293317307 Dakota Office Products Case Study PDF

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DAKOTA OFFICE PRODUCTS CASE BACKGROUND Dakota Office Products (DOP) is a merchandising company managed by John Malone, the General Manager. DOP is a regional distributor of office supplies to institutions and commercial businesses. The company had introduced the Electronic Data Interchange (EDI) in year 1999 and a new Internet site in 2000. This is to provide convenience to customers in making orders and delivery of products. The launching of electronic services was believed to improve the company’s profit margin but despite of increase in sales, actual financial result of operation for the year 2000 were reported to be Net Loss.

PROBLEM STATEMENT What caused the loss of the company for the financial year 2000 and what actions must it employ to gain back its profitability?

OBJECTIVES 1. To be able to understand the company’s current situation and be able to point out possible reasons for the company’s net loss for the year. 2. To be able to recommend actions to aid DOP to gain back its profitability. 3. To be able to recognize the relationship of cost management and customer profitability to proper pricing. 2. To appreciate ABC costing in a non-manufacturing company like DOP.

AREAS OF CONSIDERATION: 1. DOP is a retail business and thus its operating expenses (except cost of items purchased) are all considered indirect costs. 2. Launching of Innovations: Desktop delivery option and EDI, new internet site created a variety in product and customer demands. Customers are now given a choice between commercial shipment delivery or desktop delivery option, between manual order process or electronic data interchange. And this variety of services demand per customer affects costing per customer. The current cost system failed to address this issue. This change, innovation, has not yet been reflected in the company’s cost structure.

3. Product Costing - With the introduction of desktop delivery option and EDI, operating expenses are now overlapping among activities. We now have warehouse personnel assigned as drivers to make desktop deliveries and manual order operator who also caters the EDI orders. In this case, it must be noted that it is not very sensible to just total all the expenses and spread it over all the activities especially when it is indirect costs. In the current system of DOP, it assigned all warehouse, distribution and order entry as the same for costing customer A and customer B (as seen in exhibit 1) which is not very acceptable. It does not consider what services did A or B avail for the specific period. The direct cost which is usually the cost of sales can easily be determined and assigned to the product. But the cost of indirect overhead could not easily be determined and assigned. Therefore, the company should use a costing system that is fitted to the business in determining more relevant unit cost. 4. Understanding customer mix and its profitability Customer A Order Size Few large orders Order Placement Uses EDI Order Delivery Commercial Shipment Time to pay bills Within 30 days Ave A/R Balance $9,000 Exhibit 1 – Differences between Customer A and Customer B

Customer B Many more orders Manual Order Desktop delivery option 90 days or more $30,000

From this table, we compare customer A from customer B. Accordingly, Customer A utilizes EDI and avails of the commercial shipment which attached a lower cost to it (EDI, less labor hours for processing orders and cheaper cost of delivery if commercial). On the other hand, Customer B orders manually and chooses desktop delivery option which cost a little higher compared to its counterparts (Manual – longer time to process orders and additional premium for desktop delivery). By this, we can determine that A is low cost-to-serve customer while B is high cost-to-serve customer. More importantly, in this table, we can understand that Customer A is a a good payor for it can pay its bills in a shorter time compare to B. But this is where the problem arises, B being the high cost-to-serve customer (meaning it has a higher cost of sale) is the one who cannot contribute to company’s overall profit due to its relatively large A/r balance. 5. Product Pricing –DOP’s existing price system was a simple mark up over purchase price (with a small premium for desktop delivery). This system assumed that DOP’s operating expenses were proportional to the purchase costs of items it processed and delivered to customers. It assigns 155 markup to purchased product cost to cover the warehousing, distribution and freight which should not be the case. The pricing system failed to recognize the cost that it incurred to serve its varied mix of customers. As customer variety increases,

a pricing scheme based on a standard markup fails to recover the cost incurred for high cost-to-serve customers and perhaps overcharges low cost-to-serve customers.

ALTERNATIVE COURSES OF ACTION 1. Apply ABC costing system in the operation. This alternative aims to develop an ABC costing model for DOP. There are two considerations why DOP needs and ABC costing method: a. All costs (except cost to purchase) are all indirect cost or support costs b. High variety in product and customer demands PROS: 1. Proper cost management - adapting ABC system will assign indirect cost properly per activity. DOP will assign cost only to the customer that requires the activity for production. This method eliminates allocating irrelevant costs to the products served to a customer. And therefore can give more accurate profitability information (shown in exhibit 3). 2. More relevant information for easy interpretation of cost for internal management Information gathered using ABC system are more reflections of the true cost of the products and services rendered to a customer since it assigns costs only relevant to a specific activity per customer demand. This will enable DOP management to have a greater understanding of overhead costs and aid in decision-making regarding pricing and costing a specific customer. 3. Allows to compute product line profitability and customer profitability, which permits the company to make better decisions about your sales ‘mix’ and marketing efforts. 4. Helps the company set up a price structure that charges customers and clients according to the support required for their particular situation. We call it ‘just in time’ pricing.

