Professional Documents
Culture Documents
Overview
• The case focuses on how a manufacturing company measured the cost and
profitability of each of its 6000 products and 2000 customers.
• It asks the students to propose and debate options for improving product and
customer profitability.
• The company has installed a new time-driven activity-based cost system to
measure the profitability of its individual products and customers.
• The new system reveals that the most profitable 1% of products and customers
generate 100% of profits, and that the most profitable 20% of products and
customers generate 225% and 175% of profits respectively.
• The case describes the company’s near-term actions to address the large number
of unprofitable products.
• It closes with the sales manager deliberating about how the company should deal
with its most profitable and unprofitable customers.
Background on Time-Driven Activity-Based Costing
• The case mentions briefly that Elkay had tried activity-based costing ten years earlier and the
project failed.
Problems with traditional ABC
• Employees hated the surveying procedure, estimating the percentages of their time spent on the
list of activities handled to them.
• Hard to estimate percentages of time; much easier to estimate how long each instance of an
activity takes. (Example – what percentage of time a faculty in an academic year is spent in
grading final exams v/s estimating how long it takes them to grade a single exam – once they have
developed the grading scheme.
• Difficult to validate the percentage estimates – would have to observe the employee over several
weeks or months to learn about the accuracy of any estimated percentage.
• People’s estimated percentages invariable summed to 100%; this gave no visibility into unused
capacity and, when substantial unused capacity existed, the estimates cost driver rate would be
much too high, and therefore over-costed products and customers.
Time-driven ABC solved all these problems. It requires only two parameters to build a cost system
• The cost of supplying capacity for each resource.
• Estimated demands on capacity by each cost object (transaction, order, product, shipment,
customer)
Q1. Suppose you are Mark Whittington (VP of Sales). What would you do with
highly unprofitable customers, especially the two large customers, at the extreme
right-hand side of the whale curve, who lose about 40% of the company’s profits
between them?
• If you recommend firing these unprofitable customers, then the revenues would
disappear immediately, but many costs associated with producing for and serving
these customers would not disappear immediately, so short-term profits and cash
flow would decrease.
• Some of the losses with these customers are self-inflicted since Elkay may have
granted high discounts and allowances to these large customers without
realizing how unprofitable they were. So a more prudent action could be to cut
back on special deals until the customers become profitable.
• These two customers could have strategic benefits beyond what is shown in
their P&L’s. The two customers are large improvement retailers and enable
potential consumers to view Elkay’s products before purchasing them, at high
margins, from their builder or home improvement contractor.
• Elkay may have over-featured the products it is selling to these price-sensitive
retailers, and therefore be incurring high manufacturing costs for these products.
• Elkay may have options to negotiate with the retailers to improve profitability,
through a more focused product mix, modified inventory and distribution
policies, and even selective price increases.
Q2. How does a company end up in the situation with large
cumulative losses with unprofitable customers and also a large
number of unprofitable products (see Exhibit 9 on page 18)?
Elkay’s recent history and competitive situation
• It is a mature company that has introduced a new strategy of moving upscale in its
market by emphasizing product design and rapid prototyping of customized low-
volume sinks, while still retaining high-volume production of commodity sinks.
• It also has moved into new price-sensitive sales channels.
• Recently, materials price increases have led to decreased gross margins, and the onset
of the housing industry recession, reinforced by the financial crisis, has led to volume
decreases and even more pricing pressure.
• Elkay now has high product variety (high and low volume, standard and custom, mature
and new) and a proliferation of customers and selling channels.
• Its standard cost system, which allocates overhead costs proportional to the volume of
products produced and sold, will almost surely under-cost low-volume, specialized
products and over-cost high-volume standard products.
• Elkay which has historically been product-focused, and has differentiated itself by
adding complex design and fabrication capabilities and is now designing and producing
new, custom low-volume products with advanced features.
• A volume-based cost system will not attribute all the costs of designs, fabrication, and
finishing to these innovative, complex products (see pictures of these products in case
Exhibit 1).
• In addition, when entering new sales channels, such as the retail outlets and
fabricators, the company’s normal business model may not apply.
• The new customers may be much more price sensitive leading to a breakdown in
the company’s traditional pricing model.
• The new customers, many of whom are much larger than Elkay, may demand
volume-based discounts, and special sales promotion and local advertising
allowances that eat into Elkay’s margins.
• Without accurate data on customer profitability, sales and account managers
may have acceded to requests for additional discounts, allowances, and rebates
that were unrelated to the customer’s profitability.
• This issues gives an opportunity to draw a matrix which shows (in the right-hand
cell) the danger of offering discounts to customers with whom you are earning
only low margins.
Summarize the previous discussion
• Elkay was an excellent candidate for a more accurate (ABC) cost system:
• High diversity of products and customers; 6000 SKUs, 2000 customers
• High indirect and support costs (and sales deductions). The table on page 3 of the
case shows that direct labor is only 5% of total costs, while factory overhead is
25%, distribution and corporate overhead is 33% and sales deductions and
allowances are 11%.
• None of these indirect costs or revenue deductions is assigned accurately by a
volume-based costing system.
Q3. What distinguishes a low cost-to-serve customer from a
high-cost one?
Measuring Customer Profitability
High Cost-to-Serve Customers Low Cost-to-Serve Customers