I have a case analysis about cost accounting. The attachments are the case and questions.

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Purdy Call Centers Case Questions 1. What are the pre-determined overhead rates (burden rates) for the years 2000 through 2003? 2. What are the reported costs by client for the years 2000 through 2003? In your calculations, assume that the average hourly operator wages in 2000-2003 is $25 per operator hour. Be sure to report total costs for each client in each year (for Smith, the total costs in 2002 and 2003 are $0 since PCC lost them as a client after 2001). 3. What are possible explanations for the increase in costs in 2002 and 2003? Hint: For this question, split the time period 2000-2003 in half, and compare costs in 2000 and 2001 to costs in 2002 and 2003 (both in total and by client). Given the information in the case, does this increase make sense? 4. Describe what you think would happen to Purdy's profits (both by client and in total) if the firm decides to drop Krag as a client. 5. If you were Cal Purdy, then how would you bid on Krag's contract? Purdy Call Centers This is crazy, we lost a major client two years ago and now we are about to raise our fees to our largest client! Last year we almost lost another client by asking for fees that he claimed were excessive. Since we were founded we have dedicated ourselves to becoming ever more efficient, but recently our costs have climbed to such an extent that one of our clients is now losing money. Unfortunately, that client is talking about going somewhere else if we do not drop our fees. I just do not know what to do. Cal Purdy, President Purdy Call Centers Inc. (PCC) is located near Bad Axe in Huron County, Michigan. Bad Axe is located in the tip of the Thumb, a predominantly rural area containing only a small number of light industrial firms. The primary employers, other than the farming community, are Wal-Mart and K-Mart, several supermarkets, and some tourist-related operations. Unemployment in the region has historically been high and wages are correspondingly low. In 1995, Cal Purdy, founder and President of the company, decided that the Thumb area was a good place to locate a call center. Like Gateway, he believed that moving to a rural, low cost area would enable the firm to achieve low costs without sacrificing quality. Purdy's strategy is to provide superior call center support services to a limited number of customers. The typical PCC client is a small to medium size firm that has a relatively sophisticated product that requires skilled phone support. PCC only supports US and Canadian based enquiries and will not accept clients that want international support. Many firms require the services of a call center, but choose to outsource to firms like PCC. Two motivations are typically given for the decision to outsource call center activities, economies of scale and non-core competence. Economies of scale come into play because many firms do not have a critical mass of calls to justify the expense of operating their own private call center, so they can save money by outsourcing. Non-core competencies come into play when the senior management team, while agreeing that excellent call center service is necessary for business success, does not view it as mission critical. A third motivation that is less commonly identified is the higher level of service that can be supported by a professional call center. Call Center Operations To the uninitiated, a call center is a simple environment consisting of a number of telephone lines and individuals to answer them. In practice, however, they are often highly sophisticated environments requiring considerable computer support. When a PCC operator answers the phone, the entire process is recorded for quality assurance review purposes and, when appropriate, the call is used to provide training support for new hires. The operator keeps 1 detailed notes of the interaction with the caller on PCC's computer system and makes recommendations on how to cure the problem that the caller is experiencing. If the caller subsequently calls back, the case number assigned at the beginning of the first call allows another operator to access the event log and quickly come up to speed by reading the previous operator's (or operators' if the problem is particular difficult to resolve) detailed description of the steps taken to date. The event log is designed to ensure that the caller is not forced to repeat the same story again and again or even worse repeat a series of corrective steps that have already proven to be ineffective. The computer system is more than just a sophisticated note taker, it also provides the operator with specific guidance on how to resolve the problem that the caller has encountered; for example, if the caller is having trouble with setting up his or her electronic equipment, the computer system provides the operator with a step by step procedure designed to enable the caller to achieve successful setup. These computerized problem solving systems allow relatively inexperienced and unskilled individuals to provide effective support via phone. About 10% of PCC's operators are more knowledgeable and act as supervisors. Supervisors are primarily responsible for solving problems that are either undocumented or too complex for the computer system to handle. When an undocumented problem is encountered, it is flagged in the computer system and the Response Resolution Team (RRT) is automatically notified. The RRT is responsible for reviewing the event log and writing up a formal step-by-step procedure to resolve the problem. When that problem is encountered again, any operator can access the step-by- step procedure to quickly resolve the problem for the caller. The RRT is also responsible for working with the firm's clients to develop the initial response protocols