Ethical Drugs, Inc., is a decentralized pharmaceutical company. The Sales and Marketing (S&M) division oversees all distribution activities of its pharmaceutical products. The division buys products from the various production divisions at pre-determined transfer prices which are set by headquarters annually. The company identifies three main distribution channels: A. General supermarket chains B. Drugstore chains C. "Ma and Pa" single-store pharmacies For many years, the S&M division has used gross margin percentage ([Revenue minus Cost of Goods Sold] divided by Revenue), to evaluate the relative profitability of its distribution channels. The calculated gross margins for the three distribution channels for April were: General Supermarket Chains $3,708,000 Drugstore Chains Ma and Pa Stores $1,980,000 Total $8,838,000 Revenues $3,150,000 Cost of Goods Sold 3,600,000 3,000,000 1,800,000 8,400,000 $ 108,000 $ 150,000 $ 180,000 438,000 351,080 Gross Margin Other Operating Costs Operating Income Gross Margin % 86,920 2.91% 4.76% 9.09% 4.96% The overall gross margin percentage of Ethical Drugs was 4.96% ($438,000-$8,838,000). The overall operating profit margin percentage of Ethical Drugs was 0.98% ($86,920-$8,838,000). Laurie Beancount was recently appointed as the new CFO of the S&M division. To get acquainted with the business, she met with sales and other managers from different areas. What struck her was the repeated concern regarding the true profitability of the different distribution channels. Several sales managers challenged the prevailing perception that the "Ma and Pa" single stores were the most profitable. Preliminary analysis of the April data indicated a wide variation in the characteristics of the different channels. Average revenue per delivery Average cost of goods sold per delivery Number of Deliveries General Supermarket Chains $30,900 $30,000 120 Drugstore Chains $10,500 $10,000 300 Ma and Pa Stores $1,980 $1,800 1,000 Laurie decided to study channel profitability more closely. It seemed clear to her that the calculation of channel-specific cost of goods sold was accurate, but she wanted to understand better how operating costs varied across the different distribution channels. Historically, no analysis of operating costs was performed because the magnitude of operating costs seemed small (3-3.5% of total costs), and it was believed that operating costs changed in proportion to Cost of Goods Sold. Laurie held additional meetings with different managers and staff members. They all agree that there were five key activities at the S&M division: Cost Driver Activity 1. Order processing 2. Line item ordering 3. Store delivery 4. Cartons shipped to stores 5. Shelf stacking at customer store Number of orders Number of line items Number of store deliveries Number of cartons shipped to a store per delivery Number of hours of shelf stacking Each order consists of one or more line items. A line item represents a single product (such as Extra-Strength Tylenol Caplets). Each store delivery entails delivery of 1 or more cartons of products. Each product is delivered in one or more separate cartons. Ethical Drugs delivery staff stack cartons directly onto display shelves in a store. Currently there is no charge for this service and not all customers use Ethical Drugs for this activity. The April operating costs (other than COGS) of the S&M division total $351,080. The costs in each area and the number of units of cost drivers during April are: Total Costs Total Units of Cost Activity Area in April Driver in April 1. Order Processing $ 80,000 2,000 orders 2. Line item ordering 63,840 21,280 line items 3. Store deliveries 71,000 1,420 store deliveries 4. Carton deliveries 76,000 76,000 cartons 5. Shelf stacking 10,240 640 hours 6. Corporate SGA 50,000 unallocated $351,080 Other data for April are: General Supermarket Chains 140 Drugstore Chains Ma and Pa Stores 1,500 Total number of orders 360 Average number of line items per order 14 12 10 Total number of store deliveries 120 300 1,000 Average number of cartons shipped per store delivery 300 80 16 Average number of hours of shelf stacking per delivery 3 0.6 0.1 Required: 1. Assign the other operating costs to the three distribution channels, using the ABC information. Disregard the $50,000 corporate SG&A cost and only allocate the remaining $301,080. Compute the operating income for each distribution channel. Present the resulting profit margin percentages. 2. What new insights are available from the ABC analysis? What explains the differences in profit margins for the different distribution channels? 3. What decisions would you recommend to top management based on the ABC analysis? 4. Could this sort of analysis be applied to the evaluation of individual customer profitability? What additional information would you need