ZesOptics Management Team - Assignment Example

1) ZesOptics’ management team abandoned Dee Willis’ initial customer profitability report because Angelique Deboir’s Activity-Based Costing (“ABC”) approach appeared to offer a higher probability of successfully understanding the firm’s profitability problem. Indeed, ABC does have considerable advantages over the traditional approach to customer cost allocation; but in allowing Angelique Deboir to “take control of the meeting” and focus entirely on ABC, the management team failed to focus on other equally important issues. Dee Willis presented a customer profitability report based upon a simplistic allocation of sales and administrative costs as a percentage of sales revenues. Jake Lee, as Customer Relations Manager, was familiar with the amount of service each major customer demanded of ZesOptics, and thus he immediately realized that this cost allocation was problematic: BE, in particular, placed much heavier demands on the company’s sales and administrative departments than Dee Willis’ analysis indicated. Dee Willis explained how she had allocated costs, without providing any real justification for her choice of allocation method. Jake Lee then switched topics, questioning the fact that sales revenues had grown only 1% while administrative costs had grown by 2%; nobody responded to his point, even though it was quite relevant to the discussion. Dee Willis then suggested looking more closely at the five key customers’ gross margins, supporting her idea only by stating (or implying) that this was “what most companies do”. Again, nobody directly addressed her point—and this was a significant mistake, because (as shown in blue in Schedule 1 of the attached spreadsheet) some simple margin analysis would have uncovered one of ZesOptics’ major profitability problems. Angelique Deboir then stepped into the discussion, responding only to Jake Lee’s first point regarding the allocation of sales and administrative costs. She quite correctly agreed with Lee that Dee Willis’ cost-allocation system was less than convincing given the real difference in customers’ demands on the firm’s resources. A more detailed, ABC-based customer profitability analysis would indeed give ZesOptics’ management a better idea of the levels of service required by each customer, and thus of each customer’s real profitability. It could also give management some ideas regarding possible cost savings, both on a per-customer and on a company-wide basis. However, ABC alone would not address all of ZesOptics’ problems. 2A) Activity Based Costing is a general concept for allocating various forms of indirect cost. ABC can be applied at various levels of a business—for example, it can be used to allocate indirect costs such as inventory management, equipment maintenance, and so on to manufacturing processes, so that the Cost of Goods Sold on a per-product basis more accurately reflects the actual costs of manufacturing each product. Obviously, better knowledge of the true cost of goods sold can be very useful in setting prices (Wynder, pp. 16-17). In the case of customer profitability analysis, ABC can offer management a much better picture of each customer’s actual demands on their company’s resources. Customers who place large orders for standard items, pay for them promptly, and don’t ask many questions clearly make relatively small demands on sales and administrative staff; customers who place smaller orders, demand customization, require frequent nagging to pay their bills, and have lots of questions and complaints require a great deal more time and resources to service (Wynder, pp. 30-32; Searcy, p. 1). Whether it is used to allocate indirect manufacturing costs among products or to allocate sales and administrative costs among customers, ABC is most useful (A) when the costs involved are a significant part of the overall cost structure of a business (Wynder, p. 16); and (B) when different products manufactured or customers serviced involve significantly different demands on a company’s resources (p. 42). 2B) The cost driver rates for the new customer profitability system are shown in Schedule 2B/1 of the attached spreadsheet; the template for determining customer profitability is in Schedule 2B/2. Note that the template could be enhanced such that total sales, total expenses for various categories, and other inputs are parameters rather than constants. Note also that non-customer-related administrative expenses have been added, allocated according to sales revenue; this will ensure that these administrative expenses (which totaled $30,000 in 2010) are not “lost”. 