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davis

davis

Z

davis

Z

davis

Managerial

Managerial

Accounting

Accounting

www.wiley.com/college/davis

Preliminary Edition


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Focus On

CUSTOMER PROFITABILITY

After studying this focus unit, you should be able to meet the following learning objectives (LO).

1

Use activity-based costing techniques to measure customer profitability.

2

Identify alternatives for managing unprofitable customer accounts.


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The Pitch Terrence Gleason and Beth Wommack sat in the main conference room at Bradley Textile Mills, chatting as they waited for the monthly sales staff meeting to begin. “I thought I was going to be late,” Beth said. “Taylor Byrd from Sparrow Designs just called with another rush order; I don’t know why they can’t plan any better. All their orders seem to be rush jobs.” “Well, they generate almost $2 million in revenue for us, so we need to keep them happy,” Terrence responded. “I know, I know, but they take up so much of my time. I think I spend more time with them than with all my other customers combined,” said Beth. “At least they’re really nice to work with,” she added. As the meeting began, Lindsay Stang, vice president for marketing and sales, announced that the top brass at Bradley Textile Mills wanted a complete review of all sales accounts. “Selling expenses have been growing rapidly—faster than sales—and management wants to know where all those dollars are going. I told them it’s a cost of doing business and keeping our customers happy,” Lindsay said. “Apparently, the chief financial officer just returned from a conference on customer profitability. He claims we don’t really know which customers are making money for us and which are costing us more than they generate in revenues. There’s no point arguing with him. If we want to continue to get the financial resources we need, we’re going to have to demonstrate that our customers are profitable.”

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Customer Profitability GUIDED UNIT PREPARATION Answering the following questions while you read this unit will guide your understanding of the key concepts found in the unit. The questions are linked to the learning objectives presented at the beginning of the focus unit.

1. What kinds of costs do companies incur in making sales to customers? LO 1 2. Why are selling costs pooled and allocated to customers rather than directly traced to customers? LO 1

3. How do you calculate customer net profit? Customer profit margin? LO 1 4. Give an example of customers who tend to drive up a company’s costs? Explain. LO 1

5. What can a company do if it has identified customers who are unprofitable? LO 2

6. Why might a company decide to keep a customer who is unprofitable? LO 2

Many organizations believe that as long as the sales revenue a customer generates exceeds the cost of goods sold, that customer is profitable. That isn’t the case, however. Measuring customer profitability in this way ignores all the selling and administrative costs incurred to provide customer service and support, such as warehousing, billing, and order processing. In this focus unit, you will learn how to measure customer profitability more accurately. In their book Killer Customers, Larry Selden and Geoffrey Colvin estimate that the top 20% of a company’s customers generates approximately 120% of the company’s profits, while the bottom 20% loses as much as 100%.1 This finding highlights the importance of identifying the unprofitable customers and finding ways to make them profitable. If unprofitable customers cannot be turned into profitable ones, the company should consider dropping them.

Identifying Unprofitable Customers When asked if their companies have unprofitable customers, many managers claim they do not. When Bradley Textile Mills’ sales manager, Terrence Gleason, was asked this question, he quickly pulled out the customer profitability report shown in Exhibit F5-1. “Granted, some of our customers are more profitable than others,” he replied, “but all 375 of our customers are profitable at some level.” The problem with Gleason’s analysis was that the only expense it considered was the cost of goods sold. A business also incurs selling and administrative expenses. Recall from Chapter 4 that selling expenses are associated with the storage, sale, and delivery of products to the customer. Administrative expenses are associated with the general management of the business. When we examined activity-based costing in Chapter 7, these costs were not included in our analysis, since they are not considered product costs. However, in addition to covering the cost of the product, the revenue a customer generates should also cover the

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BRADLEY TEXTILE MILLS Customer Profitability (Based on Cost of Goods Sold) Profitability Rank

