Dakota Office Products Case Analysis

Concern over a first year loss prompted a case study of the business operations of Dakota Office

Products. Harvard Business School professor Robert S. Kaplan authored the case study as an illustration

of use of activity based cost allocation and profitability (Kaplan, 2005). In the case presentation, John

Malone, the General Manager of Dakota Office Products (DOP) commissioned analysis of the company’s

operations and cost allocation practices; it focused on the company’s distribution center. Activities that

emerged as cost drivers included: commercial freight shipping, personal delivery of orders under the

Desktop Delivery program, warehouse handling and space, and several product ordering and entry

activities. In this paper, the cost drivers were utilized to establish activity-based costing for DOP.

Profitability for two current DOP customers was also analyzed for behavior patterns that might lead to

or suggest improved pricing. Specific assignment questions were detailed and answered on the topic of

relative profitability of the two customers. The objective of the analysis was to utilize learnings from the

profitability calculations in order to make recommendations which would return DOP to profitable

operation following the year of the unexpected loss. If the methods in this paper were utilized, it is felt

to be a useful tool to assist DOP management in turning the company around.

Method

The assignment is summarized in this section, followed by a detail of steps taken to complete it.

Data from the case study was used to develop an activity-based costing system. The activity-based

costing system is shown in Table 1. Based on a 1 year history, relative profitability of two customers was

determined using the variable direct cost drivers summed with interest on accounts receivables and

selling and administration costs. The profitability is expressed in absolute terms and as a percentage of

sales in Table 2.

Assignment

For the BUSA 5061 assignment, the DOP case was analyzed in order to address the following

conjectures (with assignment question nos. in parentheses):

Data suggests that the existing pricing system was inadequate for Dakota Office Products (1).

Based on data from the case study, an activity-based cost system was developed for year 2000 (2).

Profitability of two customers was compared (3) and explained (4). Limitations of the profitability

estimates were discussed (5). Consideration was given to other information that could help explain

the relative profitability of the two customers (6).

Applicability of the relative profitability comparison to the entire customer base was considered.

The management tool was expected to help Dakota Office Products return to profitability (7).

A total shift from manual order entry to internet orders for a major customer was considered. The

expected influence upon the established cost driver rates was noted. Again, increased profitability

is expected (8).

Construction of Activity Based Cost System

Table 1 was generated in order to calculate activity-based cost driver rates. The first column,

“Overhead Cost Items” contains description of the activity. In the column, “Source of Annual Cost”,

reference is provided for each cost item, either the numerical basis for the calculation or the reference

exhibit in the case study. The column with the heading, “Annual Cost Driver” contains the total impact

of the driver in dollars. The values in this column will constitute the numerator of the cost driver rate.

The column, “Estimated Annual Value” is the volume in the column, which along with “Units”, will make

up the denominator of the cost driver rate. “Cost per Driver Unit” is the calculated allocation rate.

Other Costs

Interest was assigned at a rate of 10% of each customer’s average accounts receivable balance.

General and Selling Expenses were allocated as the fraction of total sales.

Tabulation of Profitability Comparison of Customers

Table 2 is a comparison of the profitability of Customer A to Customer B. Tabulation of income

in the form of sales minus cost of goods sold provides a relative gross margin for each customer.

Following calculation of gross margin, the allocation of each of the individual cost pools is subtracted

from the gross margin. The resulting total, “Contribution”, is then reduced by the amounts of “Other

Costs” which include General and Selling expenses, and interest on the customers’ average accounts

receivable balances. The result, Net Income Before Taxes (NIBT) provides a comparison of profitability

for each customer, based on the activities utilized by each customer. Profit as a percent of sales is

computed by dividing the NIBT by sales

Results

Activity Based Cost System

The results of the cost system shown in Table 1 are described in this section. Freight activity was

found to cost $6 per carton shipped commercially. Under the Desktop Delivery program, the cost of

each delivery was calculated to be $220. Manual entry of orders cost $10 per order. An additional cost

for manual orders was $4 per line item on the order. Orders originating from the internet resulted in a

total cost of $5 per order, regardless of the number of line items, due to need for verification only. For

cartons warehoused and handled through the facility, a cost of $52 per carton was calculated.

Other Costs

Interest expense of $900 was assigned to Customer A and $3000 to Customer B, based on the

average accounts receivable balances of $9,000 and $30,000, respectively, at a 10% interest rate.

General and Selling expenses were assigned at the rate of $0.05 per dollar of sales. This resulted in a

charge of $4,847 for Customer A and $4,894 for Customer B. The numbers are very similar due to the

close agreement of sales for the two customers.

Profitability Comparison of Customers

The results of the profitability analysis shown in Table 2 are described in this section. After

calculating the difference of Sales and COGS, Customer A and Customer B yielded similar gross margins

of $18,000 and $19,000, respectively.

