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Please answer only Discussion Question at the end. Western States Stationery Case Western States Stationery was founded in the late 1800s in the San Francisco

Please answer only "Discussion Question" at the end.

Western States Stationery Case

Western States Stationery was founded in the late 1800s in the San Francisco area as a one-man operation producing notepaper and cards for sale in the citys general stores. By 2004 it had grown to a large paper products corporation with sales more than $2 billion.

One division of the company produces specialty paper products, such as writing paper, envelopes, note cards and greeting cards. Another division manufactures and prints business forms. By 2002 it was one of the top 5 firms in the business forms industry.

For some period, the companys sales growth had been relatively flat and profit margins had been difficult to maintain. Competition among suppliers was much more intense than in prior years. In 2002 management decided it would venture into business forms inventory management services. This was an area that management thought offered several advantages. These services were thought to be value added allowing the firm to differentiate itself from others. Differentiation implied higher margins and the potential to further bind customers to Western, reducing the threat they might switch to an alternative supplier. Finally, the concept was relatively new, with little competition from large firms, thereby offering high sales growth potential. Western embarked on a campaign to enroll its corporate clients in a program it called Total Forms Control (TFC).

By 2004, sales from TFC were about $60 million. Western had established TFC as a separate operation within the business forms division. The services provided under TFC included warehousing and distribution of forms (including inventory financing) as well as inventory control and forms usage reporting. TFC used a sophisticated computer system network, which enabled them to monitor a clients forms inventory, forms usage and ordering activity.

As part of its distribution services, TFC also offered pick-pack services where workers opened full cartons to pick the exact number of forms requested by the clients. TFCs operating philosophy was that a well-run warehousing and distribution network was vital to any forms management program ---we know what you need the right product at the right place at the right time.

For a small number of clients TFC also offered "desk top delivery," where TFC personnel would distribute the forms to individual offices within the customers company (otherwise forms were usually delivered only to a receiving dock area). As a comprehensive forms management provider, Western's product line also had to be comprehensive. Their product line included everything from stock computer printout paper and fax paper to custom designed forms tailored by Western's design consultants to meet the exact business needs of the client.

TFC also had the ability to custom design its forms management services to meet the needs of each of its clients. TFC clients ranged from small businesses, which desired only basic inventory control, to those who had comprehensive forms management programs.

CURRENT COST ACCOUNTING SYSTEM

Western operated its forms manufacturing and TFC activities as separate profit centers. Western manufactured business forms in 13 locations. The transfer of product from manufacturing operations to TFC was at arm's length with the transfer price set at fair market value. Although the company encouraged internal sourcing for customer orders, TFC salespeople had the option of outsourcing product.

Clients who participated in the forms management program kept an inventory of forms at one of Western's 10 distribution centers. The forms were distributed to the client as they were needed. The client was charged a service fee to cover the cost of warehousing and distribution based on a percentage of the cost of sales of the product for that month, regardless of the specific level of service provided to that client. The standard charges were as follows:

Warehousing/Distribution, 20.5% of product cost

Inventory financing, 4.7% of product cost

Trucking to the customer, 7% of product cost

If a TFC client made use of any of the distribution services, they were typically charged a price for the forms which was high enough to allow for an additional 20.5% of product cost to cover warehousing and distribution expenses (everything from storage and requisition handling up to and including desk top delivery), plus 4.7% to cover the cost of capital tied up in inventory, and 7% to cover trucking costs. These percentages were determined based on actual 2002 financial data so that on an aggregate basis, in total, all expenses were covered (see Exhibit 1). Sales prices were generally determined by applying a 20% mark-up on the combined cost of the product (business forms) and the 32.2% charge for TFC services. To some degree, prices charged on customer accounts could vary from the standard formula, based on what the sales department thought customers would pay.

UNDERSTANDING CUSTOMER PROFITABILITY

With TFC profitability suffering in October 2002, General Manager John Malone began to question the appropriateness of the distribution charges: "The Business Forms Division used to earn a 20% Return on Investment (ROI). But returns have been dropping for several years. TFC is projected to earn an ROI of only 6% for 2004. Something tells me that we are not managing this business very well! It seems to me that the charges for services needs closer scrutiny."

John looked through his records and found two accounts of similar size, accounts A and B, which were handled by different salespeople. Accounts A and B had essentially the same annual

sales of about $79,000 with the cost of the product being $50,000. Under the current system, these accounts carried the same service charges, but John noticed that these accounts were similar only in the value of the product being sold; they were very different on the level of service they required from Western. Malone double-checked his records and confirmed that the two accounts had indeed generated identical sales revenues (see Exhibit 2).