Customer

Revenues $

4,819,150

Cost of Sales

Gross Profita

Profit Marginb

$

3,585,455

$ 1,233,695

25.6%

1

Morris & Morris

2

Sparrow Designs

1,978,812

1,484,109

494,703

25.0%

3

Harps of London

168,600

126,450

42,150

25.0%

4

Gold’s Upholstery

482,000

361,982

120,018

24.9%

5

Unique Uniforms

2,098,915

1,580,483

518,432

24.7%

6

C&C Sports

1,540,951

1,163,418

377,533

24.5%

7

MedTogs

4,154,500

3,157,420

997,080

24.0%

8

Florstan

67,200

51,408

15,792

23.5%

. . . 368

House of Drew

879,520

835,544

43,976

5.0%

369

Mullins and Jones

164,826

157,244

7,582

4.6%

370

Potter Drapery

94,608

90,256

4,352

4.6%

371

Huffmeyer Mills

648,425

622,488

25,937

4.0%

372

Mooney Productions

540,895

520,340

20,555

3.8%

373

Dawson Shade

64,572

62,183

2,389

3.7%

374

Shadowbox Supply

267,400

262,052

5,348

2.0%

375

Ralston Fabrics

349,800

342,804

6,996

2.0%

$200,000,000

$172,000,000

$28,000,000

14.0%

Total a

Revenue – Cost of sales b Gross profit Revenues

EXHIBIT F5-1

Bradley Textile Mills’ customer profitability.

selling costs associated with the purchase and provide enough margin to pay for administrative expenses and contribute to profit. What can managers do to get a better estimate of customer profitability? One way is to allocate selling expenses to customers through activity-based costing (see Chapter 7) using the following steps: 1. 2. 3. 4. 5.

Identify selling activities. Develop activity cost pools. Calculate activity cost pool rates. Allocate selling costs to customers. Calculate customer profitability.

Let’s look at the selling costs incurred by Bradley Textile Mills. As Exhibit F5-2 shows, the company incurred $16,815,000 in selling costs last year. After identifying all selling activities, Terrence Gleason’s group narrowed the list down to seven main activities. Then they developed seven cost pools and selected an activity driver for each. By dividing each cost pool by its annual driver activity, the company can determine the cost pool rates. For example, the company incurs an annual cost of $3,200,000 to make 3,200 sales calls to current and potential customers. That is $1,000 per sales call ($3,200,000 4 3,200). Once Customer Profitability

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all the activity rates have been calculated, Gleason can use the information shown in Exhibit F5-2 to allocate selling costs to customers and calculate customer profitability.

EXHIBIT F5-2 Calculation of cost pool rates for selling activity.

Activities Sales calls

Annual Cost

Annual Driver Activity

Activity Cost Pool Rate

$ 3,200,000

3,200 sales calls

$1,000 per call

Internet orders

2,600,000

130,000 orders

$20 per order

Catalog orders

2,925,000

45,000 orders

$65 per order

Standard packing and shipping

5,000,000

50,000,000 yards

$0.10 per yard

480,000

960,000 minutes

$0.50 per minute

210,000

600 returns

$350 per return

800,000 yards

$3.00 per yard

Support call center Product returns Express packing and shipping

2,400,000 $16,815,000

Think About It F5.1 Why aren’t administrative costs included in these selling cost activity pools?

Two different calculations can be made to measure customer profitability: customer net profit and customer profit margin. Customer net profit starts with the revenues the customer generates and subtracts both the cost of goods sold associated with those revenues and the selling expenses allocated based on the customer-specific selling activities. This measure shows managers how many dollars a customer contributes to the company’s bottom line. Customer profit margin divides customer net profit by customer revenues to obtain the profit percentage the customer generates for the company. The customer profit margin allows managers to compare customers based on how much each dollar of revenue they generate goes to the bottom line, regardless of the customers’ absolute sales volume. Customer net profit = Customer revenues – Cost of goods sold – Allocated selling expenses Customer profit margin =

Customer net profit Customer revenues

Let’s use Morris & Morris, Bradley’s most profitable customer according to Gleason’s analysis, to show how to measure customer profitability. As Exhibit F5-1 shows, based solely on cost of goods sold, last year Morris & Morris provided a 25.6% profit margin. Exhibit F5-3 shows an activity-based profitability analysis for this customer. Notice that Morris & Morris generates a customer net profit of $1,045,895 on sales of $4,819,150, which translates to a 21.7% profit margin. Even though the customer profit margin is lower than Gleason first thought, Morris & Morris is still a very profitable customer for Bradley Textile Mills.

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Sales

$4,819,150

Cost of goods sold

3,585,455

Gross profit

1,233,695

Selling costs Sales calls

12 calls 3 $1,000 per call

12,000

Internet orders

1,000 orders 3 $20 per order

20,000

Catalog orders

10 orders 3 $65 per order

Packing and shipping

1,230,000 yards 3 $0.10 per yard

Call center support

100 minutes 3 $0.50 per minute

Product returns

6 returns 3 $350 per return

Express shipping

10,000 yards 3 $3.00 per yard

Activity-based profitability analysis for Morris & Morris.