for each product and to provide clients with feedback about each problem encountered so that future products and updates can be designed to avoid repeating the problem. This feedback is often critical to the firm's clients and PCC prides itself on the speed and accuracy of the feedback that it provides. Client Staffing Protocols In 2002, PCC had just four clients (see Exhibit 1 for a descriptive list of all clients since inception). These clients are either electronic equipment manufacturers or software houses. All of the client firms sign long-term contracts with PCC. The average contract is for three years and reflects the high initial investment that both firms have to make in developing the problem resolution software and training PCC operators. It is usual for a satisfied customer to renew the contract as changing call centers is a difficult and expensive undertaking. The firm's employment manual describes the rationale for the limited number of clients. According to Purdy, \"We choose to limit ourselves to a small number of clients (six or less) because it allows us to provide highly personalized service while still reaping economies of scale. We train operators to support two clients at a time. This policy allows us to better handle the peaks of service that vary by client and to have spare capacity when operators are ill or on medical leave.\" 2 Training and Overtime Training is an ongoing activity at PCC. Every time a client introduces a new product or upgrades an existing one, new software has to be developed and the operators trained on its use. Training usually begins with the client engineers' demonstrating the new product and explaining its features to members of the RRT and a select number of operators. Then, the operators and engineers discuss likely problems that callers might encounter. Finally, the operators practice on the problem resolution software to ensure that they know how to respond to the problems they are likely to encounter. Training consumes about 5% of an operator's time. Operator training that is specific to a client is tracked separately and directly charged to clients. In contrast, the salaries of the training staff are indirectly assigned to clients. The center is open from 8 am in the morning (Eastern Standard Time) until 10 pm (7 pm Pacific Time) six days a week; it is closed on Sundays. Since PCC only supports US and Canadian based callers, it avoids the need to operate on a 24/7 (24 hours a day and seven days a week) basis. From time to time operators are asked to work overtime. Most operators want to work some overtime to increase their take-home pay. Overtime is paid at 150% of normal pay and the average operator works approximately 10 hours of overtime per week. The advantage of overtime to PCC is the ability to absorb extra workloads without having to hire additional employees. For example, when a client introduces a new product, the operators who support that client have to work long hours as they both support the existing products and train up on the new one. Overtime expenses are indirectly assigned to clients. Organization Structure PCC is functionally organized (Exhibit 2). Fred Thatcher, manager of the operations department is responsible for scheduling operator time and interfacing with the training and RRT departments. Two secretarial assistants support Thatcher. Cynthia Navarro, manager of training is responsible for ensuring that all operators are adequately trained and that the training staff is up to date on client product features. Navarro has one assistant. Jack Ryan, who has one secretarial assistant, heads the RRT department; finally, building and grounds is managed by Dick Morgan. Department heads are responsible for hiring and evaluating the individuals that report to them. Department heads report directly to the President, who has an executive assistant. Finally, Mary Roby, the COO and CFO, reports directly to the President. Roby has a team of two accountants and an assistant who report to her. Budgetary Process The first step in the budgetary process consists of estimating the total number of hours of operator time expected to be dedicated to each client in the coming year. This estimate encompasses the time each employee is expected to be spent both on processing calls and on being trained on client-specific software. The budget is based on the actual time spent on each client last year adjusted for expected changes in the workloads for the coming year. For example, if 50 full time equivalents (FTE) were consumed by a client in the previous year and 3 the client had predicted that the number of calls for the coming year would increase by 10%, the budgetary process assigns 55 FTE to the client for the coming year. The firm has a standardized chart of accounts that defines each of the firm's two direct and thirteen indirect cost categories (see Exhibit 3 for a description of these accounts). At the end of each year, the CFO and her staff estimates the expected level of expenses associated with each indirect account for the coming year. To obtain these estimates, they discuss each account with the department heads responsible for the resources it represents. For example, support staff wages is captured in account number 21000; since every department in the firm employs individuals that provided staff support; Roby and her team talk to all of the department managers to obtain estimates for this account. More specifically, they talk to Jack Ryan to obtain an estimate of RRT's wages for the coming year, to Dick Morgan to obtain an estimate of buildings and grounds wages. Finally, they also talk to Purdy to obtain the estimated wages for his executive assistant and to the departmental managers that have assistants to estimate their wages. All of these estimates are summed to give the budgetary total for that account for the coming year (Exhibit 4). Once the total costs of all of the indirect accounts are estimated, the total anticipated overhead for the coming year can be determined (Exhibit 5). Cost System PCC had used the same cost system since its founding. Mary Roby, the CFO described its history, \"My previous position was with a manufacturing firm. I originally thought that the call center would need a totally different approach to costing, but I was wrong. I essentially took the system that we used at Knapp Industries and applied it here to generate fully-absorbed client costs. The only real changes are in the nature of the overhead costs and the fact that we have no direct material content to our products. Oh yes, and of course here we determine the cost of clients, not products.