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): y y y 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). y 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). y 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

Commercial Freight

Source of Annual Cost

Exhibit 1, p4, line item: "freight" =10% of warehouse personnel expense + "Delivery Truck Expenses" from Exhibit 1, p4 $800,000 fraction of total hours =2,000/10,000 X Data Entry total fraction of total hours =7,500/10,000 X Data Entry total fraction of total hours =500/10,000 X Data Entry total

Annual Cost

Cost Driver

Estimated Cost per Annual Driver Value Unit

75000

units

No of Cartons shipped by commercial $450,000 freight

$6 $/carton

Desktop Delivery Data Entry Total

$440,000 No of deliveries by Dakota personnel

2000

$220 $/delivery

Manual Order Entry Individual lines for manual order Validate EDI/Internet order

$160,000 No. of Manual Orders

16000

$10 $/manual order

$600,000 No. of Line Items $40,000 No. of Internet Orders

150000 8000

$4 $/line item $5 $/internet order

=90% of "warehouse personnel expense" + "warehouse Warehouse handling and space 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 B $103,000 $104,000 $85,000 $85,000 $18,000 Customer A Customer B 200 150 25 6 100 60 180 6 200 200 $1,200 $60 $240 $30 $10,400 $19,000 $900 $5,500 $1,000 $720 $10,400

Sales COGS Gross Margin No of Cartons shipped by commercial freight No of deliveries by Dakota personnel No. of Manual Orders No. of Line Items No. of Internet Orders No of Cartons through the facility

Contribution Other Costs General and Selling, Allocated $/$ sales Interest on Accounts Receivables simple interest rate = 10 % on Avg Account Receivable Balance Customer A = $9,000*10% Customer B = 30,000*10% Net Income Before Taxes Profit percent of sales

$6,070 $4,847

$480 $4,894

$9,000

$30,000

$900 $323 0.3%

$3,000 -$7,414 -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.