650 123,000 50 2,100 30,000

Customer net profit Customer profit margin

EXHIBIT F5-3

$1,045,895 $1,045,895 4 $4,819,150

21.7%

How does that customer profit margin compare to Bradley’s average customer profit margin? We can calculate the average customer profit margin using the numbers for the company as a whole (see Exhibit F5-1): Revenues Cost of goods sold

$200,000,000 172,000,000

Gross margin Selling expenses (Exhibit F5-2) Customer net profit

28,000,000 16,815,000 $ 11,185,000

Customer profit margin

5.6%

No wonder the chief financial officer wants to review the accounts (see The Pitch). Administrative costs still need to be paid from the $11,185,000 net profit, so Bradley’s net income is likely to be very low. With a customer profit margin of 21.7%—well above the average customer margin—Morris & Morris is a real winner for Bradley. A different picture emerges from an analysis of Bradley’s number two customer, Sparrow Designs. Gleason believes that Sparrow generates a 25% profit margin, but an activity analysis of the resources Sparrow Designs consumes, presented in Exhibit F5-4, shows otherwise. Gleason may need to reconsider his plans for this customer. What he thought was a 25.0% profit margin is really a 0.2% loss (($3,547) 4 $1,978,812). For every dollar in sales, Sparrow costs the company $1.02. Sales

$1,978,812

Cost of goods sold

1,484,109

Gross profit

494,703

Selling costs Sales calls

6 calls 3 $1,000 per call

Internet orders

0 orders 3 $20 per order

Catalog orders

230 orders 3 $65 per order

14,950

Packing and shipping

400,000 yards 3 $0.10 per yard

40,000

Call center support

3,000 minutes 3 $0.50 per minute

1,500

Product returns

28 returns 3 $350 per return

9,800

Express shipping

142,000 yards 3 $3.00 per yard

Customer net profit Customer profit margin

EXHIBIT F5-4 Activity-based profitability analysis for Sparrow Designs.

6,000 0

426,000 ($3,547)

($3,547) 4 $1,978,812

(0.2%)

Customer Profitability

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After following these same steps for each customer, Gleason obtained the customer profitability analysis shown in Exhibit F5-5. Now he cannot claim that all Bradley’s customers are profitable.

Revenues

Cost of Sales

Morris & Morris

$4,819,150

Sparrow Designs

1,978,812

EXHIBIT F5-5 Activity-based customer profitability analysis for Bradley Textile Mills.

Customer

Selling Costs

Customer Net Profit

Customer Profit Margin

$3,585,455

187,800

$1,045,895

21.7%

1,484,109

498,250

($3,547)

20.2%

Harps of London

168,600

126,450

8,100

34,050

20.2%

Gold’s Upholstery

482,000

361,982

44,835

75,183

15.6%

Unique Uniforms

2,098,915

1,580,483

65,015

453,417

21.6%

C&C Sports

1,540,951

1,163,418

57,030

320,503

20.8%

MedTogs

4,154,500

3,157,420

204,400

792,680

19.1%

67,200

51,408

20,495

(4,703)

27.0%

House of Drew

879,520

835,544

32,625

11,351

1.3%

Mullins and Jones

164,826

157,244

1,560

6,022

3.7%

94,608

90,256

5,234

(882)

20.9%

Florstan . . .

Potter Drapery Huffmeyer Mills

648,425

622,488

31,087

(5,150)

20.8%

Mooney Productions

540,895

520,340

207,800

(187,245)

234.6%

Dawson Shade

64,572

62,183

1,578

811

1.3%

Shadowbox Supply

267,400

262,052

37,337

(31,989)

212.0%

Ralston Fabrics

349,800

342,804

70,100

(63,104)

218.0%

Think About It F5.2 The customer profitability analyses in Exhibits F5-3 and F5-4 assume that cost of goods sold is the only direct cost, and all selling expenses are indirect (that is, they need to be allocated). What selling expenses might be traced directly to the customer?