3) See Schedule 3A of the attached spreadsheet for profitability calculation for ZesOptics’ five key customers. Schedule 3B of the spreadsheet compares the new profitability results with Dee Willis’ customer profitability report. Because the new template includes an allocation of non-customer-related administrative expenses according to sales revenues (which is how Dee Willis allocated all sales and general administrative expenses), the “Customer Net Profit” figure rather than the “Profit from Customer Activity” is appropriate for comparison to Dee Willis’ “Customer Profit” figure. (Alternatively, Dee Willis’ “Customer Profit” figure could be adjusted by removing the effect of general administrative expenses.) As shown in the spreadsheet, ABC allocates significantly lower sales and administrative costs (and thus higher profits) to customers BO and ET, and allocates significantly higher costs to the remaining three key customers. In the case of BE and UO, the change in cost allocation changes very small profits to substantial losses; for FE, profitability is reduced by a bit under 20%. 4) The three customers whose sales and general expenses increased when allocated by Activity Based Costing had lower sales revenues than BO and ET, and yet they all placed more regular and special orders than BO and ET, made an equal (in the case of UO) or greater number of sales-department inquiries, were sent a substantially higher number of invoices, received more packed boxes of merchandise, and (except for FE) received a larger number of separate deliveries. The effect of the difference in orders, special orders, and invoices sent is especially significant. Schedule 4 of the spreadsheet highlights differences in the average sales revenue per order (combining regular and special orders into a single category), per invoice, and per carton packed. It is worth noting that the same two customers whose profitability benefited from the switch to ABC also received more sales visits than the other three customers; this suggests that perhaps increased attention from the sales department may be one way of reducing the other customers’ use of ZesOptics’ administrative resources. 5) While ABC customer profitability analysis is more sophisticated and probably more accurate than profitability analysis using traditional cost allocation, it does have some significant limitations: While ABC can be used to refine manufacturing cost analysis, in this case ABC has been used only to allocate non-manufacturing costs. Since ZesOptics’ COGS is more than five times its total sales and general administration expenses (and almost six times its customer-related S&G expenses), it is quite possible that focusing on S&G expenses is not actually the most productive way to reduce overall company costs (Wynder, p. 42). ABC analysis ignores the revenue side of customer profitability. In the case of ZesOptics, there are several reasons to be concerned about margins: First, the company’s overall gross margin has declined from 26% in 2009 to 25% 2010, since sales have increased by 1% (or $20,000) while COGS has increased by more than 2% (or $34, 500). Further, the biggest reason that BE and UO are unprofitable (or, based on the analysis performed with traditional cost allocation, only barely profitable) is that these two customers are being sold products at a much lower markup than the other customers analyzed, or than ZesOptics’ customer base as a whole. As shown in Schedule 5 of the spreadsheet, if these two customers were sold the same products at the firm’s current average markup of 33% instead of their current markup of 17.6% (i.e. gross margin of 25% instead of 15%), they would both be substantially profitable even if no cost reductions could be achieved. (Certainly their cost profiles do not suggest any valid reason why these two customers should be getting such advantageous pricing!) Without some more historical data, ABC analysis does nothing to explain why S&G expenses have risen twice as fast, in percentage terms, as sales revenues. Obviously, ZesOptics wants to become more, rather than less, efficient over time; extending the ABC analysis to include past years might yield some insight into why S&G expenses have been rising faster than sales growth would justify. Because ABC’s cost allocations per “driver unit” look like marginal costs, it is tempting to treat them as if they were—and thus to attempt to reduce expenses by reducing the use of particular cost drivers. However, ABC does not actually tell us which allocated costs are genuine marginal costs and which are in fact fixed (or semi-fixed) costs; most costs are really somewhere in between. In the case of ZesOptics, sales visits and deliveries are largely marginal costs (albeit, in the case of sales deliveries, a cost with significant benefits attached), while sales contacts are likely more of a fixed than a marginal cost. We might be tempted by our ABC analysis to try to “fix” BE and UO by, for example, reducing the number of separate orders they place, along with the number of invoices issued and cartons packed, by 50% while maintaining sales revenue; but while doing so would certainly make these particular customers look better in the ABC profitability analysis, it is far from clear that ZesOptics’ overall profitability would actually improve significantly. Additional investigation can reveal the areas where reducing the use of cost drivers would actually result in significantly reduced costs, and where it would simply mean shuffling numbers around without really improving the company’s bottom line (Searcy, p. 6). 