a 582 Part2 ManagementAccointing 2. Why were (a) Lourdes and (6) Greg so interested in havirig the company change its cost system? 3. What are the effects, if any, of changing the com- pany’s costing method? Specifically, are the differ fences between these three methods significant in terms of a. Their effect on individual product costs? b, Their effect on total company profits (assuming that there are no changes in any operating deci- sions, such as regarding prices and production volumes)? Where the differences are significant, explain why they exist, If there are no differences, or if the dif- ferences are not significant, explain why this is the case 4. Do you think the cost system was a cause of the re- quests that Lourdes was réceiving to discount ODDs back in 2001, when SMD was still a one- product, ODD-only company? Would it have made sense to start implementing ABC at that time? 5, What should SMD management do regarding its ‘cost system? (To the extent that they exist, discuss the advantages and disadvantages of each alterna- tive. Why did you recommend the alternative that you chose? Explain.) Case 18-5 Dakota Office Products John Malone, General Manager of Dakota Offi Products (DOP), was concerned about the financial re- sults for calendar year 2000. Despite a sales increase from the prior year, the company had just suffered the first loss in its history (see summary income statement in Exhibit 1), Dakota Office Products was a regional distributor of office supplies to institutions and commercial busi nesses. It offered a comprehensive product line rang- ing from simple writing implements (such as pens, * Professor Robert S. Kaplan, Copyright © by the President and Fellows of Harvard College. Harvard Business School case 102.021 EXHIBIT 1 Pad eect Sales Cost of items purchased Gross margin Warehouse personnel expense Warehouse expenses (excluding personnel) Freight Delivery truck expenses Order entry expenses © General and selling expenses Interest expense Net income before taxes i pencils, and markers) and fasteners to specialty paper for modern high-speed copiers and printers. DOP had an excellent reputation for customer service and re- sponsiveness. DOP operated several distribution centers in which personnel unloaded truckload shipments of products from manufacturers, and moved the cartons into desig- nated storage locations until customers requested the items. Each day, after customer orders had been re- ceived, DOP personnel drove forklift trucks around the warehouse to accumulate the cartons of items and pre- pared them for shipment. Typically, DOP shipped produc to its customers using commercial truckers, Recently, DOP had attracted Looney 00 '542,500,000 121.4% 35,000,000 100.0% 500,000 21.4% 2,400,000 6.9% 2,000,000 5.7% 450,000 13% 200,000, 0.6% 800,000 2.3% 2,000,000 5.7% 120, 0.3% 370) 1.4%new business by offering a “desk top” option by deliv- ‘ering the packages of supplies directly to individual locations at the customer's site. Dakota operated a small fleet of trucks and assigned warehouse personnel as drivers to make the desktop deliveries. Dakota charged a small price premium (up to an additional 2 percent markup) for the convenience and savings such direct, delivery orders provided to customers. The company believed that the added price for this service could im- prove margins in its highly competitive office supplies distribution business. DOP ordered supplies from many different manu- facturers. It priced products to its end-use customers by first marking up the purchased product cost by about 15 percent to cover the cost of warehousing, dis- tribution, and freight. Then it added another markup to cover the approximate cost for general and selling ex- penses, plus an allowance for profit. The markups were determined at the start of each year, based on actual expenses in prior years and general industry and competitive trends. Actual prices to customers were adjusted based on long-term relationships and com- petitive situations, but were generally independent of the specific level of service provided to that customer, except for desk top deliveries. Dakota had introduced clectronic data interchange (EDI) in 1999, and a new Internet site in 2000, which allowed customer orders to arrive automatically so that clerks would not have to enter customer and order data manually. Several customers had switched to this electronic service because of the convenience to them. Yet Dakota's costs continued to rise. Malone was con- cerned that even after introducing innovations such as desktop delivery and electronic order entry, the com- pany could not earn a profit. He wondered about what actions he should take to regain profitabi DISTRIBUTION CENTER: ACTIVITY ANALYSIS Malone turned to his controller, Melissa Dunbill, and director of operations, Tim Cunningham, for help. Tim suggested: If we can figure out, without going overboard of course, what exactly goes on in the distribution centers, maybe we can get a clearer picture about what it costs to serve our various customers. Melissa and Tim went into the field to get more specific information. They visited one of Dakot distribution facilities, Site manager Wilbur Smith con- firmed, “All we do is store the cartons, process the Chapter 18 Additional Aspects of Product Costing Systems $83 orders, and ship them to customers.” With Wilbur's help, Melissa and Tim identified four primary activities done at the distribution center—process cartons in and cout of the facility, the new desk top delivery servi