Question
Neighborhood Servings A few years ago, I didn't think we'd make it. Some other agencies and several small restaurants were competing with us, and were
Neighborhood Servings
A few years ago, I didn't think we'd make it. Some other agencies and several small restaurants were competing
with us, and were undercutting our prices. So a year ago we decided to begin making specialty
meals for AIDS and cancer patients, and for other people with special dietary needs. I thought that strategy
was working. Certainly sales were up. But now a consultant tells me that our cost accounting system is
giving us misleading results, and we may actually be losing money on our specialty meals. On top of
that, some of our regular customers are complaining about our prices.
The speaker was George Larson, CEO of Neighborhood Servings, a nonprofit organization that
produced and delivered meals to homes throughout the greater Kansas City area. He continued:
I realize that we now need to dig into our costs. We established our prices based on these costs. If the
costs for specialty meals are higher than we thought, then our prices are too low, and our whole new strategy
is in jeopardy. In addition, if our costs for regular meals are too high, then we're setting our prices too
high and we'll lose out to the competition even more. Also, we use our cost data for budgeting each year,
so if the data are bad, then our budget will be unrealistic.
BACKGROUND
Neighborhood Servings (NS) had been in business for over 10 years. It began as a "meals on
wheels" agency, providing dinners to elderly people and individuals who were permanently or temporarily
homebound. Almost all of its clients were single and lived alone. Over the years, its menu
had expanded, although, based on market research into customer preferences, NS continued to provide
its clients with only one meal a day. All meals were sold in "collections" of seven?a different
meal for each day of the week, and deliveries (of seven meals each) were made once per week to
each client (clients often froze a few of the meals for use in the latter half of the week).
During the past few years, NS had encountered some competition for its services. One or two
other nonprofits that had been successful in other parts of either Kansas or Missouri had expanded
their operations into the Kansas City area. In addition, some of the local fast-food restaurants, realizing
that they could use their kitchen staffs to provide basic fare for delivery to nearby homes, had
begun providing meals in certain neighborhoods that were close to their restaurants.
In response, and after considerable debate, NS decided to offer specialty meals. There were two
main differences between NS's specialty meals and its regular meals: (1) specialty meals used a variety
of nonstandard ingredients, frequently including organically grown fruits and vegetables, and
often being meatless, and (2) because of a greater need for freshness, specialty meals were delivered
daily (one per customer).
The new strategy seemed to be working. During the past year, approximately 80,000 of NS's
200,000 meals were specialty meals. The remainder were regular meals.
THE COST ACCOUNTING SYSTEM
NS's cost accounting system calculated the cost of a meal by summing its direct and indirect
costs. Direct costs included ingredients, packaging materials, and kitchen labor. When a new meal
was introduced, NS's accounting staff spent considerable time determining exactly what ingredients
it contained, and measuring the time it took the prep and line staffs to actually prepare the ingredients
and cook the meal. Prep staff were those kitchen workers who washed and cut the ingredients,
prepared sauces, and took care of other tasks needed prior to actually cooking the meals.
Line staff cooked and assembled the ingredients for each meal.
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Indirect costs were classified into two categories: administration and general (A&G), and occupancy.
A&G included the costs of the administrative staff, as well as the purchasing staff, drivers,
and dietitians. Occupancy included rent, utilities, and cleaning. Gus Janeway, NS's accountant explained
the process he followed to arrive at a per meal cost:
For years, we had only one overhead rate, but we realized that we got much greater accuracy by having two
rates. Our studies have shown that A&G is always about 220 percent of kitchen labor, and occupancy is always
about 20 percent of direct costs. In fact, once we know our budgeted kitchen labor and other direct costs for the
year, we use this information to set the budgets for A&G and occupancy. Sometimes the actual budgeted
amounts are slightly more or less than these standards, but we always come pretty close.
Our overhead rates were quite handy when we shifted to the special meal strategy. Both ingredient and
kitchen labor costs were higher than with the special meals than with our regular meals, and our overhead rates
were quite helpful in showing us the higher total cost of the special meals. That, of course, helped us with preparing
our budget for the year.
Mr. Janeway's computations are shown in Exhibit 1. As this exhibit indicates, the cost of ingredients
for special meals was about three times greater than for regular meals, and there were
higher kitchen labor costs. The result was higher overhead allocations, and a total cost per meal of
$11.70 as compared to only $6.90 for a regular meal.
PRICING POLICY
As Exhibit 1 indicates, NS's pricing policy was to add 20 percent to the total cost of a meal.
Since demand fluctuated slightly during the year, and since no costs were completely predictable,
Mr. Larson believed that the 20 percent margin was about right. He commented:
It gives us enough to cover seasonal and other fluctuations. It also to helps to provide the funds needed to upgrade
or replace our kitchen equipment, which includes some large items, but also small items, such as pots,
pans, and cooking utensils. The prices of these items seem to go up at about 5 percent a year. And, of course,
for items where there are constant improvements in quality and functionality, the inflation rate is even greater.