In the past year, customer A had submitted 364 requisitions for product with a total of 910 lines (all of them "pick-pack") while customer B had submitted 790 requisitions with a total of 2500 lines (all of them "pick-pack"). Customer A kept an average of 350 cartons of inventory at the distribution center while customer B kept 700 on average. Customer B's average monthly inventory balance was $50,000 ($7,000 of which had been sitting around for a whole year) while that of customer A was only $15,000. In addition, customer B had requested desk top delivery 26 times during the past year, while customer A did not request desk top delivery at all. John had support staff research the truck operating costs associated with these customers. Mileage to and from each customer was estimated and multiplied by an estimated cost per mile. Because of the greater activity on customer B's account, a shipment went out three times a week at an annual trucking cost of $7,500 while Customer A required only one shipment a week at an annual trucking cost of $2,250.

With corporate breathing down his neck, John Malone turned to TFC Controller Melissa Dunhill and Director of Operations Tim Cunningham for help. As a first step, they could provide John with the following information:

The total expenses for the distribution centers in 2002 were estimated as follows (in 000's):

Rent

$1,504

Depreciation

$208

Utilities

$200

Salaried payroll

$945

Fringe benefitssalaried

$164

Taxes/Insurance

$110

Postage & supplies

$96

Hourly payroll admin

$476

Fringes hourly admin

$69

Variable warehouse payroll

$1,599

Warehouse fringes

$336

Total

$5,707

John said, "How am I going to use this information to solve my problem?" "Well," Tim said, "if we can figure out, without going overboard of course, what exactly goes on in the distribution centers, maybe we can take these financial numbers and assign them to the activities. If we can do that, we'll have a much better idea of what it costs to serve our various clients." Tim knew that two primary activities took place in the distribution centers the warehousing of forms and the distribution of those forms in response to a customer requisition. He decided to talk to some people in the field to get more specific information.

DISTRIBUTION CENTER: ACTIVITY ANALYSIS

John and Tim visited Western's Kansas City, MO distribution facility. Site manager Wilbur Smith confirmed, "All we do is store the cartons and process the requisitions. I'll tell you, the amount of warehouse space we need just depends on the number of cartons. If we got into some flexible lease programs and changed aisle configurations, we could probably adjust our space requirements if the number of cartons we stored was to change. The other thing that bothers me is that we've got some inventory that's been sitting here forever.

The team then interviewed warehouse supervisor, Rick Fosmire, "I don't care if I get a hundred requisitions with one line each or one requisition with a hundred lines on it, my guys still have to go pick a hundred items off the shelves. And those darned "pick-pack" requests. Almost everything is "pick-pack" nowadays. No one seems to order a whole carton of 500 items anymore. Do you know how much more labor it requires to pick through those cartons? And on top of that, this desk top delivery is a time drain for my guys. It's not like my guys don't have enough to do."

John and Tim returned to Denver with a better idea of what happens in a distribution center. From what they observed, they broke the distribution center down into 5 primary value-added activities: storage, requisition handling, basic warehouse stock selection, "pick-pack" activity, and desk top delivery.

They turned to Melissa for help assigning costs to activities. Melissa spent considerable time talking to each of the site managers and warehouse supervisors. A consistent picture emerged. The majority (85%) of facility costs related to storage of business forms. The remainder (15%) was necessary to handle the administration of requisition processing. Warehouse workers were interviewed to determine where they spent their time. The basic process of finding and selecting items required half of their time (50%) - this includes finding and selecting either full box orders or pick-pack orders. If the order also required pick-pack this nearly doubled the required time as the workers opened cartons, counted items, etc. Thus, workers estimated that they spent 40% of their time dealing with pick-pack over and above basic forms selection. Preparing and handling desk top delivery shipments took up the rest of their time (10%). Based on the above information, Melissa assigned costs to these activities as follows ($'000's). (See Exhibit 3 for calculations):

Storage

$1,625

Requisition Handling

$2,147

Basic Warehouse Stock

Selection

$967

Pick-Pack Activity

$774

Desk Top Delivery

$194

Total

$5,707

Tim then estimated the following for 2004 based upon historical information and current trends:

On average, the 10 distribution centers scattered across the country will have combined inventories of approximately 350,000 cartons (most cartons were of standard size).

TFC will process about 310,000 requisitions for 2004.

Requisitions will average 2.5 lines of different stationery material requested and pulled.

About 90% of the lines will require an additional "pick-pack" activity (as opposed to shipping an entire carton).

They were still uncomfortable with the way inventory financing and trucking costs were charged out. John checked with the finance department and learned that Western obtained financing at the prime rate (currently 8%) plus 2%. He thought they could just pass that along. "Our new computer system is coming on line soon which will track mileage we log to deliver shipments to each customer," said Tim, "so, using a per mile cost we can just charge the client for what it actually costs us." They all agreed that this sounded fair.

