The PFS Business

In 1992, Commercial Paper Co. was a corporation with annual sales of $900 million in business forms and specialty paper products, such as writing paper, envelopes- note cards, and greeting cards. In 1988 the company had expanded into business forms inventory management services. This was an area where Commercial Paper Co. believed it could offer value-added services to differentiate it from other business forms manufacturers. The forms manufacturing business was mature by 1988, and all competitors were seeking ways to generate sales growth. Commercial Paper Co. created PFS for its corporate clients, the services provided under PFS included warehousing and distribution of forms (including inventory financing). As part of its distribution services, it was offered a "pick pack" service where trained workers actually opened full cartons to pick the exact number of forms requested by the clients. For a small number of clients, it was also offered "desk top delivery," where PFS personnel would distribute the forms to individual offices (forms were usually delivered only to the loading dock). Commercial Paper Co. operated its forms manufacturing and PFS activities as separate profit centers.

Current Cost Accounting System

Clients who participated in the forms management program kept and inventory of forms at one of PFS's distribution centers. The forms were distributed to the client as needed. The client was charged a service fee of 32.2% of the cost of sales to cover the cost of warehousing and distribution, regardless of the specific level of service provided to that client (see Exhibit 1). The sales force then marked up the cost of product and services by 20 percent.

Exhibit 1: Calculation of service fee charges (000s)

Year Concept Total cost percentage of product cost

1990 product sales at cost $24, 059

1990 warehousing/distribution exp. $4,932 20.5%

1990 total cost of inventory financing $1,131 4.7%

1990 total freight charges $1,684 7%

total service costs 32.2%

standard price (product cost x 1.32) x 1.2

Understanding Customer Profitability

With PFS profitability suffering in October 1992, General Manager John Malone began to question the appropriateness of the distribution charges. "PFS in 1988 earned a 20 percent Return on Investment (ROI). But returns have been dropping for several years. PFS is projected to earn an ROI of only 6 percent for 1992. Something tells me that we are not managing this business very well! It seems to 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 salespeople. Accounts A and B both had annual sales of $79,320 with the cost of the product being $50,000. In the past year, customer A had submitted 364 requisitions for product with a total of 910 lines [1] (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 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 desk top delivery 26 times during the past year, while customer A did not request desk top delivery at all.

Distribution Center: Activity Analysis

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. For the administration of the operation, everything depends on the number of requisitions. On a given requisition, the customer can request as many different items as they like. Each distribution center is made up by six primary value-added activities: storage, requisition handling, basic warehouse stock selection, "pick-pack" activity, data entry, and desk top delivery. The costs assigned to these activities are as follows (see Exhibit 2):

[1] Whenever a customer requires forms, they submit a requisition for all the different products they need. Each separate product request is a "line." If the request is for whole cartons, it is considered a "carton line." For quantities less than a whole carton, it is considered a "Pick-pack line".

Rent (85%) $1,424 x 0.85 $1,211

Depreciation (85%) $ 208 x 0.85 $ 177

Utilities (85%) $ 187 x 0.85 $ 159

Security $ 3 $ 3

Total storage expense $1,550

Rent (15%) $1,424 x 0.15 $ 214

Depreciation (15%) $ 208 x 0.15 $ 31

Utilities (15%) $ 187 x 0.15 $ 28

Salaries & fringes $ 909 $ 909

Telephone $ 96 $ 96

Taxes/insurance $ 104 $ 104

Travel/entertainment (75%) $ 40 x 0.75 $ 30

Postage $ 56 $ 56

Hourly payroll & fringes $ 316 $ 316

Temp help $ 17 $ 17

Total requisition handling expense $1,801

Variable warehouses pay & fringes $1,735 $1,735

Travel and entertainment (25%) $ 40 x 0.25 $ 10

Total warehouse activity (to be distributed among 3 activities)$1,745

Basic warehouse stock selection (44%) $ 761

"Pick pack" activity (42%) $ 734

Desktop delivery (14%) $ 250

Data Processing expense $ 612 $ 612

Total $5,708 $5,708

*Some expense items were allocated between activities.

[1] Whenever a customer requires forms, they submit a requisition for all the different products they need. Each separate product request is a "line." If the request is for whole cartons, it is considered a "carton line." For quantities less than a whole carton, it is considered a "Pick-pack line".

It is estimated for the distribution centers in the year 1992 that, on average, they will have inventories of approximately 350,000 cartons, they will process about 310,000 requisitions, that each requisition will average 2.5 lines, that about 90 percent of the lines will require "pick-pack" activity (as opposed to shipping an entire carton), that the cost of capital will be about 13 percent, that the computer system will track individual freight charges and that 8,500 'desk top' requests will be processed. With all that information the controller calculated the cost-of-service activities (see exhibit 3).

EXHIBIT 3: Activity Based Costs - Calculation of Service Costs

Value Added Total FY92 Expense Cost Driver Cost Driver Service Cost

Activities Defined as: per activity (000) Defined unitsFY92 per year

Storage $1,550 Cartons in Inv. $350,000 $4.43

Requisition Handling 1,801 Requisitions 310,000 $5.81

Warehouse Activity 761 Carton Lines 775,000 $0.98

Pick Packing 734 (PP) Lines 700,000 $1.05

Data Entry 612 Carton Lines 775,000 $0.79

Desk Top Delivery 250 Per Time 8,500 $29.42

$5,708

Freight Charge Actual Cost

Inventory Finance Inventory Value x Capital Charge*

* Assume Cost of Capital = 13.5% given that prime rate is 10%

Services Based Pricing (SBP)

The entire management team felt that there had to be a better way of charging out distribution services to help PFS become more profitable. They now had a much better understanding of the drivers of costs involved in distribution services. Although PFS maintained 1100 separate accounts, a large portion of the business came from very few accounts. The top 40 accounts represented 48 percent of the company's net sales (see Exhibit 4).

Since such a large part of the profit opportunity rested with so few accounts, management felt 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 the next step should be. They also wondered what other issues might be important for improving the overall profitability of PFS.

EXHIBIT 4: PFS Net Sales, 1991

Annual Sales/ Account Number of Accounts % of PFS Net Sales

> $ 300,000 40 48%

> $150,000 53 19

> $ 75,000 86 15

> $ 30,000 143 11

> $0 778 7

Total 1,100 100%

The top management team asked you, an external consultant, to

1) identify the reasons for profit problems through quantitative and qualitative analysis,

2) calculate and comment on the distribution services costs for "Customer A" and "Customer B" and

3) recommend solutions for the company to improve profitability.