Pricing Problems
The problem that Mr. Larson alluded to in his opening comments had arisen because a growing
number of regular customers were complaining about NS's prices. Some said that they had tried
the meals of competing organizations and found them comparable, with prices about $1.00 to
$1.50 below those of NS.
It was because of these complaints that Mr. Larson had called in a consultant, who subsequently
had told him that the cost accounting system was giving misleading information. The result
was Mr. Larson's concern not only about having his regular meals priced too high, but having his
special meals priced too low.
THE CONSULTANT'S REPORT
According to Ramona Canard, Mr. Larson's consultant, the problem with NS's accounting
system was that overhead was divided into only two "pools," as she called them:
Two overhead pools could work if all overhead activities were about the same regardless of the kind of meal
produced. That seems to be true for occupancy, but A&G is another matter. Purchasing, for example, is quite
different for special meals. This is because purchasing people need to work very closely with local farmers to
make sure that the food is organically grown, which takes much more of their time than when they're purchasing
for regular meals, which only requires a few phone calls.
Similarly, the dietitians have to spend a lot more time and effort designing the meals around the organic
foods that are available during each season. That takes a whole lot longer than when they can just specify a
meal's ingredients without concern for product availability?these days you can buy anything at almost any
time of the year as long as you don't care where it comes from.
Finally, delivering special meals is a lot different than delivering regular meals. Each customer for a special
meal receives only one meal per delivery, whereas a customer for the regular meals gets seven meals at a time.
So the per-meal delivery cost is a lot higher.
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What this means is that we need different overhead pools for different costs. My goal was to not only create
the pools, but to identify a "driver" for each?that is, an activity that causes the pool to increase or decrease.
Ms. Canard's overhead pools are contained in Exhibit 2. As this exhibit indicates, she removed
$447,500 from the original A&G line, and distributed it among three new lines: purchasing, dietitians,
and delivery. Purchasing contained not only the salaries of the purchasing agents, but transportation
associated with trips to farms, and other purchasing-related expenses. She did the same
for the dietitians, including both their salaries and associated expenses. Finally the pool for delivery
included not only drivers' salaries, but depreciation on the delivery vehicles, and expenses for fuel,
repairs, maintenance, and garaging. Ms. Canard commented on this effort:
Creating the pools was relatively easy, although pretty time consuming. The hard part was the "cost drivers,"
as I call them. I talked with purchasing people, dietitians, and van drivers to try to get a sense of what would
cause their costs to rise. At the end I reached what I think are some pretty solid conclusions. Purchasing costs
are related to purchase orders, and because there are many small local organic farmers, the number of purchase
orders for special meals is a lot greater than for regular meals. I verified this by going through two years' worth
of purchase orders, and comparing them prior to and after the switch to special meals.
Dietitian costs are related to the number of special ingredients, and, again, special meals have more special
ingredients than regular meals. That was easy to figure out. The hard part here was verifying that, as the number
of special meals increased, the company's dietitian-related costs rose, not linearly, of course, but in a way
that seemed pretty directly related.
Delivery was the easiest; it's pretty clearly related to the number of trips that the drivers must make to customers.
Now, it's true that a driver can take many meals with him when he goes out in the van, so a "trip"
wasn't a driver leaving the plant and returning. Rather, it was a "stop" at a customer's house. With regular
meals, one stop was needed to deliver seven meals, but with special meals, one stop resulted in only one meal
being delivered. This obviously causes delivery costs to be higher for special meals than for regular meals.
Ms. Canard's cost driver data are contained below:
Regular Special Total
Number of meals 120,950 79,600 200,550
Number of purchase orders 150 500 650
Special ingredients per meal 2 8
Number of "trips" 17,279 79,600 96,879
She continued:
It's pretty clear when you use my new overhead pools and cost drivers that the per-meal costs are quite different
than George and Gus think they are. I plan to present my conclusions to them this afternoon. I expect that this
information will help George to rethink not only NS's prices, but perhaps the agency's whole strategy.
Mr. Larson, in thinking about the upcoming meeting, had a couple of reactions:
I think Ramona is on to something here, and I guess when we run the numbers, her approach will make a difference,
but is it a big enough difference to be meaningful? Assuming it is, what do we do with this new information?
Should we compute these costs once a year as part of preparing the budget, and should we use the information
to assist us with pricing? If so, we don't need a new cost accounting system? we just need an annual
analysis of the sort that Ramona did. Or should we be computing these figures on a monthly basis to assist
us with controlling our costs? If so, it looks as though we'll need to completely update our cost accounting
system so that we can produce monthly reports. Of course, the question then is whether it's worth the time
and effort. What would it cost to prepare monthly reports using this new information, and what kinds of decisions
would I make on the basis of these reports that I couldn't make without them?
Assignment:
1. Compute the cost of a regular and special meal using the new overhead pools and cost drivers. What explains
the differences between these costs and the ones in Exhibit 1?
2. What is your assessment of the overhead pools and cost drivers that Ms. Canard has chosen? How, if at all,
might they be improved?
3. Assuming the overhead pools and cost drivers better indicate actual costs, what should Mr. Larson do with this
information? In answering this question, you should address the questions he raises at the end of the case.
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NEIGHBORHOOD SERVINGS
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