Addressing Unprofitable Customers Now that the managers of Bradley Textile Mills have a better understanding of each customer’s profitability, they must decide what to do with the information. Recall from your study of activity-based management (Unit 7.3), that to the extent possible, non-value-added activities should be eliminated. Because most of these activities are generated by the customer, we can assume that they have some value to the customer, but managers need to investigate other, less costly ways to deliver the service. Drastically reducing the activities would not be a viable option. Customers generally want good service, and developing a reputation for good customer service is one way for a company to differentiate itself from its competitors. Therefore, we cannot expect selling costs to be reduced to some nominal level. For purposes of this discussion, we will assume that Bradley Textile Mills is delivering customer service as efficiently and effectively as possible.

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Reality Check—Sprint drops more than a call

In 2007, Sprint Nextel dropped about 1,000 customers because of their excessive use of customer service.

Cell phone customers have long complained about dropped calls. Now, some of those customers may be complaining about another kind of dropped call. In 2007, Sprint Nextel dropped about 1,000 customers because of their excessive use of customer service. After reviewing the customers’ accounts over a 6- to 12-month period, Sprint concluded that they averaged 40 to 50 calls to customer service per month. At an average cost of $10 to $20 per call, canceling their accounts could have saved Sprint $400,000 to $1,000,000 per month—if the company reduced customer service personnel. What is more likely is that the freed-up resources were deployed to other customer service activities. While Sprint may not have realized any true savings as a result of dropping the customers, the company may have improved its customer service image by handling other customer calls in a more timely manner. Sources: Barry Levine, “Sprint Saves Cash by Cutting Customers,” http://www.crm-daily.com/story.xhtml?story_ id=100001VW8F08 (accessed July 16, 2007); Samar Srivastava, “Sprint Drops Clients over Excessive Iinquiries,” The Wall Street Journal, July 7, 2007; David Twiddy, “Sprint Nextel Defends Axing Customers,” http://www.crm-daily. com/story.xhtml?story_id=100001VW8BUC (accessed July 16, 2007).

At first glance, it may appear that all unprofitable customers should be dropped, and that is exactly what some companies do. However, that is not the first action a manager should take after identifying an unprofitable customer. Before any action is taken, managers should evaluate all the implications of the action for the affected customer, for other customers, and for the company. Rather than drop an unprofitable customer, managers should first identify the reason the customer is unprofitable and then work with the customer to return to profitability. Let’s look at Sparrow Designs again. Exhibit F5-4 shows the activities performed to support this customer. Does anything look out of the ordinary to you? Do you see any opportunities for cost reduction? One that should jump out at you is express shipping, which consumes over 86% of Sparrow’s gross profit. Perhaps Beth Wommack, Bradley’s customer service representative, can work with Sparrow’s managers to encourage them to order earlier or in larger quantities, to avoid the need for express shipping. Another opportunity for improvement is order placement. Notice that Sparrow places all its orders through the catalog sales channel rather than the cheaper Internet sales channel. Again, Beth could educate Sparrow’s purchasing agents on the benefits of Internet ordering, which would reduce the cost to serve Sparrow while still meeting the company’s needs. That is what managers at Fidelity Investments did when they discovered how frequently some unprofitable customers called Fidelity’s customer service representatives. Representatives instructed the customers in how to use the company’s website—a much cheaper delivery method for Fidelity. As customers became more comfortable with the technology, their satisfaction increased, and unprofitable customers turned into profitable ones. Customer Profitability

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Customer profitability can also be improved by raising the prices unprofitable customers pay. If customers are using a service, they should value it enough to pay for it. For example, Terrence Gleason might consider charging Sparrow for express shipping. The same could be required of customers who order in small quantities that require warehouse workers to select and pack individual items rather than ship a full case. Prices for such customers may be higher than for customers whose orders require less handling. Raising prices for these customers is not a punishment for their unprofitability; it is merely a reflection of the cost of doing business with them. If the customer accepts the price increase or stops requiring costly activities, the company has turned an unprofitable customer into a profitable one. If the customer rejects the price increase and buys from a competitor, the company will be better off financially. All other things held equal, either result will improve the company’s profitability. Perhaps not all customers can be returned to profitability. If a customer remains unprofitable after efforts have been made to increase profitability, managers may reluctantly decide to drop the customer. Doing so will increase the company’s overall profitability, even though total sales revenue will decrease. Managers then will have more resources with which to serve profitable customers, and overall sales may eventually increase. Just as we saw in Chapter 7, however, the company cannot increase its profitability simply by dropping a customer. To increase the company’s overall profitability, the resources used to serve the unprofitable customer must be divested. If Bradley Textile Mills decides to eliminate some of its unprofitable customers but does not eliminate the resources (people and supplies) used to serve those customers, the remaining costs will be redistributed to other customers, reducing their profitability, even though there has been no change to Bradley’s overall profitability.