6) The first point of attack in addressing the unprofitability of BE and UO is to improve their gross margin; as things stand, these customers are being sold products at such a low markup that even without ABC-based profitability analysis they are not significantly profitable. What ABC does for ZesOptical in this regard is simple: it shows the company that these customers are so unprofitable that if they take their business elsewhere due to increased prices, ZesOptical hasn’t lost much. The next issue to address is these two customers’ inflated number of orders, shipments, and invoices. Before doing anything to change customer behavior, management should investigate the extent to which reducing the use of these cost drivers would actually reduce costs; if the real savings would be minimal, there is no point in trying to change customer behavior. On the other hand, if management believes that substantial savings could be achieved in this area, ZesOptics can influence customer behavior by providing economic incentives—for example, by offering progressively larger discounts for progressively larger orders. Sales contact expenses might be reduced by publishing clearer and more detailed terms and conditions, reducing the number of questions customers need to ask. A third issue to address applies to all customers, but especially to those who issue a large number of orders and are sent a large number of invoices: management should investigate the extent to which unit costs for these activities can be reduced without harming ZesOptics’ quality of service. For example, the current process for order entry seems old-fashioned and needlessly expensive; customers should be able to enter their orders online through a secure Internet site, avoiding the necessity for a ZesOptics employee to receive a phone call and enter order details into ZesOptics’ computer system (or scan a fax). The billing process likely also has considerable room for increased efficiency. 7) The first way in which customer profitability analysis should be used to increase ZesOptics’ profits is not directly connected with ABC—it involves identifying those customers for whom the gross margin/markup are too low, and taking appropriate action to improve margins for these customers. ABC can contribute to this process by helping to identify customers for whom lower prices might be appropriate due to their lower cost-to-service, and others (like BE and UO) that are particularly undeserving of discounts. Customer profitability analysis should also be used to identify particularly profitable customers, since it would be to ZesOptics’ advantage to enlarge these customer relationships and seek out new customers with similar characteristics. The second way to use customer profitability analysis is to identify potentials for increased efficiency—both in how services are provided to customers, and in how customers use services. For example, when a customer is placing a routine order, it is inefficient to have a customer employee talking on the telephone to a ZesOptics employee who must type the order into ZesOptics’ computer; instead, the customer employee should be entering the information directly (typically via a website), and ZesOptics employees should be involved in the process only to answer questions or deal with unusual situations. Customers should also be given economic incentives to lower their use of ZesOptics services—for example, by receiving discounts for large orders and/or placing their orders online instead of by telephone. ABC is helpful in this regard in that it highlights the specific activities where efficiencies are likely to be available, even though ABC alone does not tell us precisely where savings can be achieved or how much can be saved. References Harvey, Roger K. & Mullins, Peter L., “Implementing Activity-Based Cost Accounting, Customer Profitability, and Product-Line Analysis in a Distribution Business”, 2003 (?), available at http://www.valueassociates.org/Web%20Articles/White3.pdf . Searcy, DeWayne L, “Using activity-based costing to assess channel/customer profitability”, Management Accounting Quarterly, Winter 2004, available at http://findarticles.com/p/articles/mi_m0OOL/is_2_5/ai_n6102141/?tag=content;col1 . Wynder, Monte, “Activity-Based Costing and Customer Profitability”, undated, University of the Sunshine Coast, Queensland, Australia, available at http://www.hs-augsburg.de/~wellner/ProfMonteWanderAustria/ActivityBasedCostingWynder.pdf or http://tinyurl.com/36hjcp4 . Read More