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--~- r ;~" .~ ! ! Allied Office Products This case is set in the businessorms businessin 1992 in a company that augmentsits f "commodity" products with value-addeddistribution and logistics services. The subject is customer rofitability analysis using ABC, ABM and SCM p THE TFC BUSINESS i r I , In 1992, Allied Office Productswas a corporation with annualsales of $900 million in business forms and specialtypaperproducts,suchas writing paper, envelopes, ote cards,and greeting cards. n In 1988the companyhad expandedinto business orms inventory management ervices.This was f s an area where Allied believed it could offer value-addedservicesto differentiate it from other businessforms manufacturers. The forms manufacturing businesswas mature by 1988 and all competitorswere seekingways to generatesalesgrowth. Allied embarkedon a campaignto enroll its corporateclients in a programwhich it called "Total FormsControl" (TFC). By 1992, sales from TFC were about $60 million and Allied had establisheda separate I i I"' company within the business orms division to handletheseaccounts. The servicesprovided under f TFC included warehousingand distribution of forms (including inventory financing) as well as invento~ contr~l and forms ~sagereporting. Allied useda soph~sticate~~mputersystems.netwo~k ~ " to monitor a client's forms Inventory, forms usage,and orderIng activities. They provided thIS information to their clientsvia comprehensive et simple to read managementeports. y r As part of its distribution services,Allied also offered "pick pack" service where trained actually opened full cartons to pick the exact number of forms requestedby the clients. Allied's philosophywas that a well run warehousingand distribution network is vital to any forms .workers Ii management time." program-"we know what you need... the right product at the right place at the right For a small number of clients Allied also offered "desk top delivery," where Allied personnelwould distributethe forms to istdividualofficcs (forms were usually delivered only to the loading dock). As a comprehensiveorms management rovider,Allied's product line also had to be f p comprehensive. Their productline included everything from standardcomputerprintout paperand fax paper to custom designed forms tailored to meet the exact business needs of the client. " , versionspreparedby Professor ijay Govindarajanand Jay Weiss (T93) of the Amos Tuck School, V and copyright (1992) by OsceolaInstitute. This casewas madepossible with the cooperationof a Fortune 500 firm. The nameof the companyand financial dataare disguised. -~-- 10 I CURRENT COST ACCOUNTING SYSTEM Allied operated its forms manufacturing and TFC activities as separate profit centers. The transfer of product to TFC was at arm's length with th,e transfer price set at fair market value. Allied manufactured business forms in 13 locations. Although the company encouraged internal sourcing for customer orders, TFC salespeople had the option of outsourcing product if necessary. The industry value chain for TFC is shown in Exhibit 6. Clients who participated in the forms management program kept an invent?ry of forms at one of Allied's 10 distribution centers. The forms were distributed to the client as 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. If a TFC client made use of any of the distribution services, they were supposed to be charged a price for the forms which was high enough to allow for an additional 32.2% of product cost to cover warehousing and distribution expenses, the cost of capital tied up in inventory and freight expense. This percentage was determined based on actual 1990 financial data so that on an aggregate basis, in total, all expenses were covered (see Exhibit 1): The sales force then marked up the cost of product and services by 20%, on average. As shown in Exhibits 4 and 5, prices for individual accounts could vary from the standard formula. UNDERSTANDING CUSTOMER PROFIT ABILITY With TFC profitability suffering in October 1992, General Manager John Malone began to question the appropriateness of the distribution charges. "The Business Forms Division in 1988 earned 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 1992. Something tells me that we are not managing this business very well! It seemsto me that the charge for services needs closer scrutiny. I believe we should charge our clients for the services they use. It doesn't seem fair that if two clients buy the same amount of product from us, but one keeps a lot of inventory at our distribution center and is constantly requesting small shipments and the other hardly bothers us at all, both should pay the same service fees." John looked through his records and found two accounts of similar size, accounts A and B, which were handled by different sales people. Accounts A and B both had annual sales of $79,320 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 Allied. In the past year, customer A had submitted 364 requisitions for product with a total of 910 linesI (all of them "pick-pack") while customer B had submitted 790 