Question

Work Depot sells office supplies to area corporations and organizations. Tom Dooley, founder and CEO, has been disappointed with the operating results and the profit margin for the last two years. Business forms are mostly a "commodity" business with low profit margins. To increase profit margins and gain competitive advantages, Dooley introduced "Desk-Top Delivery" service (smaller orders, same-day delivery). The business seems to be as busy as ever. Yet, the operating income has been declining. To help identify the root cause of declining profits, he decided to analyze the profitability of two of the firm's major customers: Gamma International (Gamma) and City of Albany (Albany).

Based on the customer profitability analysis that Work Depot conducts regularly, both Gamma and Albany have the same amount of total sales. However, the firm earns a higher gross margin and gross margin ratio from Albany than those from the sales to Gamma, as shown in Table 1 of the accompanying Excel file.

Work Depot adds a flat 17.5% fee to all sales for expenses incurred in such activities as handling customers' requests, pick-packing, order delivery, warehousing, and data entry. However, not all customers require the same level of services. Operation Manager, Jamie Steel, points out that Albany has been a much heavier service user than Gamma. Table 2 of the accompanying Excel file shows data to support her belief.

Steel points out that activities cost money. Two customers who request different service activities most likely are not costing the firm the same. Tom requested the Controller to investigate ways to determine the costs of performing various activities. His summarized findings are presented in Table 3 of the accompanying Excel file.

REQUIRED:

a. On your Excel file, present the activity-based costing (ABC), computing the charges per unit of service activities and total distribution costs for each of the customers. (Part of the grade is based on the clarity of your steps and presentation of the information.

b. What are the Customer Profitability measures for Gamma and Albany under ABC?

c. Consider the different “types” of customers that Gamma and Albany represent, the product that Work Depot sells, and the new Desk-Top Service it provides. How might Work Depot reconsider its current pricing strategy of adding the flat 17.5% fee to all customers?

4 5 TABLE 1 6 7 8 Customer Profitability Analysis Gamma Albany $ 80,000 $ 80,000 $ (50,000) $ (48,000) $ (14,000) $ (14,000) $ 16,000 $ 18,000 20.0% 22.5% Sales Product cost Service fees (17.5% of sales) Gross margin Gross margin percent 9 10 11 12 13 14 15 16 17 18 TABLE 2 Distribution Services Activities for Gamma and Albany Gamma Number of requisitions 300 Average number of cartons in warehouse 50 Requisition line (all pick-packing) 900 Number of miles per delivery 5 19 Albany 700 500 2,100 6 20 21 22

This is all the data given

Answer 1

a.         Service cost rate per unit of activity.

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Service Cost

Omega International Requisition Handling $3,000 (300 requisitions * $10/requisition) Warehouse Activity 750 (50 cartons * $15.00 per carton) Pick-Packing 1,350 (900 pick-pack lines * $1.50) Data Entry 900 (900 lines * $1.00/line) Freight Out 3.450 ($10 x 300) + (S0.30 * 5 * 300) Total Service Costs $9450 City of Albion $ 7.000 (700 requisitions * $10/requisition) 7,500 (500 cartons $15.00 per carton) 3,150 (2,100 pick-pack lines * $1.50) 2.100 (2,100 lines * $1.00/line) 8.260 ($10 * 700) + ($0.30 *6* 700) $28.010

b. Customer profitability Analysis-Activity Based

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The above profitability analysis indicates that, under activity-based costing, Omega International, Not City of Albion, is more profitable to Boston Depot. The apparent higher gross margin percentage of the City of Albion relative to the Omega International was the result of not recognizing differences in the service activities requested by different customers under the firm's existing costing system.

City of Albion is a much heavier user of services provided by Boston Depot. Although both customers had the same total sates, City of Albion made more desktop delivery requests in smaller quantities and maintained more inventory by Boston Depot.

c. The answer depends on the competitive strategy of the firm. The gross profit margin ratios show that Omega is the better customer of the two. Omega does not use much of the desktop delivery service Boston offers. Most likely Omega is a buyer of "commodity" items and does not need the convenience of desktop delivery. However, Boston's pricing is likely to have incorporated the average cost of desktop deliveries. If Omega realizes that it is paying for services not used, it may buy the commodity it needs elsewhere, unless Boston lowers the price to Omega. All custom-printed business forms by different suppliers are likely to be the same. Delayne wanted to "differentiate" its forms from those of competitors' by offering desktop delivery services. In the long-run, Omega is not likely to be a customer staying with Boston Depot. Boston Depot needs to be prepared to lower the price to Omega. If the firm desires to compete on a differentiation strategy it needs to price accordingly. Boston

Depot needs to raise prices to City of Albion. If City of Albion is willing to pay a higher price for the convenience of desktop delivery, it is the kind of customer that Delayne wants.