Think About It F5.3 What kind of impact might product demand have on your strategy for improving customer profitability?

FOCUS REVIEW K E Y TE RM S Customer net profit p. 404

Customer profit margin p. 404

SE L F STU DY Q U E STION S 1. LO 1 If you add up all a company’s customer profit margins, the total will equal net income. True or False?

2. LO 1 Which of the following selling expenses would be traceable directly to a customer?

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a.

Commissions based on the sales amount

b. Invoice processing c.

Technical support

d. Returns processing


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b. Dropping a customer with a 2.5% customer profit

3. LO 2 The only way to recover the losses from an un-

margin when the average customer profit margin is 6%

profitable customer is to stop selling to that customer. True or False?

4. LO 2 Which of the following will not increase a company’s

c.

net income, all other things held equal?

a.

Persuading a customer to accept an inexpensive activity rather than an expensive activity

d. All these actions will increase the company’s net

Reducing the resources dedicated to serving a customer

income

FOCU S 5 P RA CTICE EXERCIS E Compass Directives prints road maps of major cities and distributes them to bookstores, convenience stores, and gas stations. Each map costs $1.30 to produce and is sold to retail outlets for $2.00. Sales to three of Compass’s best customers last month were as follows: BookMasters Price’s QuikStop FastLanes

20,000 maps 15,000 maps 12,000 maps

Jason Paul, Compass’s sales manager, has gathered the following information concerning the company’s sales support activities: Total Annual Costs Small-quantity bundling Order processing Display setup Display replenishment

Annual Activity Level

$400,000 840,000 238,000 110,000

50,000 bundles 200,000 orders 1,000 setups 20,000 replenishments

As part of the study, Paul also calculated the following data on monthly usage of sales support services by the top three customers: Small Bundles Orders Display Setups Display Replenishments BookMasters Price’s QuikStop FastLanes

400 20

400 100 10

25 5

100 10

Required 1. Calculate an activity rate for each of the four sales support services. 2. Calculate the customer net profit and customer profit margin for each of the top three customers. 3. What actions could Paul suggest that BookMasters take to increase its profitability?

SE LE CTE D FOCU S 5 ANS WERS Think About It F5.1 Administrative costs, which are related to running the entire business, include rent (or depreciation) on the corporate office building, the president’s salary, and filing expenses for tax returns and other corporate documents. Though

customers benefit from these organizational expenditures, allocating such costs to customers is not practical. You may recall that general overhead costs were treated the same way in Chapter 7.

Think About It F5.2 Commissions on sales and shipping cost per unit are examples of direct selling expenses.

Think About It F5.3 When demand for a company’s products and services is greater than the supply, managers are not likely to be concerned about dropping customers. In a highly competitive environment, however, managers must carefully weigh the implications of charging for services that were once considered free. If customers can get the services they want

from another company, they may be quick to leave, and other customers may not replace them. Losing those customers could require more than simply cutting back on selling and administrative resources. If total sales decline as a result, it may require cutting back on production.

Focus Review

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Self Study Questions 1. False 2. A 3. False 4. B

Focus 5 Practice Exercise 1.

Small-quantity bundling Order processing Display setup Display replenishment

Total Annual Costs

Annual Activity Level

Activity Rate

A

B

A4B

$400,000 840,000 238,000 110,000

50,000 bundles 200,000 orders 1,000 setups 20,000 replenishments

$8.00 per bundle $4.20 per order $ 238 per setup $5.50 per replenishment

2. BookMasters Unit Price/ Cost Revenues Cost of goods sold Small-quantity bundling Order processing Display setup Display replenishment Customer net profit Customer profit margin

$ $

2.00 1.30

Units 20,000 maps 20,000 maps

$ 8.00 $ 4.20 $238.00

400 bundles 400 orders 25 setups

$

100 replenishments

5.50

Price’s QuikStop

FastLanes

Revenue/ (Cost)

Units

Revenue/ (Cost)

$ 40,000 (26,000)

15,000 maps 15,000 maps

$ 30,000 (19,500)

