BACKGRD UNI} Tangeriro Tents Ltd. [TI] imports lightweight tents into New Zealand and clnrently sells them to three independent outward bolmd equipment wholesalers. "IT does net currently sell to retail stores or direct to the general public. The managing director, Guy Rope, is concerned that the company has too much spare capacity and is not making adequate I'B'l'll'l'. He believes that T1" must therefore expand the company's customer base. As there are a limited number of outward bound equipment wholesalers in New Eealand he is considering whether "IT should start selling tents to retailers or even direct to the general public. Moreover. T1" is such a small company that it has no control over the price it pays to its overseas tent suppliers. Hence, to improve profitability T1" needs to concentrate on expansion, better use of its capacity and improved efficiency in sales and distribution. Guy knows that it is no use 'buying' market share with excessive discounts and he is rather concerned that, in an effort to grow the business rapidlyI the level of discounts that were offered in order to acquire some customers were excessive. DETAIL Guy therefore asked his management accountant to review last year's nancial statements and to produce a customer profitability analysis (EPA). The management accolmtant is still a trainee and was not entirely sure what IBuy wanted, but she used her knowledge of the principles of activitybased costing {ABC} to produce the CPA shown in table 1. Guy arranges a meeting with TT's sales and marketing director, Dolly Peg in order to discuss what the new CPA statement reveals. He is not terribly happy and starts ring questions at Dolly: \"We threw a pen): testyenr when you won the MeKthtei-r account, but this CPA new shows its that the account mode a ELIE? operating toss lestyeer. Are theygettt'ng excessive discounts? " THE CPA REPORT Table 1 - Customer Profitability Analysis: Spare Everest Cook Mckinley capacity Total $ S S Revenues (list price) 1,800,000 487,500 450,000 1 2,737,500 Gross Profit 336,000 105,625 120,000 561,625 Gross margin 18.7% 21.7% 26.7% 20.5% Less Selling and Distribution costs: Account management 19.200 20,800 24,000 9,600 73,600 Sales and marketing 27,000 27,000 36,000 0 90,000 Packing and loading 24,000 18,000 25,000 8,000 75,000 Transport to customer 19.200 21,600 50,000 0 90.800 Total S&D costs 89.400 87,400 135,000 17,600 329.400 Customer Contribution 246,600 18,225 -15,000 -17,600 232,225 Corporate sustaining costs 67,068 18,164 16,767 0 102,000 Net operating profit 179,532 61 -31,767 -17,600 130,225 Operating Profit Margin 10.0% 0.0% -7.1% 4.8%Dolly argues: "Definitely not! They actually pay full list prices and consequently their gross margin is higher than either the Everest or Cook accounts because the latter receive 8% and 5% discounts on list prices respectively. However, Mckinley is a new customer and they are currently very demanding. Look at the costing data, it shows the activities and cost drivers we have used and hence explains why their selling and distribution costs are so high." Dolly starts to explain that the selling and distribution costs of $329,400 are traced to the 3 individual customers using cost drivers and burden rates/activity rates (see table 2) and the cost driver data relevant to the last accounting year (see table 3). Guy interrupts by exclaiming: "Quite obviously we would be nearly $32,000 better off if we dropped Mckinley now and concentrated on selling more to Everest and Cook". Dolly explains that it is not quite that simple: "In the CPA statement (table 1) the corporate sustaining costs of $102,000 are traced to customers in proportion to sales revenue. That's a pretty arbitrary allocation base and these costs include things like audit fees and legal expenses. I don't believe such costs would change if we dropped one of the 3 customers. Moreover, we have spare capacity. I need more customers, not less!"Guy is getting frustrated: "What's an arbitrary allocation base? Even if the corporate sustaining costs don't change we would be $15,000 better off wouldn't we? Shouldn't we fire our unprofitable customers before we go out looking for more customers? Dolly tries to calm Guy down by promising to commission a report that will explain everything clearly. "We should do something about unprofitable customers, but not necessarily drop them. This analysis is just a historical snapshot, and Mckinley is a new customer. Now we have acquired Mckinley I intend to develop better relationships with them, sell more to them and make them more profitable. Also, I am close to acquiring Kilimanjaro. They are the only big outward bound equipment wholesaler in New Zealand that we do not yet sell to, and I've been working on them all last year. I forecast that Kilimanjaro will buy tents with a list price of $200,000 in their first year, and even after discounts we'll make a 20% gross margin on their business. Over the year I estimate that they will place 12 customer orders and will be happy with monthly deliveries. Each delivery would be a 45 kilometre round trip, so 12 deliveries means only 540 delivery kilometres per year. To get them 'bedded in' I will need to make 24 sales visits in the first year, but I will probably need no more than 12 sales visits per year thereafter." Dolly knows about your management accounting expertise and has asked you to produce the report she promised to commission, and to provide the necessary explanations and advice to the management team of Tongariro Tents.ACTIVITY-BASED COSTING DATA Table 2 - Activity costs, driver capacity and burden rates: Activity Cost Burden cost driver rate (S) Cost Drivers capacity ($) Account management 73,600 Number of Customer Orders 92 800 Sales and marketing 90,000 Number of Sales Visits 60 1500 Packing and loading 75,000 Number of Deliveries 150 500 Transport to customer 90,800 Delivery Kilometres 9,080 10 329,400 Table 3 - Cost driver transactions data for last accounting year: Capacity Spare Full Everest Cook Mckinley used capacity capacity Number of Customer Orders 24 26 30 80 12 92 Number of Sales Visits 18 18 24 60 0 60 Number of Deliveries 48 36 50 134 16 150 Delivery Kilometres 1,920 2,160 5,000 9,080 0 9,080