\" The budgeted operators' costs for answering calls and training are directly assigned to each client. All other costs are indirectly assigned in proportion to operator hours. Roby explained why operator hours is used instead of operator dollars, \"Operators are paid based upon their level of experience, with an experienced operator making about 25% more than a new hire. However, we do not assign operators to clients based upon their level of experience. Consequently, we do not want to charge one client more than another simply because more experienced operators are currently assigned to that client.\" To determine the overhead rate for the year, the total amount of budgeted indirect costs is divided by the total estimated operator hours. The fully absorbed cost of each client is determined by summing the cost of the operators' wages dedicated to that client (which includes an allowance for down time) and the operators' hours multiplied by the overhead rate. During the year, PCC records the actual time spent on each client. The computer system tracks time spent on each call by operator by client, operator down time (i.e., the time not spent answering calls), and training time by client. The down time is analyzed weekly to fine-tune operator assignments. For example, if over a period of several weeks a client's calls are only 4 sufficient to keep 40 FTE busy and 45 FTE were currently assigned, then five FTE would be reassigned to other clients. While the firm maintains relatively high employee retention rates, it is usually possible to adjust operator levels to match demand to a fairly accurate degree. Consequently, down time is limited to about 10% of total available time. The actual cost of the indirect expenses are accumulated monthly and compared to the budget. Any account category that shows excess spending compared to the budget is subjected to a managerial review. For example, if supplies are running above expectations, management would request that Finance analyze the expenditures on supplies for the last few months to understand why they are higher than expected. Whenever possible, corrective action is taken to bring spending back into line. The budget is not restated during the year even if conditions change quite significantly. Roby commented, \"We want the annual budget to really mean something. If we allowed people to change it at will, it would lose a lot of its authority. We compute variances monthly and expect our managers to find ways keep spending to their previously agreed budgetary levels.\" Fee Structure The firm's fee structure is based upon the number of operator hours expended on the client over the year. Each client contract is negotiated separately. From PCC's perspective, the primary objective is to generate an acceptable return for PCC's shareholders by charging an hourly fee that well exceeded the fully absorbed hourly cost. Since all operator hours have the same reported cost, the differences in hourly fees reflects the intensity of the negotiations with the client and not specific differences in the level of resources dedicated to each client. Clients are billed monthly and the fees are based solely upon the number of FTE dedicated to the client. If the FTE dedicated to a client changed during a month, the fee is adjusted correspondingly. At the end of the year, PCC provided each client with an efficiency report that documents the total level of down time and training for all operators that were dedicated to that client. The training time reported is specific to each client, but since each operator serviced two clients at a time, the downtime was assigned equally to each client. For example, if an operator had 100 hours of downtime in a period, then each client was assigned 50 hours. When the system was first designed, there was some discussion about assigning these costs based upon the ratio of time the operator spent on each client, but in the end the simpler 50-50 solution was adopted. In 2001, two of the five client contracts that were currently in force, Carlin Software and Smith Electronics, came up for renewal. Unfortunately, one of the firms decided to go in-house and open their own call center. P urdy commented, \"It was a serious blow to the firm when we lost Smith Electronics. We spent six months looking for a replacement client before we laid off some of our operators. Now two years later, we still have not found a replacement for them. Unfortunately, the number of firms requesting bids for call center services for the first time is small and firms rarely switch call center providers because the cost of developing the new relationship is so high. It is a thin market out there.\" 5 In 2002, the Gunn Computers contract came up for renewal and, after rather unexpectedly strenuous negotiations, a new hourly rate was established. This rate, while higher than the previous one, generated a lower profit level than in the first year of the original Gunn contract. Purdy commented, \"We tried to increase the fees for Gunn Computer so that it generated the same profit percentage as the original contract, but they really pushed back and in the end we were forced to accept a lower profitability rate.