Compilation of relative activity-based costs shows some differences in customer behavior,

however. Customer A utilized more commercial freight shipments (200 vs. 150) which resulted in

activity cost assignment of $1,200 vs. $900 for Customer B. Customer B requested 25 Desktop Deliveries

at a relative differential in cost of $5,500 against Customer A, with none of this delivery method.

Customer A selected 6 manual orders compared to Customer B’s 100 manual orders, with contrasting

costs of $60 vs. $1,000, respectively. The total number of line items, 60 for Customer A, and 180 for

Customer B yielded an allocation of $240 and $720, respectively. Customer A executed 6 internet

orders at a cost of $30. Customer B did not use the internet ordering method. Each customer

warehoused 200 cartons, for an assigned cost of $10,400.

After consideration of all activity-based costs, a significant difference can be seen in profitability

of each customer, with Contribution Margin from Customer A calculated to be $6,070 against $480 for

Customer B. Following assignment of Other Costs, Customer A is calculated to be slightly profitable with

a Net Income Before Taxes of $323, or 0.3% profit as a percent of sales. Customer B has proven to be

unprofitable through the activity-based cost system, showing a loss of ($7,414), or (7.1%).

.

Table 1

Dakota Office Products: Calculation of Activity-Based Cost Driver Rates from Year 2000 Data

Overhead Cost Items Source of Annual CostAnnual Cost Cost Driver

Estimated Annual Value

Cost per Driver Unit units

Commercial Freight Exhibit 1, p4, line item: "freight" $450,000No of Cartons shipped by commercial freight 75000 $6 $/carton

Desktop Delivery

=10% of warehouse personnel expense + "Delivery Truck Expenses" from Exhibit 1, p4 $440,000 No of deliveries by Dakota personnel 2000 $220 $/delivery

Data Entry Total $800,000

Manual Order Entryfraction of total hours =2,000/10,000 X Data Entry total $160,000 No. of Manual Orders 16000 $10 $/manual order

Individual lines for manual order

fraction of total hours =7,500/10,000 X Data Entry total $600,000 No. of Line Items 150000 $4 $/line item

Validate EDI/Internet orderfraction of total hours =500/10,000 X Data Entry total $40,000 No. of Internet Orders 8000 $5 $/internet order

Warehouse handling and space

=90% of "warehouse personnel expense" + "warehouse expense" from Exhibit 1, p4 $4,160,000 No of Cartons through the facility 80000 $52 $/carton

Table 2

Dakota Office Products: Comparison of Profitability of Two Customers for Year 2000 Data

Customer A Customer BSales $103,000 $104,000COGS $85,000 $85,000

Gross Margin $18,000 $19,000Customer A Customer B

No of Cartons shipped by commercial freight 200 150 $1,200 $900No of deliveries by Dakota personnel 25 $5,500No. of Manual Orders 6 100 $60 $1,000No. of Line Items 60 180 $240 $720No. of Internet Orders 6 $30No of Cartons through the facility 200 200 $10,400 $10,400

Contribution $6,070 $480Other Costs

General and Selling, Allocated $/$ sales $4,847 $4,894Interest on Accounts Receivablessimple interest rate = 10 % on Avg Account Receivable Balance Customer A = $9,000*10%Customer B = 30,000*10% $9,000 $30,000 $900 $3,000

Net Income Before Taxes $323 -$7,414

Profit percent of sales 0.3% -7.1%

Discussion of Results

Questions posed for the assignment are discussed in this section.

Adequacy of Prior Pricing System

The current system of cost allocation is inadequate, as evidenced by the unexpected loss in

2000. An adequate cost allocation and pricing system would allow the management of DOP to

anticipate shifts in costs and profitability. Activity-based pricing would allow for passing along costs of

more expensive services to customers who use them at a higher rate.

Discussion of Activity-Based Costing System

An activity-based cost system is a good tool for management of cost flows resulting from

customer behavior. With the proposed activity-based costing system, differences in profitability were

exposed along with reasons the company might have operated at a loss. Even for customers with

behaviors incurring the lowest costs to DOP, activity-based costing provides a better picture of costs.

For example, Customer A showed what could be considered the ideal, lowest-cost behavior pattern: all

commercial freight; no Desktop Deliveries; a low number of total orders (12), and a good portion (50%)

of orders which were internet-originated. After consideration of “Other Costs”, Customer A was barely

profitable, as explained in the next section.

Profitability of Two Customers Compared

Under the original costing system used by DOP, Customer A was shown to be slightly less

profitable than Customer B. However, this analysis showed the opposite – Customer A was slightly

profitable at 0.3% profit as a percent of sales, and Customer B was not profitable, at a loss of (7.1%).

