Dakota Analysis
-
Upload
tonylcaston -
Category
Documents
-
view
2.176 -
download
23
Transcript of Dakota Analysis
Dakota Office Products Case Analysis
Concern over a first year loss prompted a case study of the business operations of Dakota Office
Products. Harvard Business School professor Robert S. Kaplan authored the case study as an illustration
of use of activity based cost allocation and profitability (Kaplan, 2005). In the case presentation, John
Malone, the General Manager of Dakota Office Products (DOP) commissioned analysis of the company’s
operations and cost allocation practices; it focused on the company’s distribution center. Activities that
emerged as cost drivers included: commercial freight shipping, personal delivery of orders under the
Desktop Delivery program, warehouse handling and space, and several product ordering and entry
activities. In this paper, the cost drivers were utilized to establish activity-based costing for DOP.
Profitability for two current DOP customers was also analyzed for behavior patterns that might lead to
or suggest improved pricing. Specific assignment questions were detailed and answered on the topic of
relative profitability of the two customers. The objective of the analysis was to utilize learnings from the
profitability calculations in order to make recommendations which would return DOP to profitable
operation following the year of the unexpected loss. If the methods in this paper were utilized, it is felt
to be a useful tool to assist DOP management in turning the company around.
Method
The assignment is summarized in this section, followed by a detail of steps taken to complete it.
Data from the case study was used to develop an activity-based costing system. The activity-based
costing system is shown in Table 1. Based on a 1 year history, relative profitability of two customers was
determined using the variable direct cost drivers summed with interest on accounts receivables and
selling and administration costs. The profitability is expressed in absolute terms and as a percentage of
sales in Table 2.
Assignment
For the BUSA 5061 assignment, the DOP case was analyzed in order to address the following
conjectures (with assignment question nos. in parentheses):
Data suggests that the existing pricing system was inadequate for Dakota Office Products (1).
Based on data from the case study, an activity-based cost system was developed for year 2000 (2).
Profitability of two customers was compared (3) and explained (4). Limitations of the profitability
estimates were discussed (5). Consideration was given to other information that could help explain
the relative profitability of the two customers (6).
Applicability of the relative profitability comparison to the entire customer base was considered.
The management tool was expected to help Dakota Office Products return to profitability (7).
A total shift from manual order entry to internet orders for a major customer was considered. The
expected influence upon the established cost driver rates was noted. Again, increased profitability
is expected (8).
Construction of Activity Based Cost System
Table 1 was generated in order to calculate activity-based cost driver rates. The first column,
“Overhead Cost Items” contains description of the activity. In the column, “Source of Annual Cost”,
reference is provided for each cost item, either the numerical basis for the calculation or the reference
exhibit in the case study. The column with the heading, “Annual Cost Driver” contains the total impact
of the driver in dollars. The values in this column will constitute the numerator of the cost driver rate.
The column, “Estimated Annual Value” is the volume in the column, which along with “Units”, will make
up the denominator of the cost driver rate. “Cost per Driver Unit” is the calculated allocation rate.
Other Costs
Interest was assigned at a rate of 10% of each customer’s average accounts receivable balance.
General and Selling Expenses were allocated as the fraction of total sales.
Tabulation of Profitability Comparison of Customers
Table 2 is a comparison of the profitability of Customer A to Customer B. Tabulation of income
in the form of sales minus cost of goods sold provides a relative gross margin for each customer.
Following calculation of gross margin, the allocation of each of the individual cost pools is subtracted
from the gross margin. The resulting total, “Contribution”, is then reduced by the amounts of “Other
Costs” which include General and Selling expenses, and interest on the customers’ average accounts
receivable balances. The result, Net Income Before Taxes (NIBT) provides a comparison of profitability
for each customer, based on the activities utilized by each customer. Profit as a percent of sales is
computed by dividing the NIBT by sales
Results
Activity Based Cost System
The results of the cost system shown in Table 1 are described in this section. Freight activity was
found to cost $6 per carton shipped commercially. Under the Desktop Delivery program, the cost of
each delivery was calculated to be $220. Manual entry of orders cost $10 per order. An additional cost
for manual orders was $4 per line item on the order. Orders originating from the internet resulted in a
total cost of $5 per order, regardless of the number of line items, due to need for verification only. For
cartons warehoused and handled through the facility, a cost of $52 per carton was calculated.
Other Costs
Interest expense of $900 was assigned to Customer A and $3000 to Customer B, based on the
average accounts receivable balances of $9,000 and $30,000, respectively, at a 10% interest rate.
General and Selling expenses were assigned at the rate of $0.05 per dollar of sales. This resulted in a
charge of $4,847 for Customer A and $4,894 for Customer B. The numbers are very similar due to the
close agreement of sales for the two customers.
Profitability Comparison of Customers
The results of the profitability analysis shown in Table 2 are described in this section. After
calculating the difference of Sales and COGS, Customer A and Customer B yielded similar gross margins
of $18,000 and $19,000, respectively.