requisitions with a total of 2500 lines (all "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. Because of the greater activity on customer B's account, a shipment went out three times a week at an annual freight cost of $7,500 while Customer A required only one shipment a week at an annual freight cost of $2,250. In addition, customer B had requested desktop delivery 26 times during the past year, while customer A did not request desktop delivery at all. John Malone turned to TFC Controller Melissa Dunhill and Director of Operations Tim Cunningham for help. John said, "How can I better understand customer profitability?" "Well," Tim said, "if we can figure out, without going overboard of course, what exactly goes on in the distribution centers, maybe we can 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 and John decided to talk to some people in the field to get more specific information. DISTRIBUTION CENTER: ACTIVITY ANALYSIS John and Tim visited Allied's Kansas City, MO distribution facility. Site manager. Wilbur Smith confirmed, "All we do is store the cartons and process the requisitions. The amount of warehouse space we need just depends on the number of cartons. It seems like we've got a wt of cartons that just sit here forever. If we created som~ flexible lease programs and changed aisle configurations, we could probably adjust our space requirements if the number of cartons we stored were to change. The other thing that really bothers me is that ; I Whenever a customer requires forms, they submit a requisition for all the different products they need. Each separate roduct requestis a "line." If the requestis for whole p cartons,it is considered "cartonline." for quantitieslessthan a a whole carton, it is considered "pick-pack line." a I I Allied Office Products we've got some inventory that's beensitting hereforever. What's it to the client? They don't pay for it until they requisition it. Isn't there a way we can make them get this stuff out of here?" "As far as the administration of the operation goes, everything dependson the number of requisitions. And, on a given requisition,the customercan requestas many different items as they like." 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 damn "pickpack" requests. Almost everything is "pick-pack" nowadays. No one seemsto 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 desktop delivery is a real pain for my guys. Sure, we offer the service, but the clients who use it should haveto pay somethingextra. It's not like my guys don't have enoughto do." Johnand Tim were starting to get a pretty good idea of what goes on in the distribution centers,but there was still one personto talk to. They knew that a lot of moneywas spenton dataprocessing,mostly labor. They neededto know how thosepeople spenttheir time. Hazel Nutley had beena data entry operator at Allied for 17 years. "Alii do is key in those requisitions, line by line by line. I've gottento the point where I know the customersso well that all the order information is easy. The only thing that really matters is how many lines I haveto enter." Based on the interviews and observations,Tim and John broke down distribution into 6 primary valueadded activities-storage, requisition handling, basic warehouse stock selection, "pick-pack" activity, data entry and desktop delivery. With Melissa's help, they assignedcoststo theseactivities as follows for a sample of five of the distribution centers: (See Exhibit 2 for I ! ~ i I ! " ! 1 ! ! I I I t i ; calculations): Storage $1,550 RequisitionHandling $1,80I Basic WarehouseStock Selection $761 "Pick-Pack" Activity $734 Data Entry $612 Desktop delivery ~ Total $5,708 Tim thenestimated he following for 1992based t upon historical information and current trends for the sampleof five warehouses: 11 .On average, these 5 distribution centers scattered acrossthe country, will have combined inventories of approximately 350,000 cartons (most cartons were of fairly standardsize). .They will process about 310,000 requisitions for 1992. Eachrequisition will average2.5 lines. .About 90% of the lines will require "pick pack" -activity (as opposed o shipping anentire carton). t .Cost of capital in 1992was probably about 13%. "Our new computer sy~temis coming on line soon which will track individual freight charges," said Tim, "so, we can just charge the client for what it actually costs us." John and Melissa agreed that this sounded air. f Some things that were said at the distribution center still stuck in Tim's mind. "Don't you think we should do somethingto get that old inventory moving? What about charging something extra, say 1.5% per month,for anything that's beenthere over 9 months." "Great idea," Melissa said, "this will also help protectus againstthe losswe often take on old inventory whenthe clients end up changingtheir forms. You know we just eatthat and neverchargethem for it." They were almost finished. "What about desk top delivery?" Tim said. "I think we shouldchargeextra for it, but I don't wantthis to get too complicated." Jobn said, "How much extra time does it take Y!:irguys on averageto run