What inference do you draw about the profitability of customer A and customer B? Which one is the good customer? Which one is the bad customer? Explain your response. Submit a an ABC calculation of distribution service costs for customer A and customer B to support your answer.

In 1992, Allied Office Products 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 Allied 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. Allied embarked on a campaign to enroll its corporate clients in a program which it called "Total Forms Control" (TFC).

By 1992, sales from TFC were about $60 million and Allied had established a separate company within the business forms division to handle these accounts. The services provided under TFC included warehousing and distribution of forms (including inventory financing) as well as inventory control and forms usage reporting. Allied used a sophisticated computer systems network to monitor a client's forms inventory, forms usage, and ordering activities. They provided this information to their clients via comprehensive yet simple to read management reports.

As part of its distribution services, Allied also offered "pick pack" service where trained workers actually opened full cartons to pick the exact number of forms requested by the clients. Allied's philosophy was that a well-run warehousing and distribution network is 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 Allied also offered "desk top delivery," where Allied personnel would distribute the forms to individual offices (forms were usually delivered only to the loading dock). As a comprehensive forms management provider, Allied's product line also had to be comprehensive. Their product line included everything from standard computer printout paper and fax paper to custom designed forms tailored to meet the exact business needs of the client.

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 the 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 inventory 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 PROFITABILITY

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 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. 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 lines1 (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 desk top delivery 26 times during the past year, while customer A did not request desk top 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 lot of cartons that just sit here forever. If we created some 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 we've got some inventory that's been sitting here forever. 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 depends on the number of requisitions. And, on a given requisition, the customer can request as 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 '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 real pain for my guys. Sure, we offer the service, but the clients who use it should have to pay something extra. It's not like my guys don't have enough to do."

John and Tim were starting to get a pretty good idea of what goes on in the distribution centers, but there was still one person to talk to. They knew that a lot of money was spent on data processing, mostly labor. They needed to know how those people spent their time.

Hazel Nutley had been a data entry operator at Allied for 17 years. "All I do is key in those requisitions, line by line by line. I've gotten to the point where I know the customers so well that all the order information is easy. The only thing that really matters is how many lines I have to enter."

Based on the interviews and observations, Tim and John broke distribution down into 6 primary value-added activities-storage, requisition handling, basic warehouse stock selection, "pick-pack" activity, data entry and desk top delivery. With Melissa's help, they assigned costs to these activities as follows for a sample of five of the distribution centers: (See Exhibit 2 for calculations):

Storage $1,550 Requisition Handling $1,801 Basic Warehouse Stock Selection $761 \"PickPack\" Activity $734 Data Entry $612 Desk top delivery 31511 Total $5,708 EXHIBIT 1 Calculation of Service Fee Charges ('000's) 1990 Product Sales at Cost $24,059 1990 Warehousing/Distribution Expense $4,932 ...% of Product Cost 20.5% 1990 Average Inventory Balance $10,873 1990 Average Cost of Capital 10.4% Total Cost of Inventory Financing $1,131 ...% Product Cost 4.7% 1990 Total Freight Charges $1,684 ...% Product Cost 7.0% Total Services Costs 32.2% Standard Price = (Product Cost x 1.32) x 1.2EXHIBIT 2 Breakdown of Expenses by Activity ('000's) Total Activity Expense Costs\" Rent $1,424 x 85% $1,211 Depreciation $208 x 85% $177 Utilities $187 x 85% $159 Security $3 $3 Total Storage Expense $1,550 Rent $1,424 x 15% $214 Depreciation $208 x 15% $31 Utilities $187 x 15% $28 Salaries + Fringes $909 $909 Telephone $96 $96 Taxes/ Insurance $104 $104 Travel/Entertainment $40 x 75% $30 Postage $56 $56 Hourly Payroll + Fringes $316 $316 Temp Help $17 m Total Requisition Handling Expense ' $1,801 Variable Warehouse Pay + Fringes $1,735 $1,735 Travel & Entertainment (25%) $40 x 25% $132 Total Warehouse Activig $1,745 Basic Warehouse Stock Selection (44%) $761 \"PickPack\" Activity (42%) $734 Desk Top Delivery (14%) $250 Data Processing Expense $_6Q m Total M m *Some expense items were allocated between activities EXHIBIT 3 TFC Net Sales, 1991 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 1 1% >$0 778 7% Total 1100 100%EXHIBIT 4 Top 20 TFC Accounts for August, 1992 (Ranked by Contribution S) Actual Product ABC Based Revised Account Net Sales _Co_st Service Costs 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 18 45,893 29,570 6,904 9,419 19 62,954 41,034 13,746 8,174 20 26,699 16,830 342,39 1,6,3; T01; 1,279,133 779,003 209,852 290,278 EXHIBIT 5 Bottom 20 TFC Accounts for August, 1992 (Ranked by Contribution $) Actual Product ABC Based Account Net Sales Cost Service Costs 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 . 1098 74,569 50,745 45,698 -21,874 1099 88,345 64,930 53,867 -30,452 1 100 113,976 82,987 72,589 -41,600 Total 717,142 486,035 417,472 -186,365EXHIBIT 6 The Value Chain Concept-TFC The Industry Chain Customer Forms Forms TFC Purchasing Customer Forms Trees Pulp Paper Receiving User Mfg. Sales Manager The TFC Chain Storage & Stock Order Entry & Desk Top Inventory Requisi Selection & Freight Delivery Financing ing Pick Pack Billing