Dakota Case Solution

Introduction

The case may be used for your final exam on cost management issues. It works well as to
illustrate (i) how ABC applies in a service setting, and (ii) how to measure and manage
customer profitability.

The case describes an office products distributor that has just suffered the first loss in its
history despite the introduction of automated ordering capabilities that should have
lowered its operating costs.
The analysis reveals how the company’s traditional pricing scheme is no longer adequate as
Dakota, responding to customers’ requests, introduces enhanced service features such as
desktop delivery.

The case is actually a simplification of the complexity that a distribution organization would
actually encounter since additional features, such as break-packs for small orders (opening a
carton and picking out a few items to ship to a customer), that add even more costs for
some customer orders have been suppressed.

But the case contains enough variety and complexity at the customer order level that you
should get the general idea of how two customers of similar size can make very different
demands on a company.
You build a simple ABC model, apply the model to two customers, and then propose action
plans to deal with the unprofitable customer.

Questions

1. Why was Dakota’s existing pricing system inadequate for its current operating
environment?
2. Develop an activity-based cost system for Dakota Office Products (DOP) based on Year
2000 data. Calculate the activity cost-driver rate for each DOP activity in 2000.
3. Using your answer to Question 2, calculate the profitability of Customer A and Customer
B.
4. What explains any difference in profitability between the two customers?
5. What are the limitations, if any, to the estimates of the profitability of the two
customers?
6. Is there any additional information you would like to have to explain the relative
profitability of the two customers?
7. Assume that Dakota applies the analysis done in Question 3 to its entire customer base.
How could such information help the Dakota managers increase company profits?
8. Suppose that a major customer switched from placing all its orders manually to placing all
its orders over the internet site. How should this affect the activity cost driver rates
calculated in Question 2? How would the switch affect Dakota’s profitability?

Answers
Question 1: Why was Dakota’s existing pricing system inadequate for its current operating
environment?

Dakota’s pricing policy of a standard mark-up over its purchasing cost from manufacturers
was adequate when all customers were similar in terms of order size and delivery terms.
Some of Dakota‘s customers, however, had recently adopted just-in-time principles that led
to many small orders. In addition, Dakota had attracted new customers and retained others
by offering a new desktop delivery service that was considerably more expensive than
standard shipments. And Dakota had introduced new ordering channels—EDI and the
internet—that lowered both their customers’ costs of ordering and Dakota’s processing
costs. The different ordering channels introduced yet another dimension of variety among
customers.

Think-- “for two customers with the same annual volume of sales, what causes one to be
low cost-to-serve and the other to be high cost-to-serve?”.
The low cost-to-serve customer achieves its annual sales volume through only a few large
orders placed during the year, uses EDI or the internet to submit its orders, and requests
standard delivery. The high cost-to-serve customer manually places many small orders most
of all of which require desktop delivery.

Dakota satisfies the two key reasons for when activity-based cost systems can contribute
the greatest insights and value:
1. Large amounts of indirect and support costs: all of its operating expenses (other than cost
of items purchased) were indirect
2. High variety in product and customer demands

Dakota’s existing price system was a simple mark-up over purchase price (with a small
premium for desktop delivery). This system assumed that Dakota’s operating expenses were
proportional to the purchase costs of items it processed and delivered to customers. The
pricing system failed to recognize the cost that it incurred to serve its varied mix of
customers. As customer variety increases, a pricing scheme based on a standard mark-up
fails to recover the costs incurred for high cost-to-serve customers and perhaps overcharges
low cost-to-serve customers. Over time, the mix of customers can shift as the “over-
charged” customers defect to other suppliers and Dakota attracts more-high cost-to serve
customers because of its low prices relative to services offered.

As described in the case, the increase in complexity of orders processes has led to increases
in Dakota’s operating expenses. They have had to add personnel to handle the desktop
delivery option, and these people are fungible: they could either work in the warehouse
processing cartons or handle desktop deliveries. This information confirms that resource
costs at Dakota are variable. Increased work requires increased resources. If the demands
for work decrease, Dakota could reduce the supply of resources and lower its operating
expenses.

Question 2: Develop an activity-based cost system and calculate activity cost driver rates.

Work to develop a diagram of an ABC system for Dakota.

D-1: Activity Based Cost System Diagram for Dakota Office Products

You can have trouble deciding on the activity cost drivers for some of the activities. For
example, for desktop delivery, some students use number of cartons delivered to the
desktop (5,000) as the cost driver, yielding a cost driver rate of $88/carton. This isn’t correct
since the cost of the desktop delivery is independent of how many cartons get delivered
(the driver carries all the cartons at the same time in the delivery truck and delivers them in
one load to the customer’s destination).

But it is directionally correct since it does distinguish desktop from regular freight deliveries.
Also, while 80,000 cartons are processed through the warehouse, only 75,000 are shipped
by commercial freight.

So one needs to define two different activities—process cartons, ship cartons—because

The case describes, in a couple of places that Dakota’s resources were working at capacity
during 2000. For the basic cost driver rate calculations, we can suppress issues of capacity
utilization. This issue is raised in Question 8.