They were almost finished. "What about desk top delivery?" Tim said. I think we should charge extra for it, but I don't want this to get too complicated."

John said, "How much extra time does it take your guys on average to prepare a desk top delivery and then run around the customers company?"

"I'd say about an hour and a half to two hours."

"Alright. At $12 per hour, that's about $24 each time.

"Sounds OK to me. That ties pretty well to the $194,000 overall assignment, since we will process somewhere around 8,500 'desk top' requests this year."

The above information was used to derive activity / cost drivers (See Exhibit 4).

The entire management team, including Doug Kingsley, Finance Director of the Business Forms Division, felt that there had to be a better way of charging out distribution services and that the solution would help TFC become more profitable. They now had a much better understanding of the drivers of costs involved in distribution services. As the four headed off in Doug's SUV for the Broncos first home game, they tried to figure out how to use this information to find a workable alternative.

SERVICES BASED PRICING (SBP)

"It would not be easy getting the sales force on board with an activitybased pricing program," John said. "Some of them get pretty stuck in their ways and don't like change. Some accounts would see increases because of the additional distribution charges under a Services Based Pricing (SBP) scheme. These salespeople wouldn't be very happy. On the other hand, some salespeople may see their margins increase." Overcoming these organizational problems would be only the tip of the iceberg.

Kingsley, as well as many of the senior managers at corporate, continued to be very concerned with TFC profitability. While everyone thought TFC now had a better understanding of its cost drivers, they were not convinced that overall profitability would improve without significant changes in marketing. They were still wondering how to use their new activity based costing (ABC) analysis to improve the profitability of TFC. So they decided to do additional analysis on their customer base.

The accounting department had maintained a database, which showed all activity against individual accounts and calculated a contribution from that account. Although TFC maintained 1100 separate accounts, a large portion of the business came from very few accounts. The top 40 accounts represented 48% of the company's net sales volume (see Exhibit 5).

As a way of understanding customer profitability, TFC management reworked the information in the database as if the accounts had been charged service fees based on actual usage, leaving net sales and product cost the same as before. They recalculated contribution based on these figures. They ranked the accounts according to profit contribution. Exhibit 6 shows the top 20 accounts for the month of August and Exhibit 7 shows the bottom 20.

The team looked at all accounts where the revised contribution was below 20% and determined that if these accounts were managed to a 20% contribution, the profit improvement would be $4.3 million annually. Of those, the top 40 accounts (ranked by the contribution opportunity if improved to a 20% contribution) represented 70% of the $4.3 million opportunity.

Another way of summarizing the range of profitability across the 1,100 customers is shown in Exhibit 8. This was a new way of looking at account management which combined the effects of both volume and contribution margin. Since such a large piece of the opportunity rested with these few accounts, management determined that it might be possible to significantly improve profitability by concentrating on individual account management. The team felt they were on the right track for improving account profitability and wondered what should be the next step. They also wondered what other issues might be important for improving the overall profitability of TFC. Management called the ABC based pricing system SBP and was seriously considering adopting it for all TFC customers.

Case Questions to Consider

How did Total Forms Control (TFC) fit into Westerns strategy? Was it performing up to expectations?

How did the existing accounting system handle the costs of services that TFC provided? Did this suit TFCs needs?

Using the information in the case calculate ABC based services costs per unit of activity for the TFC business. Using these new activity costs calculate distribution services and gross profit for customer A and customer B. What inferences do you draw about the profitability of these two customers?

What does TFCs analysis of individual customer accounts (exhibits 5-8) suggest about TFCs overall customer profitability? What might managers do based on this information?

What are likely to be some of the issues in adopting Service Based Pricing (menu) pricing? Do you think that TFC should implement the SBP pricing system?

Do you have any additional comments or recommendations concerning the Total Forms Control (TFC) business?

EXHIBIT 1

Calculation of Service Fee Charges

(Current Method)

('000's)

2002 Product Sales at Cost

$24,059

2002 Warehousing/Distribution Expense

$4,932

...% of Product Cost

20.5%

2002 Average Inventory Balance

$10,873

2002 Average Cost of Capital

10.40%

Total Cost of Inventory Financing

$1,131

...% Product Cost

4.70%

2002 Total Truck Operating Costs

$1,684

...% Product Cost

7.00%

EXHIBIT 2

Actual Service Fee Charges

(Current Method)

Customer A

Customer B

Product Cost

50000

50000

Warehousing/Distribution (20.5%)

10250

10250

Inventory Financing (4.7%)

2350

2350

Trucking (7%)

3500

3500

Total Service Fees

16100

16100

Markup (20%)