aroundthe client company?" "I'd say aboutan hour and a half to two hours at $15 per hour, that's about$30 eachtime. Soundfair?" "SqundsOK to me. Also, that ties pretty well to the $250,000 overall assignment, ince.we will process s somewhere rouna8,500 'desk top' requestshis year." ~ t SERVICES BASED PRICING (SBP) Th~ entire managementteam, including Doug Kingsley, Ch'1ef inancial Officer of the BusinessForms F Division, fen that there had to be a better way of charging out distribution services to help TFC become more profitable. They now had a much better understanding of the drivers of costs involved in distributionservices. "It wouldn't be easy getting the sales force to accept an activity-based pricing program," John said. "Some of them get pretty stuck in their ways and don't , '"--~- I 12 like change. Someaccountswould seeincreases ecause b 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. The accounting departfi)ent maintained a database that showed all activity against individual accountsand calculateda contribution from that account. However, they had not yet been able to use this information effectively. TFC man~gement-ook their t dataand beganto analyzeit. . i ! rested with so few accounts, managementfelt 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.The also wondered what other issuesmight be importantfor improving the overall profitability ofTFC. Although TFC maintained 1100 separate accounts,a large portion of the businesscame from very few accounts. The top 40 accountsrepresented 8% of 4 the company's net sales(see Exhibit 3). As a way of understanding customerprofitability, TFC managementreworked the information in the database s if the accountshad beenchargedservice a fees basedon actualusage,leaving net salesand product cost the sameas before. They recalculatedcontribution based on these figures. They ranked the accounts accordingto profit contribution. Exhibit 4 showsthe top 20 accountsfor the month of Augustand Exhibit 5 shows the bottom20. Since sucha large part of the profit opportunity 2. Using your new costing system, calculate distribution services costs for "Customer A" and "CustomerB." ASSIGNMENT QUESTIONS 1. Using the information in the text and in Exhibit 2, .calculate "ABC" based services costs for the TFC business. 3. What inferencedo you draw about the profitability of thesetwo customers? 4. ShouldTFC implementthe SBPpricing system? 5. What managerial advice do you have for Allied aboutthe Total Forms Control (TFC) business? ow H does Exhibit 6 relateto this question? EXHIBIT 1 Calculation of Service FeeCharges ('OOO's) 1990ProductSalesat Cost $24,059 1990Warehousing/Distribution xpense E ...% of ProductCost 1990Average Inventory Balance 1990Average Cost of Capital Total Cost of Inventory Financing ...% ProductCost 1990Total FreightCharges ...% ProductCost Total ServicesCosts StandardPrice = (ProductCost x 1.32) x 1.2 $4,932 ~ "" $10,873 10.4% $1,131 ~ $1,684 ~ 32.2% - r --~ Allied Office Products 13 EXHIBIT 2 Breakdown of Expensesby Activity ('OOO's) Total Activity Expense Rent Depreciation Utilities Security Total StorageExpense ~ $1,424 x 85% $208 x 85% $187 x 85% $3 Rent Depreciation Utilities Salaries+ Fringes $1,211 $177 $159 $,1 $1,550 $1,424 x 15% $208 .x 15% $187 x 15% $909 Telephone Taxes/Insurance $214 $31 $28 $909 $96 $104 $96 $104 Travel/Entertainment $40 x 75% Postage $56 $56 $316 $17 $316 ill ill!li Hourly Payroll+ Fringes Temp Help Total ReQuisition andling Expense H Variable Warehouse ay+ Fringes P Travel & Entertainment 25%) ( Total Warehouse ctivi~ A $30 $1,735 $40 x 25% $1,735 llQ bill BasicWarehouseStock Selection(44%) "Pick-Pack" Activity (42%) DeskTop Delivery (14%) Data Processing xpense E $761 $734 $250 Total $.Qll .$Jill ~ ~ *Some expensetems were allocatedbetweenactivities i TFCEXHIBIT 3 991Net Sales,1 Annual Sales/Account . . No. of Accounts % ofTFC Net Sales " >$300,000 >$150,000 >$75,000 40 53 86 48% 19%, 15% >$30,000 >$0 143 778 11% 7% Total 1100 ~ 100% T! , , ; 14 EXHIBIT 4 Top 20 TFC Accounts for August; 1992 (Ranked by Contribution $) Account 1 2 3 4 5 6 18 19 2.Q. Total Actual Net sates 76,904 130,582 .74,396 72,~56 64,903 45,088 104,689 45,893 62,954 Product CQ! 49,620 I 48,216 37,981 26,098 62,340 ABC Based ServiceCosts 2,862 34,578 3,456 6,574 1,309 25,356 Revised Contribution 24,422 21,608 21,284 20,348 17,681 16,993 29,570 41,034 6,904 13,746 9,419 8,174 2.Q.222 l2..8J..Q 1,279,133 779,003 U1(i 1.Qll 209,852 290,278 EXHIBIT 5 Bottom 20 TFC Accounts for August, 1992 (Ranked by Contribution $) Account 1081 1082 1083 1084 1085 1086 Actual Net Sales 3,657 38,467 5,926 163 3,256 82,086 Product CQ! 2,356 26,301 3,840 89 2,006 61,224 ABC Based ServiceCosts 2,325 13,740 4,214 2,390 3,590 23,756 Contribution -1,024 -1,574 -2,128 -2,316 -2,340 -2,894 1098 1099 1100 Total 74,569 88,345 113.976 717,142 50,745 64,930 ~ 486,035 45,698 53,867 ~ 417,472 -21,874 .-30,452 -41,600 -186,365 .. "- I ! ! ! L . Allied Office Products 15 EXHIBIT 6 The Value Chain Concept- TFC ~ @ . ...QJ E '" ~~ 0 ~ 0 .-/) , ~ ~ 'Q .> 0 J O/) E.-U "C -QJ =' QJ u~ ...' 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