Question 3: Calculate the profitability of Customer A and Customer B.

D-2: Customer Profitability

Question 4: What explains the difference in profitability between the two customers?

Customer A is more profitable than average since it places only a few orders, of large size
(>16
cartons/order) and uses EDI for 50% of its orders. It makes no use of the costly desktop
delivery service, and it pays its bills on time (only 30 days of A/R).

Customer B, in contrast, shows a loss even before G&A expenses, though with an
assignment of interest expense based on its high average A/R of 90 days. Customer B places
lots of small orders (average order size is two cartons per order), places all it orders
manually (more expensive to process), and had 25 desktop deliveries.

Question 5: What are the limitations, if any, to the estimates of the profitability of the two
customers?

The analysis uses only transactional drivers (number of cartons, number of shipments,
number of orders processed).
Transactional drivers assume that every carton processed and shipped costs the same, and
that each desktop delivery costs the same.
Also, it assumes that all customers are identical in the time taken to set up an order, and all
EDI orders require the same degree of validation.
A more accurate analysis could use, for example, duration drivers for order processing and
intensity drivers (actual freight charges) for shipping expenses. Of course, using such drivers
is more expensive and the increase in accuracy may not be worth the higher measurement
expense.
Also worth mentioning is that the ABC system depends of subjective estimates, via
interviews, which introduces measurement error and the opportunity for employees to
distort the measures.
The analysis also ignores the assignment of General and Selling expenses, an issue that is
addressed in the next question.
Question 6: Is there any additional information you would like to have to explain the
relative profitability of the two customers?

The biggest gap in the analysis, especially given the emphasis in the case on customer
profitability, is an analysis of the large amounts of General & Selling Expenses. Dakota
should analyse its G&S expenses, as it did the warehouse and order handling expenses, and
drive these down to individual customers, calculating the cost of selling and the
administrative and customer relationship expenses attributed to individual customers.

Recognize that G&S expense was a large expense category that likely varied by customer
and hence should be analyzed in greater detail.

This is explicitly discussed in Kanthal (A), 190-002, which has been given to you as
assignment.

Question 7: Assume that Dakota applies the analysis done in Question 3 to its entire
customer base. How could such information help the Dakota managers increase company
profits?

The primary answer should be the role of pricing. Dakota could charge for special services,
such as desktop delivery ($220 per order rather than an arbitrary 1% to 2% mark-up).
Also, Dakota could offer discounts to encourage customers to order electronically or to
place larger orders.
For Customer B, pricing desktop deliveries and reducing the cost to serve by switching B
from manual to EDI order entry raise the contribution margin by more than $5,500.
Dakota could also charge 1% or 1.5% interest per month for receivables longer than 30 days
to reduce financing charges.
In general, these options are examples of menu-based pricing where the company earns a
target margin on its basic product or service, and charges premiums—at or above cost—for
special features and services.
In this way the company does not have to pressure customers to switch away from features
and services that the customer finds desirable.
Dakota could try to change its customer mix by focusing on customers with the
characteristics of high-profit customers, and de-emphasize customer types that are typically
low profit. Another action to affect the demand for activities would be imposing a minimum
order size, though other than order entry (setting up the customer order), order size does
not play a big role in Dakota’s economics.
You should also identify the opportunities for process improvements—try to schedule trucks
better to reduce the cost of desktop deliveries—or consider outsourcing the function to a
courier service (or UPS); try to improve the efficiency of warehouse operations—receiving,
moving materials (e.g., computerized materials handlers), and preparing items for shipment.

And, finally, as demands for activities change and activity efficiency improves, Dakota must
manage the resources no longer needed out of the system to realize the cost savings (this
issue shows up again in the next question). The activity-based management actions—
minimum order size, shift to more efficient order channels, improve operating efficiencies—
create unused capacity in Dakota’s resources. To capture the benefits, Dakota must either
acquire new business that can be handled with the now unused capacity (so operating
expenses will not increase as volume expands) or it must stop spending on resources no
longer needed.

Question 8: Suppose that a major customer switched from placing all its orders manually
to placing all its orders over the internet site. How should this affect the activity cost
driver rates calculated in Question 2? How would the switch affect Dakota’s profitability?

This question is designed to explore the role of capacity costing, and the desirability of
basing cost driver rates on practical capacity not actual (or budgeted) utilization. Shifting
orders from manual to internet should not change the cost driver rate.
The rate should be calculated at practical capacity, so even if the number of manual orders
declines, the cost of processing a manual order remains the same.
Cost driver rates change only when there has been a change in the efficiency (practical
capacity) of the activity, or a change in the prices of the resources supplied to accomplish
the activity.
The switch in submitting orders, from manual to internet, does not affect Dakota’s
profitability.
Only when Dakota eliminates one or more order entry clerks (because of reduced demand
for their services) does its profitability improve.

Summary:

You will have had the opportunity to build a simple ABC model in a distribution (non-
manufacturing) setting, estimate cost driver rates and customer profitability, discuss the
limitations of the simple model, propose action implications from the more valid cost
information, and consider the role of capacity in estimating cost driver rates and in realizing
the benefits from actions taken.