Compilation of relative activity-based costs shows some differences in customer behavior,
however. Customer A utilized more commercial freight shipments (200 vs. 150) which resulted in
activity cost assignment of $1,200 vs. $900 for Customer B. Customer B requested 25 Desktop Deliveries
at a relative differential in cost of $5,500 against Customer A, with none of this delivery method.
Customer A selected 6 manual orders compared to Customer B’s 100 manual orders, with contrasting
costs of $60 vs. $1,000, respectively. The total number of line items, 60 for Customer A, and 180 for
Customer B yielded an allocation of $240 and $720, respectively. Customer A executed 6 internet
orders at a cost of $30. Customer B did not use the internet ordering method. Each customer
warehoused 200 cartons, for an assigned cost of $10,400.
After consideration of all activity-based costs, a significant difference can be seen in profitability
of each customer, with Contribution Margin from Customer A calculated to be $6,070 against $480 for
Customer B. Following assignment of Other Costs, Customer A is calculated to be slightly profitable with
a Net Income Before Taxes of $323, or 0.3% profit as a percent of sales. Customer B has proven to be
unprofitable through the activity-based cost system, showing a loss of ($7,414), or (7.1%).
.
Table 1
Dakota Office Products: Calculation of Activity-Based Cost Driver Rates from Year 2000 Data
Overhead Cost Items Source of Annual CostAnnual Cost Cost Driver
Estimated Annual Value
Cost per Driver Unit units
Commercial Freight Exhibit 1, p4, line item: "freight" $450,000No of Cartons shipped by commercial freight 75000 $6 $/carton
Desktop Delivery
=10% of warehouse personnel expense + "Delivery Truck Expenses" from Exhibit 1, p4 $440,000 No of deliveries by Dakota personnel 2000 $220 $/delivery
Data Entry Total $800,000
Manual Order Entryfraction of total hours =2,000/10,000 X Data Entry total $160,000 No. of Manual Orders 16000 $10 $/manual order
Individual lines for manual order
fraction of total hours =7,500/10,000 X Data Entry total $600,000 No. of Line Items 150000 $4 $/line item
Validate EDI/Internet orderfraction of total hours =500/10,000 X Data Entry total $40,000 No. of Internet Orders 8000 $5 $/internet order
Warehouse handling and space
=90% of "warehouse personnel expense" + "warehouse expense" from Exhibit 1, p4 $4,160,000 No of Cartons through the facility 80000 $52 $/carton
Table 2
Dakota Office Products: Comparison of Profitability of Two Customers for Year 2000 Data
Customer A Customer BSales $103,000 $104,000COGS $85,000 $85,000
Gross Margin $18,000 $19,000Customer A Customer B
No of Cartons shipped by commercial freight 200 150 $1,200 $900No of deliveries by Dakota personnel 25 $5,500No. of Manual Orders 6 100 $60 $1,000No. of Line Items 60 180 $240 $720No. of Internet Orders 6 $30No of Cartons through the facility 200 200 $10,400 $10,400
Contribution $6,070 $480Other Costs
General and Selling, Allocated $/$ sales $4,847 $4,894Interest on Accounts Receivablessimple interest rate = 10 % on Avg Account Receivable Balance Customer A = $9,000*10%Customer B = 30,000*10% $9,000 $30,000 $900 $3,000
Net Income Before Taxes $323 -$7,414
Profit percent of sales 0.3% -7.1%
Discussion of Results
Questions posed for the assignment are discussed in this section.
Adequacy of Prior Pricing System
The current system of cost allocation is inadequate, as evidenced by the unexpected loss in
2000. An adequate cost allocation and pricing system would allow the management of DOP to
anticipate shifts in costs and profitability. Activity-based pricing would allow for passing along costs of
more expensive services to customers who use them at a higher rate.
Discussion of Activity-Based Costing System
An activity-based cost system is a good tool for management of cost flows resulting from
customer behavior. With the proposed activity-based costing system, differences in profitability were
exposed along with reasons the company might have operated at a loss. Even for customers with
behaviors incurring the lowest costs to DOP, activity-based costing provides a better picture of costs.
For example, Customer A showed what could be considered the ideal, lowest-cost behavior pattern: all
commercial freight; no Desktop Deliveries; a low number of total orders (12), and a good portion (50%)
of orders which were internet-originated. After consideration of “Other Costs”, Customer A was barely
profitable, as explained in the next section.
Profitability of Two Customers Compared
Under the original costing system used by DOP, Customer A was shown to be slightly less
profitable than Customer B. However, this analysis showed the opposite – Customer A was slightly
profitable at 0.3% profit as a percent of sales, and Customer B was not profitable, at a loss of (7.1%).