13220

13220

Net Sales

79320

79320

EXHIBIT 3

Breakdown of Expenses by Activity

('000's)

Total Expenses

Share of Expenses

Storage

Rent

$1,504x 85%

$1,278

Depreciation

$208 x 85%

$177

Utilities

$200 x 85%

$170

Total

$1,625

Requisition Handling

Rent

$1,504 x 15%

$226

Depreciation

$208 x 15%

$31

Utilities

$200 x 15%

$30

Salaries + Fringes

$1,109

$1,109

Taxes/Insurance

$110

$110

Postage & supplies

$96

$96

Hourly Payroll + Fringes

$545

$545

Total

$2,147

Warehouse Activities

Variable Warehouse Pay + Fringes

$1,935

$1,935

Basic Warehouse Stock Selection (50%)

$967

"Pick-Pack" Activity (40%)

$774

Desk Top Delivery (10%)

$194

Total

$1,935

EXHIBIT 4

TFC Activities and Cost Drivers

Activities / Cost Driver

Cost Driver in units

Storage / Cartons in inventory

(cartons)

350,000

Requisition handling / Requisitions

(requisitioning)

310,000

Basic Warehouse Stock Selection / Carton lines

(carton lines)

775,000

"Pick-Pack" / Pick-Pack lines

(Pick-Pack" lines)

700,000

Desk Top delivery / Desk Top deliveries

(Desk Top deliveries)

8500

Inventory financing / Inventory value

Not available or given elsewhere

Trucking / Mileage

Not available or given elsewhere

EXHIBIT 5

TFC Net Sales, 2003

Annual

No. of

% of TFC

Sales/Account

Accounts

Net Sales

>$300,000

40

48%

>$150,000

53

19%

>$75,000

86

15%

>$30,000

143

11%

>$O

778

7%

Total

1100

100%

EXHIBIT 6

Top 20 TFC Accounts for August, 2004

(Ranked by Contribution $)

Account

Actual Net Sales

Product Cost

ABC Based Service Costs

Revised Contribution

1

76,904

49,620

2,862

24,422

2

130,582

74,396

34,578

21,608

3

72,956

48,216

3,456

21,284

4

64,903

37,981

6,574

20,348

5

45,088

26,098

1,309

17,681

6

104,689

62,340

25,356

16,993

7

52,890

32,083

4,386

16,421

8

38,902

23,087

1,245

14,570

9

87,130

54,923

17,685

14,522

10

67,935

42,012

12,290

13,633

11

58,290

32,074

12,834

13,382

12

84,589

54,023

17,528

13,038

13

36,587

22,657

1,345

12,585

14

47,890

32,'545

3,657

11,688

15

56,294

27,801

16,923

11,570

16

61,056

38,924

11,034

11,098

17

56,902

32,789

13,904

10,209

18

45,893

29,570

6,904

9,419

19

62,954

41,034

13,746

8,174

20

26,699

16,830

2,236

7,633

Total

1,279,133

779,003

209,852

290,278

EXHIBIT 7

Bottom 20 TFC Accounts for August, 2004

(Ranked by Contribution $)

Account

Actual Net Sales

Product Cost

ABC Based Service Costs

Revised Contribution

1081

3,657

2,356

2,325

1,024

1082

38,467

26,301

13,740

1,574

1083

5,926

3,840

4,214

2,128

1084

163

89

2,390

2,316

1085

3,256

2,006

3,590

2,340

1086

82,086

61,224

23,756

2,894

1087

29,320

20,647

11,843

3,170

1088

467

302

4,086

3,921

1089

17,935

11,087

10,872

4,024

1090

17,649

12,903

8,903

4,157

1091

638

420

5,109

4,891

1092

16,104

9,102

12,134

5,132

1093

289

178

5,698

5,587

1094

23,965

17,345

16,523

9,903

1095

38,065

23,391

27,623

12,949

1096

32,898

23,054

22,985

13,141

1097

129,367

73,128

69,527

13,288

1098

74,569

50,745

45,698

21,874

1099

88,345

64,930

53,867

30,452

1100

113,976

82,987

72,589

41,600

Total

717,142

486,035

417,472

186,365

Exhibit 8

Current Operation Profit for 2004

The most profitable 5% of customers (55) contribute 80%

The next most profitable 45% of customers (145) contribute 220%. Profit could be 300% of the current level if we dropped the remaining 50% of customers (550)!

48% of customers (528) reduce profit by 140%.

2% of customers (22) reduce profit by 60%.

DISCUSSION QUESTIONS:

Discuss the following concepts only in the context of this problem.

1. Alternative Cost Driver Classification Schemes

2. ABC Implementation Issues

3. ABC and Customer Profitability Analysis

4. Activity Based Management

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