\" At the end of 2003, the two more clients, Krag Wireless and Mason Software, were scheduled to come up for renewal. They were both happy with the level of service that they were receiving, but were waiting to review PCC's latest fee structure. The CFO of Krag Wireless, in particular, had warned Purdy that they would seek other bids to ensure that PCC's prices were competitive. Mason Software seemed less concerned as long as the fees were \"reasonable.\" Purdy commented, \"I am really concerned about this fee issue, especially for Krag Wireless because we currently lose money on that account. The fundamental problem is that we are incurring higher costs to serve our clients than we did in the past. A lot of the increase reflects the higher level of service that they are now receiving, but some of it appears to be due to a loss of efficiency on our part. I have initiated a cost reduction campaign and we have taken some costs out of the firm over the last couple of years, but our fees will still have to be increased to offset our higher costs.\" 6 Purdy Call Centers Exhibit 1 Client List from Inception Client Name Status Carlin Software Current Gunn Computers Krag Wireless Mason Graphics Smith Electronics Description Develops accounting packages for dental offices. Tracks billing and insurance co-payments by health plan. Major selling point: comprehensiveness of package. Current Manufactures high-end personal computers gaming systems based upon Wintel technologies. Major selling point: extremely fast video processing speed. Current Manufactures high-speed local area networks for small businesses and schools. Major selling point: network stability. Current Develops 3-D animation software for commercial use. Major selling point: ease of use. Did not renew Manufactures digital video recorders and provides contract in download service for all major cable and satellite 2001 systems in the US. Major selling point: very high storage capacities. 7 Purdy Call Centers Exhibit 2 Organization Chart CEO Cal Purdy CFO Mary Roby Executive Assistant Finance and Accounting Staff Operator Department Fred Thatcher Secretarial Assistant Training Department Cynthia Navarro Secretarial Assistant Operator Staff RRT Department Jack Ryan Support Staff Secretarial Assistant Training Staff Buildings and Grounds Dick Morgan Programmer Staff 8 Purdy Call Centers Exhibit 3 Standardized Chart of Accounts Account Number Name 10000 Operator Wages 10500 Operator Training Wages 20000 Operator Benefits 20100 20200 Operator Overtime Unused Operator Time 21000 Support staff wages 21050 Support staff benefits 30000 Managerial Salaries 30050 Managerial Benefits 40100 50100 Depreciation Equipment Depreciation and property taxes building. Communications 60100 Supplies 60200 60300 Utilities Miscellaneous 40200 Description The wages of all operators. These costs are assigned directly to each client. The wages of all operators while training for specific clients. These costs are assigned directly to each client. The benefits such as health care and retirement that are paid to the operators. Overtime paid to operators Operator time that cannot be assigned to a client because the operator is excess to current requirements. Wages of support staff such as secretarial and buildings and grounds. The benefits such as health care and retirement that are paid to the support staff. The salaries of the management team. Includes all individuals above the supervisor level, including the manager of the Response Resolution Team. Also includes all training and finance department salaries. The benefits such as healthcare and retirement that are paid to the management team. The depreciation charge for all call center equipment. Primarily computer systems. The depreciation charge and property taxes for the building Includes costs of the telephone lines and high speed internet connections. Stationary, computer supplies, and other miscellaneous supplies. Includes costs of electricity and gas. Includes consulting and other infrequent expenses. 9 Purdy Call Centers Exhibit 4 2003 Annual Budget Process Account 21000 2003 Budget Process Account 21000 Support Staff Wages $(000) RRT Wages CEO - Executive Assistant Wages Operator - Secretarial Wages Training - Secretarial Wages Finance Secretarial RRT - Secretarial Wages Buildings and Grounds $1,250 $100 $80 $35 $50 $35 $40 Total $1,590 10 Purdy Call Centers Exhibit 5 2000 - 2003 Annual Budgets ($000) Account 2000 2001 2002 2003 Revenue $ $ $ $ $ 2,170 2,555 5,120 3,885 4,560 $ $ $ $ $ $ 18,290 $ 19,432 $ 16,485 $ 18,038 $ $ $ $ $ 620 655 1,600 1,050 1,200 $ 680 $ 725 $ 1,800 $ 1,200 $ 1,059 $ 720 $ 750 $ 1,900 $ 1,300 $ - $ 740 $ 775 $ 2,100 $ 1,500 $ - $ 5,125 $ 5,464 $ 4,670 $ 5,115 $ $ $ $ $ $ $ $ 1,708 769 1550 683 1,525 513 1,750 $ 1,821 $ 820 $ $ 1706 $ 728 $ 1,750 $ 625 $ 1,850 $ 1,557 $ 701 $ 530 $ 1575 $ 691 $ 1,750 $ 625 $ 1,950 $ 1,705 $ 767 $ $ 1590 $ 710 $ 2,010 $ 750 $ 2,050 $ $ $ $ $ 850 325 225 300 50 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Total Overhead $ 10,248 $ 11,105 $ 11,109 $ 11,397 Call Center Profit $ 2,917 $ 2,863 $ $ 1,526 Carlin Software Gunn Computers Krag Wireless Mason Graphics Smith Electronics Total Revenue 2,380 2,828 5,760 4,440 4,024 $ $ $ $ $ 2,520 3,075 6,080 4,810 - $ $ $ $ $ 2,590 3,178 6,720 5,550 - Operator Wages (includes training) Carlin Software Gunn Computers Krag Wireless Mason Graphics Smith Electronics Total Operator Wages Overhead Operator Benefits Operator Overtime Unused Operator Time Support staff wages Support staff benefits Managerial Salaries Managerial Benefits Depreciation Equipment Depreciation and property taxes building. Communications Supplies Utilities Miscellaneous Budgeted Operator Hours (000) 205.0 850 350 235 315 55 218.5 850 300 200 320 60 706 186.9 850 350 225 325 65 204.6 11