Customer A was a consumer of low-cost services. Timely servicing of debt contributed to
profitability. Customer B was shown to be the user of highest-cost services. Use of the high-cost
Desktop Delivery method is the greatest influence, at an activity cost of $5,500, but is not the only
factor. A relatively high number (100) of small manual orders (average 1.8 lines) and much more variety
of orders as evidenced by the high number of line items (180) are all higher-cost drivers. Add “Other
Costs”, namely, the interest accrued due to slow payment of its obligations to DOP, and Customer B
becomes a losing proposition in terms of profitability.
Profitability could be improved for Customer A and restored for Customer B through use of
pricing based on prevailing market markups based on Net Profit Before Taxes. A 3-4% markup after
activity-based cost allocation and after assignment of Other Costs - on NIBT would restore and ensure
profit for DOP. However, the higher pricing could lower demand. The markup could be fine-tuned to
maximize demand and profit though estimates and experiential determination of the demand vs. price
effect.
Limitations of the Profitability Study for the Two Customers
Limitations of the activity-based costing system and profitability analysis were considered. The
costs used to project the cost driver rates are a snapshot in time and are accurate for the previous year.
Use of the cost driver rates assumes that the overall mix of services does not change. Update of the cost
driver rates would be required periodically to reflect changes in the balance of services.
Other Factors to Explain Profitability
Customers may not realize that they are using relatively high-cost services. Education of the
customer could help profitability. Activities such as manual order entry, Desktop Delivery, and lack of
standardization mean higher costs. Standards could mean fewer line items and less cost. DOP could
bring awareness that prompt payment of accounts receivable balances would help lower costs. DOP
could also ask why Customer A uses the internet for 50% of orders and learn if there is margin for
increased internet order entry. Through education and interaction, DOP could also discern the
customer’s needs. This is necessary to assist customers to be deliberate in the choice of the highest
value services.
Applicability of Relative Profitability to Entire Customer Base
The proposed activity-based costing system should be extended to the entire customer base,
followed by a test of profitability of all customers. At a minimum, a one-time profitability analysis of all
customers is indicated in order to provide an apples-to-apples comparison of customers.
Once this profitability “check” has been completed for all customers, DOP would have clarity on
whether customers were profitable or not. DOP could be confident that there are no more latent and
unexpected losses imminent. The decision to continue profitability analysis on an ongoing basis requires
judgment of the effort required vs. the value gained.
Applying the proposed pricing system to all customers will force either price increases or
reductions of service. One factor that should be considered is volume of sales on a per customer basis.
Major customers will likely expect a volume discount pricing structure; price increases will require
negotiation. The decrease in demand following a price increase is difficult to predict. The impact of
losing a major customer is a more clear result.
What If: Major Customer Shifts from Manual Orders to Internet
If a major customer primarily enters orders manually, a shift to all internet orders could
constitute a substantial decrease in expenses for DOP. The total cost impact for manual entry of
customer orders and the associated entry of line items constitutes a spend of $760,000 in 2000. Manual
order entry consumes 95% of the available resources. Comparison of manual entry cost to internet
entry cost represents a potential decrease of at least 67%.
If the customer constitutes 10% of total DOP sales, a total shift to internet order entry could
equate to (1-.67)*$76,000 = approximately $25,000 savings to the cost driver. Data entry resources
were assessed to be operating at capacity. The shift to internet orders would free up data entry labor.
In order to realize the savings, resources must be utilized in internet entry or other functions. Personnel
could be cross-trained to drive a forklift, pick stock, make deliveries, or support sales. If additional
resource demand did not accompany the shift to internet orders, a reduced labor cost would translate
to a decrease in data entry staff.
The potential for major shifts in service mix such as this could significantly change DOP’s cost
drivers. This potential underscores the need to revisit the activity-based cost driver rates on an annual
basis.
Conclusion
Profitability must be improved at DOP. Profitability can be ensured and unexpected losses can
be avoided through use of activity-based costing and pricing at the company.
The current cost allocation system at DOP provides inadequate information to manage the
business for a profit. For the services provided, DOP prices are too low to be profitable. The example of
two “similar” customers with very dissimilar activities illustrated the blind spots with the current cost
system at DOP. The proposed activity-based costing system would provide information necessary for
improved pricing.
Customers should understand the cost drivers for DOP’s business. Education will aid customers’
deliberate choice of services with the highest value to them.
Extension of the analysis of relative profitability to the entire customer base has value as a test
of overall profitability for DOP. Use of the method outlined here will also provide clarity and confidence
surrounding individual customer profitability.
But, new pricing would be higher and could lower demand. Major customers will likely expect
advantaged pricing or service concessions. Price increases should be fine-tuned to maximize demand
and profit though estimates and experiential determination of the demand vs. price effect.
Finally, past performance has value to predict future cost drivers but should be revisited
annually or more frequently if needed. This is because major shifts in the balance of services provided
by DOP could significantly change the cost drivers.
References
Kaplan, R. (2005, February). Dakota Office Products. Harvard Business School Publishing, Boston.