(3,200) (1,680) (5,950) (550) $

20 bundles 100 orders 5 setups 10 replenishments

(160) (420) (1,190) (55)

Units 12,000 maps 12,000 maps 0 bundles 10 orders 0 setups 0 replenishments

Revenue/ (Cost) $ 24,000 (15,600) 0 (42) 0 0

2,620

$ 8,675

$ 8,358

6.55%

28.92%

34.83%

3. BookMasters consumes many more activities than the other two customers, even allowing for the number of units the company purchases throughout the year. Display setups, replenishment, and small-quantity bundling seem to be special services that BookMasters values more than other customers. Paul needs to find out whether BookMasters values these services enough to pay a premium for them, or whether the level of service can be reduced without losing BookMasters’

business. To bring BookMasters’ requirements in line with those of other customers, Paul may want to establish a standard order size. If BookMasters values small orders (probably because they eliminate excess inventory), Paul might consider adding a surcharge for this service. However, before Paul changes the pricing or order size, he should determine what services competitors offer and the impact that such changes would have on existing customers.

The Wrap-up After performing a profitability analysis of all 375 customers, Terrence Gleason understood that there was more to understanding a customer’s profitability than gross margin. He realized that some customers, such as Morris & Morris, remained profitable after considering customer service costs. Others, such as Sparrow Designs, were unprofitable.

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Gleason examined the activities required to service the unprofitable customers to identify ways to move them to profitability. He encouraged Sparrow’s Taylor Byrd to begin using Internet orders instead of catalog orders and to order with enough lead time to avoid express shipping services. He also informed Byrd that should Sparrow continue to require express shipping services, there would be an additional charge to cover the higher shipping cost. Byrd’s initial reaction to these changes was favorable. At this point, Gleason wasn’t ready to make drastic changes for all customers, however. He knew that alienating customers or changing the way the company provides service could well have a detrimental effect on the company’s reputation for high-quality products and excellent customer service. Gleason wanted to study the services Bradley provides to customers and compare them to competitors’ services. He also wanted to monitor Sparrow’s activities closely for a couple of months to see how the changes affected customer profitability. Only after he feels reasonably confident that he can anticipate customers’ reactions will he make sweeping changes to Bradley’s selling activities.

F O C U S S U M M A RY In this focus unit you learned how to evaluate customer profitability. Specifically, you should be able to meet the objectives set out at the beginning of this chapter:

1.

Use activity-based costing techniques to measure customer profitability. To use activity-based costing techniques for measuring customer profitability, a company should follow these five steps for allocating selling expenses to customers: Step 1. Identify selling activities. Step 2. Develop activity cost pools. Step 3. Calculate activity cost pool rates. Step 4. Allocate selling costs to customers. Step 5. Calculate customer profitability.

2.

Identify alternatives for managing unprofitable customer accounts. Companies that find they have unprofitable customers might try to manage those accounts in the following ways:

Reduce the customer’s use of selling activities.

Add a service charge for certain selling activities or the excessive use of selling activities.

Stop providing the service to the customer.

EXERCISES F5-1 Identify activities (LO 1) Place an “X” in the columns to indicate whether each of the following the activities would be included in a bank’s customer profitability analysis.

Exercises

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INCLUDED

a.

Opening a bank account

b.

Supporting an online banking system

c.

Developing a corporate logo

d.

Preparing bank statements for mailing

e.

Renting off-site document storage facilities (to preserve company data)

f.

Hosting the board of directors’ annual meeting

NOT INCLUDED

g. Gathering information for federal bank auditors h.

Balancing transactions at the end of the day

i.

Taking deposits at the drive-in window

j.

Providing access to safety deposit boxes

F5-2 Identify activity drivers (LO 1) Williams Enterprises is a small, locally owned provider of network services. Brian Williams, CEO, has considerable experience in the industry and knows that certain customers can run a company out of business. He has determined that the following customer activities are the major ones in which the company engages:

a. b. c. d. e.

Establishing new customers and new orders Installing new systems Processing customer invoices Making service calls Customer training

Required Identify an activity driver for each of the major activities.

F5-3 Identify high-cost activities (Adapted from Robert S. Kaplan and V. G. Narayanan, “Measuring and Managing Customer Profitability,” Journal of Cost Management, 15, no. 5 (September/October 2001): 5–15.) (LO 1) Customer profitability is influenced by the activities that customers consume. Indicate whether each activity listed in the following table would be associated with a high cost-to-serve customer or a low cost-to-serve customer.

