefore, by using the total cost of $1,801 – from Exhibit 2 – and dividing by the total requisitions of310,000, the unit price for requisition handling is $5.81 per requisition.
Similarly, basic warehouse stock selection activity also uses requisitions as its primary cost driver and derives a unit price of $2.45 per requisition. As previously mentioned, the activity of “pick-packing” will use “pick-packed” lines as its cost driver.
It’s important to note that the total carton lines must be multiplied by 90% to derive the amount of “pick-packed” lines in this sample. Since data entry expense is directly correlated with the amount of lines that are entered, we choose carton lines as our primary cost driver. For the desk top delivery service, we used the total activity cost from Exhibit 2 and the 8,500 desk top requests that were estimated. Since we were able to calculate all of the unit prices for each activity, we can now accurately distribute the expenses to each of the customers.Customer CostsTo demonstrate how to properly allocate costs to each of the customers, we will use customers A and B from the case. Both customers have annual sales of $79,320 and the cost of the product is $50,000. With the current cost system, the sales price is derived from multiplying the product cost by 158%, which covers an additional 32% of product costs resulting from services and another 20% of product and service costs from the sales department.
Once you compare the amount of services requested by Customer A to Customer B, it becomes evident that the sales price determination is unfair/unprofitable. Customer A’s service expenses include: submitting 364 requisitions, consisting of 910 lines (all of which are pick-packed); having an average inventory of 350 cartons and an inventory balance of $15,000; requesting no desk deliveries; and, having freight of $2,250. Customer B’s service expenses include: submitting 790 requisitions, consisting of 2500 lines (all of which are pick-packed); having an average inventory of 700 cartons and an inventory balance of $50,000 ($7,000 of which was inactive); requesting twenty-six desk deliveries; and, having freight of $7,500. Customer B almost triples Customer A in every service activity.Figure 3Customer ACustomer BStorage350 Cartoons/pm700 Cartoons/pm350 x $0.
37 x 12 months700 x $0.37 x 12 months$1,554$3,108Requisition Handling364 Requisitions790 Requisitions$5.81/requisition$5.81/requisition$2,115*or $4,590*or910 Lines2,500 lines$2.32/line$2.32/line$2,111$5,800Warehousing Activity364 Requisitions 790 Requisitions$2.45/requisition$2.45/requisition$892$2,450Pick packing activity910 Pick Packed Lines2500 Pick Packed Lines$1.
05/pick pack line$1.05/pick pack line$956$2,625Data Entry910 Carton Lines2500 Carton Lines$.79/carton line$.79/carton line$719$1,975Desk Top Delivery0 Deliveries26 Deliveries$29.41/Delivery $29.41/Delivery$0$765Freight out$2,250 Annual Freight$7,500 Annual FreightInventory Financing 13%$15,000 Inventory $50,000 Inventory13% Financing Charge13% Financing Charge$1,950$6,500Inactive inventory storage cost$0 Inactive Inv.$7,000 Inactive Inv.
1.5% Charge per Month 1.5% Charge per Month$0$1,260Total Service Charges as per ABC$10,435$30,773* Amounts used for calculation of total.Figure 3 shows the service calculation for each customer. The majority of activities are calculated by using the unit costs from Figure 2 and the data from each customer listed above. However, inventory financing is calculated by using the 13% cost of capital derived from the sample and multiplying it by the inventory balance.
The inactive inventory storage cost is calculated using the suggested charge rate of 1.5% per month, for anything in storage over 9 months. Customer A clearly uses far less services than customer B.Figure 4Customer ACustomer BSales$79,320$79,320Product Cost of Sales$50,000$50,000Gross Profit$29,320$29,320ABC Bases service fees$10,435$30,773Operating Profit$18,885$-1453Operating Profit % %23.8%-1.8By examining Figure 4, it is easy to see how much more profitable customer A is than customer B. The difference in profitability lies in the amount of services requested. Customer A returns the desired profit by minimizing service expenses, while customer B pulls in a loss due to the large amounts of services required.
At this point in time, TFC would much rather have customers with less service requirements. This is due to the fact that the company is losing money on the clients with a large number of services. However, if a new pricing system is implemented that charges extra amount for additional services, not only could Customer B become more profitable, but sales would also rise, resulting in greater market share. TFC has a couple of options on how to maximize its profits.