order handling, and data entry. Wilbur described some details of these activities. The amount of warehouse space we need and the people to move cartons in and out of storage and zget them ready for shipment just depends on the number of cartons. All items have about the same inventory tumover so space and handling costs are proportional to the number of cartons that go through the facility. ‘We use commercial freight for normal ship- ‘ments, and the cost is based more on volume than on anything else. Each carton we ship costs about the same, regardless of the weight or distance. Of course, any carton that we deliver ourselves, through our new desktop delivery service, avoids the commercial shipping charges. ‘The team confirmed the information with the ware- house supervisor who noted This desktop delivery is a real pain for my people. Sure, we offer the service, and it’s attracted in- creased business. But I have had to add people since existing personnel already had more than enough to do. Melissa and Tim next checked on the expenses of entering and validating customer order data. The order entry expenses included the data processing system and. the data entry operators. They spoke with Hazel Nutley, a data eniry operator at Dakota for {7 years. ALI do is key in the orders, line by line by line I start by entering the customer ID and validating, ‘our customer information. Beyond that, the only thing that really matters is how many lines T have to enter. Each line item on the order has to be centered separately. Of course, any order that comes in through our new EDI system or Internet page sets up automatically without any interven- tion from me. I just do a quick check to make sure the customer hasn't made an obvious error, and that everything looks correct. This validity ‘check takes about the same time for all electronic orders: it doesn’t depend on the number of items ordered, Melissa and Tim collected information from com- pany data bases and learned the following: + The distribution centers processed 80,000 cartons in year 2000. Of these, 75,000 cartons were shipped.584 Part 2 Management Accounting by commercial freight. The remaining 5,000 cat- tons were shipped under the desktop delivery op- tion. DOP made 2,000 desktop deliveries during the year. + People felt this total amountof handling, processing and shipping was about the capacity that could be handled with existing resources. + The data entry operators processed 16,000 manual orders, and validated 8,000 EDI orders, The 16,000 ‘manual orders had an average of nearly 10 items per order, or 150,000 order lines in total. As with the carton handling, shipping, and delivery personnel, supervisors felt that the data entry operators were operating at capacity rates with the existing business, They then formed two small project teams, one made up of distribution center personnel and the other of data entry operators, to estimate the amount of time people spent on the various activities they had identi- fied. The teams conducted interview, asked some peo- ple to keep track of their time for several days, and observed other people as they went about their daily jobs. The distribution center team reported that 90 per- cent of the workers processed cartons in and out of the facility. The remaining 10 percent of workers were assigned 10 the desktop delivery service. All of the ‘other warchouse expenses (rent, building and equip- ment depreciation, utilities, insurance, and property taxes) were associated with the receipt, storage, and handling of cartons, The delivery trucks were used only for desktop delivery orders. These estimates were reviewed by supervisors and felt to be representative of operations not just in the current year, but in the past year (2000) as well The data entry team, from monitoring computer records, learned that operators worked 10,000 hou during year 2000. Further analysis of the records revealed the following distribution of time for each of the activities performed by data entry operators. Data Entry Activity Operators Time Set up a manual customer 2,000 hours order Enter individual order lines 7,500 hours in an order Validate an EDI/Internet order __500 hours Total 10,000 hours UNDERSTANDING CUSTOMER PROFITABILITY Melissa looked through the customer accounts and found two typical accounts of similar size and activity volumes. Customers A and B had each generated sales in year 2000 slightly above $100,000, The costs of the products ordered were also identical at $85,000. The overall markups (21.2 percent for Customer A, and 22.4 pereent for B) were in the range of markups tar- geted by Dakota Office Products, The markup for Cus- tomer B was slightly higher because of the premium charges for desktop delivery. Both customers had or- dered 200 cartons during the year, The existing cus- tomer profitability system (see Exhibit 2) indicated that both customers generated a contribution margin sufficient to cover normal general and selling, expenses and return a profit for the company. Melissa noticed, however, that the two accounts differed on the service demands made on Dakota. Cus- tomer A placed a few large orders, and had started to use EDI to place its orders (half its orders, in year 2000, arrived electronically). Customer B, in contrast, placed many more orders, so its average size of order was much smaller than for Customer A. Also, all of Customer B's orders were either paper or phone XHIBIT 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 expenses, and profit 5,250 6.2% 6,250 7.4%