Tongariro Tents Limited.

BACKGROUND

Tongariro Tents Ltd. (TT) imports lightweight tents into New Zealand and currently sells them to three independent outward bound equipment wholesalers. TT does not currently sell to retail stores or direct to the general public. The managing director, Guy Rope, is concerned that the company has too much spare capacity and is not making adequate returns. He believes that TT must therefore expand the company's customer base. As there are a limited number of outward bound equipment wholesalers in New Zealand he is considering whether TT should start selling tents to retailers or even direct to the general public.

Moreover, TT is such a small company that it has no control over the price it pays to its overseas tent suppliers. Hence, to improve profitability TT needs to concentrate on expansion, better use of its capacity and improved efficiency in sales and distribution. Guy knows that it is no use 'buying' market share with excessive discounts and he is rather concerned that, in an effort to grow the business rapidly, the level of discounts that were offered in order to acquire some customers were excessive.

Details

Guy therefore asked his management accountant to review last year's financial statements and to produce a customer profitability analysis (CPA). The management accountant is still a trainee and was not entirely sure what Guy wanted, but she used her knowledge of the principles of activity-based costing (ABC) to produce the CPA shown in table 1.

Guy arranges a meeting with TT's sales and marketing director, Dolly Peg in order to discuss what the new CPA statement reveals. He is not terribly happy and starts firing questions at Dolly:

"We threw a party last year when you won the McKinley account, but this CPA now shows us that the account made a $31,767 operating loss last year. Are they getting excessive discounts?"

Table 1 - Customer Profitability Analysis:

Everest($) Cook($) McKinley($) Spare capacity($) Total

Revenue(list price) 1800000 487500 450000 - 2737500

Gross Profit 336000 105625 120000 - 561625

Gross margin 18.7% 21.7% 26.7% - 20.5%

less: Selling and distribution

Account management 19200 20800 24000 9600 73600

Sales & marketing 27000 27000 36000 0 90000

Packaging and loading 24000 18000 25000 8000 75000

Transport to customer 19200 21600 50000 0 90800

Total S&D 89400 87400 135000 17600 329400

Customer Contribution 246600 18225 -15000 -17600 232225

Corporate sustaining cost 67068 18164 16767 0 102000

Net operating profit 179532 61 -31767 -17600 130225

Operating profit margin 10% 0% -7.1% - 4.8%

Dolly argues:

"Definitely not! They actually pay full list prices and consequently their gross margin is higher than either the Everest or Cook accounts because the latter receive 8% and 5% discounts on list prices respectively. However, McKinley is a new customer and they are currently very demanding. Look at the costing data, it shows the activities and cost drivers we have used and hence explains why their selling and distribution costs are so high."

Dolly starts to explain that the selling and distribution costs of $329,400 are traced to the 3 individual customers using cost drivers and burden rates/activity rates (see table 2) and the cost driver data relevant to the last accounting year (see table 3).

Guy interrupts by exclaiming:

"Quite obviously we would be nearly $32,000 better off if we dropped McKinley now and concentrated on selling more to Everest and Cook".

Dolly explains that it is not quite that simple:

"In the CPA statement (table 1) the corporate sustaining costs of $102,000 are traced to customers in proportion to sales revenue. That's a pretty arbitrary allocation base and these costs include things like audit fees and legal expenses. I don't believe such costs would change if we dropped one of the 3 customers. Moreover, we have spare capacity. I need more customers, not less!"

Guy is getting frustrated:

"What's an arbitrary allocation base? Even if the corporate sustaining costs don't change we would be $15,000 better off wouldn't we? Shouldn't we fire our unprofitable customers before we go out looking for more customers?

Dolly tries to calm Guy down by promising to commission a report that will explain everything clearly.

"We should do something about unprofitable customers, but not necessarily drop them. This analysis is just a historical snapshot, and McKinley is a new customer. Now we have acquired McKinley I intend to develop better relationships with them, sell more to them and make them more profitable.

Also, I am close to acquiring Kilimanjaro. They are the only big outward bound equipment wholesaler in New Zealand that we do not yet sell to, and I've been working on them all last year. I forecast that Kilimanjaro will buy tents with a list price of $200,000 in their first year, and even after discounts we'll make a 20% gross margin on their business. Over the year I estimate that they will place 12 customer orders and will be happy with monthly deliveries. Each delivery would be a 45 kilometre round trip, so 12 deliveries means only 540 delivery kilometres per year. To get them 'bedded in' I will need to make 24 sales visits in the first year, but I will probably need no more than 12 sales visits per year thereafter."

Dolly knows about your management accounting expertise and has asked you to produce the report she promised to commission, and to provide the necessary explanations and advice to the management team of Tongariro Tents.

ACTIVITY-BASED COSTING DATA

Table 2 - Activity costs, driver capacity and burden rates:

Activity cost($) Cost driver Cost driver capacity Burden Rate |($)

Account management 73600 No. of customer order 92 800

Sales & marketing 90000 No. of sales visit 60 1500

Packaging & Loading 75000 No of deliveries 150 500

Transport to customer 90800 Delivery Kilometres 9080 10

329400

Table 3 - Cost driver transactions data for last accounting year:

Everest Cook McKinley Capacity used Spare capacity Full Capacity

No. of customer order 24 26 30 80 12 92

No of sales visit 18 18 24 60 0 60

No of deliveries 48 36 50 134 16 150

deliveries Kilometres 1920 2160 5000 9080 0 9080

REQUIRED

Prepare your consultant's presentation and report to the management team of Tongariro Tents (TT) Ltd, advising on the suitability of their customer profitability analysis and any management action required.

Your report should

A. Explain the potential advantages and disadvantages of TT seeking to acquire retail customers as well as wholesalers.

B. Summarise the advantages and disadvantages of tracing corporate sustaining costs to individual customers and advise whether they should be traced to individual customers for decisions about the hiring and firing of customers

C. Assuming that the information in the Customer Profitability Analysis (table 1) is based on reliable data, advise the TT management team what they should do (if anything) about each of their 3 current customers.

D. Include an estimate of the likely first year customer contribution of the Kilimanjaro account, based on the estimates provided by Dolly. Also, on the basis of this estimate, and any other factors you think may be relevant, make recommendations, stating your reasoning, regarding whether this customer account should be pursued.

E. Outline any potential weaknesses of the Customer Profitability Analysis that has so far been produced at TT Ltd and offer solutions for those weaknesses. Also, describe any further customer accounting measures that you believe the TT management team might find useful, and explain their potential benefits.