CONS: 1. R equires substantial resources in implementing the system. Once implemented, an activity based costing system is costly to maintain. Data concerning numerous activity measures must be collected, checked, and entered into the system.

2. ABC produces numbers such as product margins, that are odds with the numbers produced by traditional costing systems. Management might find it hard to adjust with the new costing system. 3. Activity based costing data can be easily misinterpreted and must be used with care when used in making decisions. Costs assigned to products, customers and other cost objects are only potentially relevant. Before making any significant

decision using activity based costing data, managers must identify which costs are really relevant for the decisions at hand. *Analysis part shows how ABC system can work in DOP costing structure

2. Stick to the current costing and pricing system. Staying with the current system means not to change any costing application and therefore pricing method as well. Meaning in costing, operating expenses will be spread throughout all customers disregarding if they will choose to order through EDI or manual. Pricing will still be based on 15% markup on product cost. PROS: 1. No adjustments to be done, therefore, no additional cost to be incurred. CONS: 2. Indirect cost will still be spread over all activities and therefore not allocating it properly. 3. The wrong costing per customer will continue and the income statements in the years to come will be either understated or overstated.

SUPPORTING ANALYSIS Below is the proposed ABC model to be used in costing orders.

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Freight is a direct cost to all customers who opt commercial shipments of orders. Warehouse, rent and depreciation is a direct cost to all customers. Warehouse distribution personnel is an indirect cost. It must be spread over ordinary customers and customer who choose desktop delivery. This is supported by the fact the warehouse personnel also do delivery services. 90% for nondesktop delivery option (75,000 cartons/85,000 cartons) and 10% for desktop delvery option (5,000/85,000 cartons) rounded off. Delivery truck expenses is direct cost to all customers who opt for desktop delivery option. For order entry, cost are allocated as to manual, EDI and entering individual order lines per order. Cost driver is based on time distribution per activity. Process manual custom order 20% (10,000 hrs/ 2,000 hrs), enter items ordered 75% (10,000/7500) and EDI 5% (10,000 hrs/500hrs). -We divide the cost per activity to number of units affected by the said activity.

We now compute the customer profitability

This shows a more accurate customer profitability for both Customers A and B. Using the ABC system, we assigned cost per activity that is unique to a specific customer. In this case for instance, we do not assign any cost of EDI order placement to Customer B for it did not avail of the said feature.

RECOMMENDATION Recommended alternative is Alternative 1 – Implement the ABC system model for costing. In this way, costing can be made properly as to reflect the true costs per customer. And proper pricing will follow in the sense that higher price must be given to high cost-to-serve customers and also it can propse a more strict collection of receivable especially for this high cost-to-serve customers.

CONCLUSION With innovations there is change. Change in variety of product and services that can be demanded by customers. And this change entails additional cost. With additional cost comes a need to modify pricing strategy to better cover up the added cost. With pricing comes the need to understand customer and their profitability. And with right costing comes right pricing and profitability is the end result. In the case, the net loss for the financial year 2000 can be greatly pointed out to the improper costing method DOP employed. It spread it indirect cost over all the customers disregarding the customer mix it created when it introduced the innovations on its operations. It must be noted that change in product costing must be well addressed in the company’s cost structure.

This is what DOP failed to incorporate. It caused the company to disregard the customer. And recommending and implementing ABC system will answer this change in cost structure. It was raised in the analysis that DOP indeed needs ABC system for two basic concerns: (1) All costs (except cost to purchase) are all indirect cost or support costs and (2) High variety in product and customer demands. With these concerns, employing ABC system will result in more accurate costing and pricing of products and when information from this will be used accordingly, the end result of profitability will follow.

POTENTIAL PROBLEM ANALYSIS There are threats or potential problem that may arise in implementing ABC costing procedure of the company as stated below: 1. 2. 3.

Additional cost will be incurred in the launching of ABC system Difficulty in adapting the ABC system in its initial implementation stage Change in pricing strategy may affect the market...