Dakota Office Products

John Malone, General Manager of Dakota Office Products (DOP) was concerned about the

financial results 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

businesses. It offered a comprehensive product line ranging from simple writing implements (such as

pens, pencils, and markers) and fasteners to specialty paper for modern high-speed copiers and

printers. DOP had an excellent reputation for customer service and responsiveness.

DOP operated several distribution centers in which personnel unloaded truckload shipments of

products from manufacturers, and moved the cartons into designated storage locations until

customers requested the items. Each day, after customer orders had been received, DOP personnel

drove forklift trucks around the warehouse to accumulate the cartons of items and prepared them for

shipment.

Typically, DOP shipped products to its customers using commercial truckers. Recently, DOP had

attracted new business by offering a desk top option by delivering the packages of supplies

directly to individual locations at the customers 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% markup) for the convenience and savings such direct delivery

orders provided to customers. The company believed that the added price for this service could

improve margins in its highly competitive office supplies distribution business.

DOP ordered supplies from many different manufacturers. It priced products to its end-use

customers by first marking up the purchased product cost by about 15% to cover the cost of

warehousing, distribution, and freight. Then it added another markup to cover the approximate cost

for general and selling expenses, 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 competitive

situations, but were generally independent of the specific level of service provided to that customer,

except for desk top deliveries.

Dakota had introduced electronic 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 Dakotas costs continued to rise. Malone was concerned that even

after introducing innovations such as desktop delivery and electronic order entry, the company could

not earn a profit. He wondered about what actions he should take to regain profitability.

Distribution Center: Activity Analysis

Malone turned to his controller, Melissa Dunhill 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 Dakotas

distribution facilities. Site manager Wilbur Smith confirmed, All we do is store the cartons, process

the orders, and ship them to customers. With Wilburs help, Melissa and Tim identified four

primary activities done at the distribution centerprocess cartons in and out of the facility, the new

desk top delivery service, 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 get

them ready for shipment just depends on the number of cartons. All items have about the same

inventory turnover so space and handling costs are proportional to the number of cartons that go

through the facility.

We use commercial freight for normal shipments, 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 warehouse supervisor who noted.

This desktop delivery is a real pain for my people. Sure, we offer the service, and its attracted

increased 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 entry operator at Dakota for 17 years.

All I 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 I have to enter.

Each line item on the order has to be entered separately. Of course, any order that comes in through

our new EDI system or internet page sets up automatically without any intervention from me. I just do

a quick check to make sure the customer hasnt made an obvious error, and that everything looks

correct. This validity check takes about the same time for all electronic orders; it doesnt depend on the

number of items ordered.

Melissa and Tim collected information from company data bases and learned the following:

• The distribution centers processed 80,000 cartons in year 2000. Of these, 75,000
• cartons were shipped by commercial freight. The remaining 5,000 cartons were
• shipped under the desktop delivery option. DOP made 2,000 desktop deliveries
• during the year.

• People felt this total amount of 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 identified. The teams conducted interviews, asked some people 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% of the workers processed cartons in and out of the

facility. The remaining 10% of workers were assigned to the desktop delivery service. All of the other

warehouse expenses (rent, building and equipment 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

hours during year 2000. Further analysis of the records revealed the following distribution of time for

each of the activities performed by data entry operators.

Activity Data Entry Operators Time

Set up a manual customer order 2,000 hours

Enter individual order lines in an order 7,500 hours

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% for

Customer A, and 22.4% for B) were in the range of markups targeted by Dakota Office Products. The

markup for Customer B was slightly higher because of the premium charges for desktop delivery.

Both customers had ordered 200 cartons during the year. The existing customer 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.

Customer 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 Bs orders were either paper or phone orders, requiring manual data entry; and 25% of Bs orders requested the desktop

delivery option.

Melissa, concerned about increases in Dakotas borrowings from the bank, also noticed that

Customer A generally paid its bills within 30 days, while Customer B often took 90 or more days to

pay its bills. A quick study revealed that the average accounts receivable balance during the year for

A was $9,000, while it was $30,000 for B. With Dakota paying interest of 10% per year on its working

capital line of credit, Melissa thought this difference might be significant.

Exhibit 3 shows Melissas summary of the actual ordering, delivery and payment statistics for the

two customers. She believed she was now ready to assess the actual profitability of customers, and

make recommendations about how to reverse Dakotas recent profit slide.

Questions: Dakota Office Products

1. Why was Dakotas existing pricing system inadequate for its current operating environment?

2. Provide a brief analysis of the attached activity-based costing system. Do you agree with the activities and/or cost drivers identified for each activity? Why or why not?

3. Using the activity-based costing system from Question 2, calculate the profitability of Customer A and Customer B. (Hint: This should be a relatively straightforward calculation given the ABC system in Question 2)

4. What explains any difference in profitability between the two customers? What are the limitations, if any, to the estimates of the profitability of the two customers?

5. Assume that Dakota applies the analysis done in Question 3 to its entire customer base. How could such information help the Dakota managers increase company profits?

Exhibit 1 Dakota Office Products: Income Statement CY2000 Sales 42,500,000 121.4% Cost of Items Purchased 35,000,000 100.0% Gross margin 7,500,000 21.4% Warehouse Personnel Expense 2,400,000 6.9% Warehouse Expenses (excluding personnel) 2,000,000 5.7% Freight 450,000 1.3% Delivery Truck Expenses 200,000 0.6% Order entry expenses 800,000 2.3% General and selling expenses 2,000,000 5.7% Interest expense 120,000 0.3% Net Income Before Taxes (470,000) -1.3% Exhibit 2 Customer Profitability Report (Current Method) Customer A 103,000 121.2% Customer B 104,000 Sales 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 12,750 15.0% 12,750 15.0% Order Entry 5,250 6.2% 6,250 7.4% Contribution to general and selling expenses, and profit Exhibit 3 Services Provided in Year 2000 to Customers A and B Customer A 200 Customer B 200 Number of cartons ordered 200 150 Number of cartons shipped commercial freight Number of desktop deliveries 25 Number of orders, manual 6 100 Number of line items, manual 60 180 Number of EDI orders 6 Average accounts receivable $9,000 $30,000