Customer A was a consumer of low-cost services. Timely servicing of debt contributed to

profitability. Customer B was shown to be the user of highest-cost services. Use of the high-cost

Desktop Delivery method is the greatest influence, at an activity cost of $5,500, but is not the only

factor. A relatively high number (100) of small manual orders (average 1.8 lines) and much more variety

of orders as evidenced by the high number of line items (180) are all higher-cost drivers. Add “Other

Costs”, namely, the interest accrued due to slow payment of its obligations to DOP, and Customer B

becomes a losing proposition in terms of profitability.

Profitability could be improved for Customer A and restored for Customer B through use of

pricing based on prevailing market markups based on Net Profit Before Taxes. A 3-4% markup after

activity-based cost allocation and after assignment of Other Costs - on NIBT would restore and ensure

profit for DOP. However, the higher pricing could lower demand. The markup could be fine-tuned to

maximize demand and profit though estimates and experiential determination of the demand vs. price

effect.

Limitations of the Profitability Study for the Two Customers

Limitations of the activity-based costing system and profitability analysis were considered. The

costs used to project the cost driver rates are a snapshot in time and are accurate for the previous year.

Use of the cost driver rates assumes that the overall mix of services does not change. Update of the cost

driver rates would be required periodically to reflect changes in the balance of services.

Other Factors to Explain Profitability

Customers may not realize that they are using relatively high-cost services. Education of the

customer could help profitability. Activities such as manual order entry, Desktop Delivery, and lack of

standardization mean higher costs. Standards could mean fewer line items and less cost. DOP could

bring awareness that prompt payment of accounts receivable balances would help lower costs. DOP

could also ask why Customer A uses the internet for 50% of orders and learn if there is margin for

increased internet order entry. Through education and interaction, DOP could also discern the

customer’s needs. This is necessary to assist customers to be deliberate in the choice of the highest

value services.

Applicability of Relative Profitability to Entire Customer Base

The proposed activity-based costing system should be extended to the entire customer base,

followed by a test of profitability of all customers. At a minimum, a one-time profitability analysis of all

customers is indicated in order to provide an apples-to-apples comparison of customers.

Once this profitability “check” has been completed for all customers, DOP would have clarity on

whether customers were profitable or not. DOP could be confident that there are no more latent and

unexpected losses imminent. The decision to continue profitability analysis on an ongoing basis requires

judgment of the effort required vs. the value gained.

Applying the proposed pricing system to all customers will force either price increases or

reductions of service. One factor that should be considered is volume of sales on a per customer basis.

Major customers will likely expect a volume discount pricing structure; price increases will require

negotiation. The decrease in demand following a price increase is difficult to predict. The impact of

losing a major customer is a more clear result.

What If: Major Customer Shifts from Manual Orders to Internet

If a major customer primarily enters orders manually, a shift to all internet orders could

constitute a substantial decrease in expenses for DOP. The total cost impact for manual entry of

customer orders and the associated entry of line items constitutes a spend of $760,000 in 2000. Manual

order entry consumes 95% of the available resources. Comparison of manual entry cost to internet

entry cost represents a potential decrease of at least 67%.

If the customer constitutes 10% of total DOP sales, a total shift to internet order entry could

equate to (1-.67)*$76,000 = approximately $25,000 savings to the cost driver. Data entry resources

were assessed to be operating at capacity. The shift to internet orders would free up data entry labor.

In order to realize the savings, resources must be utilized in internet entry or other functions. Personnel

could be cross-trained to drive a forklift, pick stock, make deliveries, or support sales. If additional

resource demand did not accompany the shift to internet orders, a reduced labor cost would translate

to a decrease in data entry staff.

The potential for major shifts in service mix such as this could significantly change DOP’s cost

drivers. This potential underscores the need to revisit the activity-based cost driver rates on an annual

basis.

Conclusion

Profitability must be improved at DOP. Profitability can be ensured and unexpected losses can

be avoided through use of activity-based costing and pricing at the company.

The current cost allocation system at DOP provides inadequate information to manage the

business for a profit. For the services provided, DOP prices are too low to be profitable. The example of

two “similar” customers with very dissimilar activities illustrated the blind spots with the current cost

system at DOP. The proposed activity-based costing system would provide information necessary for

improved pricing.

Customers should understand the cost drivers for DOP’s business. Education will aid customers’

deliberate choice of services with the highest value to them.

Extension of the analysis of relative profitability to the entire customer base has value as a test

of overall profitability for DOP. Use of the method outlined here will also provide clarity and confidence

surrounding individual customer profitability.

But, new pricing would be higher and could lower demand. Major customers will likely expect

advantaged pricing or service concessions. Price increases should be fine-tuned to maximize demand

and profit though estimates and experiential determination of the demand vs. price effect.

Finally, past performance has value to predict future cost drivers but should be revisited

annually or more frequently if needed. This is because major shifts in the balance of services provided

by DOP could significantly change the cost drivers.

References

Kaplan, R. (2005, February). Dakota Office Products. Harvard Business School Publishing, Boston.