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 rightplace 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.

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If a TFC client made use of any of the distribution services, they were supposed to be charged a priceAfor the fonns 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 detennined 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 fonnula.

UNDERSTANDING CUSTOMER PROFITABILITY

With TFC profitability suffering in October

1992, General Manager John Malone began to question

the appropriateness ofthe distribution charges.

"The Business Fonns 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 sales people. 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

¹Whenever a customer requires fonns, they submit a requisition for all the different products they need. Each separate product request is a "line." Ifthe request is for whole cartons, it is considered a "carton line." For quantities Jess than a whole carton, it is considered a "pick-pack line."

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

fonns and the distribution of those fonns in response to a

customer requisition. He and John decided to talk to

some people in the field to get more specific infonnation.

DISTRIBUTION CENTER: ACTIVITY ANALYSIS

John and Tim visited Allied's Kansas City, MO distribution facility. Site manager Wilbur Smith confinned, "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. Ifwe 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 Jines on it, my guys still have to go pick a hundred items off the shelves. And those 'pickpack' requests. Almost everything is 'pick-pack' nowadays. No one seems to order a whole carton of 500

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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 valueadded 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 "Pick-Pack" Activity $734 Data Entry $612 Desk top delivery $250 Total $5, 708

Tim then estimated the following for 1992 based upon historical information and current trends for the sample of five warehouses:

On average, these 5 distribution centers scattered across the country, will have combined inventories of approximately 350,000 cartons (most cartons were of fairly standard size).

They will process about 310,000 requisitions for 1992.

Each requisition will average 2.5 lines.

About 90% of the lines will require "pick pack" activity (as opposed to shipping an entire carton).

Cost of capital in 1992 was probably about 13%.

"Our new computer system is coming on line soon which will track individual freight charges," said

Tim, "so, we can just charge the client for what it actually

costs us." John and Melissa agreed that this sounded fair.

Some things that were said at the distribution

center still stuck in Tim's mind. "Don't you think we

should do something to get that old inventory moving?

What about charging something extra, say 1.5% per

month, for anything that's been there over 9 months."

"Great idea," Melissa said, "this will also help

protect us against the loss we often take on old inventory

when the clients end up changing their forms. You know

we just eat that and never charge them for it."

They were almost finished. "What about desk

top delivery?" Tim said. "I think we should charge extra

for it, but I don't want this to get too complicated."

John said, "How much extra time does it take

your guys on average to run around the client company?"

"I'd say about an hour and a half to two hours at

$15 per hour, that's about $30 each time. Sound fair?"

"Sounds OK to me. Also, that ties pretty well to

the $250,000 overall assignment, since we will process

somewhere around 8,500 'desk top' requests this year."

SERVICES BASED PRICING (SBP)

The entire management team, including Doug Kingsley, Chief Financial Officer of the Business Forms Division, felt that there had to be a better way of charging out distribution services to help TFC become more profitable. They now had a much better understanding of the drivers of costs involved in distribution services.

"It wouldn't be easy getting the sales force to accept an activity-based pricing program," John said. "Some of them get pretty stuck in their ways and don't like change. Some accounts would see increases because of the additional distribution charges under a Services Based Pricing (SBP) scheme. These salespeople wouldn't be very happy. On the other hand, some salespeople may see their margins increase." Overcoming these organizational problems would be only the tip of the iceberg.

The accounting department maintained a database which showed all activity against individual accounts and calculated a contribution from that account. However, they had not yet been able to use this information effectively. TFC management took their data and began to analyze it.

Although TFC maintained 1100 separate accounts, a large portion of the business came from very few accounts. The top 40 accounts represented 48% of the company's net sales (see Exhibit 3).

As a way of understanding customer profit

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ability, TFC management reworked the information in the database as ifthe accounts had been charged service fees base& on actual usage, leaving net sales and product cost the same as before. They recalculated contribution based on these figures. They ranked the accounts according to profit contribution. Exhibit 4 shows the top 20 accounts for the month of August and Exhibit 5 shows the bottom

20.

Since such a large part of the profit opportunity rested with so few accounts, management felt that it might be possible to significantly improve profitability by concentrating on individual account management. The team felt they were on the right track for improving account profitability and wondered what should be the next step. The also wondered what other issues might be important for improving the overall profitability ofTFC.

QUESTIONS:

1. From your review of the case, 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.

2. Is the classification of good and bad from "Week 8 - Profitability" based on service usage? Pricing? Is the customer really bad, or could there be another perspective to the problem AOP is facing? Explain your answer.

Answer rating: 100% (QA)

1 The profitability of customer A and customer B is very different Customer A is much more profitabl... View the full answer