It could simply raise the prices universally under the current system, further increasing A’sprofitability and pushing B’s profitability from a loss to a gain. However, this would probably hurt the business because both customers would equally dislike the increased prices without sufficient notice or information regarding the change in prices. On the other hand, the company could continue with its current pricing strategy and agree to the 6% ROI. However, the company would then be settling for the status quo, and failing to successfully make a business change is a leading cause of business failure. Therefore, the best option is switching to a service based pricing (SBP) model, which will allow TFC to properly charge all customers while maintaining a desired rate of investment.
While size plays a role in profitability, Exhibit 4 and 5 reiterate how the biggest factor in contribution per client is the allocated service costs. The top twenty accounts range in sales sizes, but they all have relatively low service costs. The actual net sales price is slightly higher than the suggested standard price for these accounts, at 164% ($1,279,133 sales /$779,003 product cost) rather than 158% of product costs. Thus, these accounts are being over charged. For the bottom twenty accounts the sales price average was 147% of product costs, meaning that these accounts were being undercharged. Changing the sales prices back to the recommended sales price only changes profitability slightly. The real profit maximization strategy is to increase the sales price in correlation with the service activities.
Customer A could be charged less since it requires such little service and customer B would be charged more for the services offered. With almost 50% of sales coming from accounts with $300,000+ sales, charging these large accounts an additional amount for services would create an increased profit for the company. Therefore, since all allocated activities are value-added activities, we recommend that TFC implement the SBP pricing system. This system will charge customers more accurately for the activity services that are requested and used. It will also help to create more profitability from those clients that request a plethora of additional services, while also reducing the costs for those clients that have more easily maintained accounts.
RecommendationWhile TFC is not the most important branch within the company’s value chain (Exhibit 6 locates TFC behind form manufacturing and form sales), it is an integral part of the company. It provides services to the customers, and these services often play a pivotal role in customer’s perception of the company. By recommending a new service based pricing system, the company will be able to track expenses thoroughly and charge clients accurately.
Although some clients may not agree with the increased pricing scheme, by explaining how the price change reflects services provided, the client could then decide to cut back on services in order to prevent rises in costs. If some of the salespeople do not like the decreased commission on certain products, then explain to them the big picture of how bringing on new clients or additional services will increase their commissions more than before. Doing so creates a win win situation by setting the salespeople’s eyes on bigger commissions in the future and more business being brought in. The SBP system will only change business temporarily, but in the long run it will prove to increase profits and efficiency.
Another recommendation to help cut activity costs and as a result cut client sales prices, the company should work with the clients to reconfigure cartons to resemble the top forty accounts buying pattern to reduce the pick pack orders. Another focus on point would be, reducing redundant data entry. One way to decrease the redundant data entry is, integrating purchase history in the requisition process. In this way, based on the previous orders, requisition lines would be entered and can significantly reduce redundancy and time.The company also should strive to improve its supply chain management. Optimization of warehouse space and customer inventory level would lead to lower activity costs, resulting again in lower prices to clients to offset the price increases from the new service based pricing system. Methods to improve the supply chain include predictive analysis, forecast models, and JIT inventory. These strategies would reduce the amount of cartons being stored in the warehouse and help the company become more efficient.
Before changing to service based costing, a through competitive market analysis should be done including the five competitive forces that shape the strategy. However, in a competitive business environment, the importance of market timing cannot be eliminated and should be considered as an inevitable part of decision making process. If competitive market analysis mirrors optimal market timing, implement service based pricing and the changes in supply chain management to maximize profits.We also recommend that TFC’s current management follows, Jim Collins’ “Good to Great”, an example related to employees within the company. Collins noted that it is important to have the right people on the bus and the wrong people off the bus.
(Collins, 2001) If some employees do not accept the new SBP, then get them “off of the bus”. For the employees who recognize the potential in this new pricing system, keep them “on the bus”, as they are the employees who will help in the company’s success.We also want to point out, that upper management is practicing very important level 5 leadership attributes. Level 5 leaders are never satisfied with the status quo and strive to produce results. (Collins, 2001) The ambition to increase the profitability of the TFC department shows that upper management is committed to the company and will not settle for mediocre results.
Rather than place the blame on anything, upper management has used its employee resources; for example Tim, Melissa, Hazel, and Rick, to gather all important and necessary evidence and to brainstorm possible solutions. By visiting the distribution centers, upper management has shown that it is willing to be a plow horse and is also interested in hearing from all people within the company. Even those employees at the bottom, like Hazel and Rick. All three of these actions have led to an uplifted morale within the company, and the company will continue to develop and grow with its upper management leadership and its new pricing system.