HIGH COST-TO-SERVE

Orders custom products in small quantities Uses standard delivery services Frequently changes delivery requirements Places orders using automated processing, such as EDI or the Internet Requires little to no presales support Requires installation and training Requires frequent deliveries to accommodate just-in-time inventory system Pays slowly (high accounts receivable)

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LOW COST-TO-SERVE


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F5-4 Calculate customer net profit and customer profit margin (LO 1) Wingo Widgets makes and sells widgets to individual and corporate customers. Widgets cost $1.75 to make and are sold for $3.00 each. Individual customers typically require little service beyond order processing. Because widgets don’t differ much from one producer to the next, corporate customers demand additional services before they will commit to a purchase. Wingo’s selling activities and cost pools are as follows: Cost Pool

Annual Cost

Annual Driver Activity

Order processing Telephone technical support Product demonstrations Express deliveries

$200,000 45,000 66,000 37,500

2,500 orders 1,500 hours 120 demonstrations 375 deliveries

$348,500 The following table compares the activity levels for the average individual customer and the average corporate customer: Individual Widgets purchased Orders Technical support hours Product demonstrations Express deliveries

1,000 12 3 0 1

Corporate 10,000 50 70 8 15

Required a. Calculate the activity rate for each cost pool. b. Calculate the customer net profit and customer profit margin for the average individual customer and the average corporate customer.

c. If Wingo wanted to drop one average corporate customer, how many average individual customers would need to be added to make up the lost net income?

F5-5 Calculate customer net profit and customer profit margin (LO 1) Stoner Excursions offers several services to customers. Susan Stoner realizes that some customers use more services than others, so the company has conducted a customer profitability analysis that identified the following cost pools and activity drivers: Cost Pool

Annual Cost

Annual Driver Activity

Online reservations Phone reservations Ticket mailings Courier deliveries

$ 240,000 980,000 500,000 160,000

40,000 online reservations 98,000 phone reservations 125,000 mailings 10,000 deliveries

$1,880,000

Required a. Calculate the activity rate for each cost pool. b. Two of Stoner’s customers have the following activity levels. Calculate the customer net profit and customer profit margin for each customer:

Ticket purchases Ticket cost Online reservations Phone reservations Ticket mailings Courier deliveries

Customer A

Customer B

$172,500 $129,375 500 0 500 0

$180,000 $135,000 0 600 120 480

Exercises

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F5-6 Calculate the customer profit margin; calculate the income effect of dropping customers (LO 1) Corley Communications performed a customer profitability analysis and obtained the following results for its bottom five customers: Customer

Sales

Albert Brown Carter Dyson English

Customer Net Profit

$ 425,000 $1,100,000 $1,000,000 $ 675,000 $ 560,000

Customer Profit Margin

$ 8,500 $16,500 $ 3,000 ($ 1,350) ($ 4,480)

2.00% 1.50% 0.30% (0.20%) (0.80%)

Chris Corley, vice president for marketing, believes that if these five customers are dropped, the selling expenses required to serve them will be eliminated. Company revenues total $15,000,000; the current average customer profit margin is 6.8%, and net income is $220,000.

Required a. Calculate the total customer net profit. b. What effect would dropping all five customers have on the average customer profit margin?

c. What effect would dropping all five customers have on net income? d. What action would you recommend? Why?

PROBLEMS F5-7 Customer profitability (adapted from D. L. Searcy, “Using activity-based costing to assess channel/customer profitability, Management Accounting Quarterly, 5, no. 2 (Winter 2004): 51–60) (LO 1, 2) Time Solutions, Inc., is an employment services firm that places both

temporary and permanent workers with a variety of clients. Temporary placements account for 70% of Time Solutions’ revenue; permanent placements provide the remaining 30%. President Gia Johnson recently read an article that discussed the need to consider selling and administrative costs in determining customer profitability—a practice that Time Solutions does not follow. Johnson is concerned that the company may be making poor choices in the selection of customers. In the temporary market, Time Solutions advertises and searches for workers, hires them, and pays them for the hours they work. The company then bills customers for an amount that is higher than the workers’ pay plus taxes. Because the temporary market is very competitive, Time Solutions has had to reduce the rates charged to customers to keep their business. After reviewing the year’s operations, Johnson has determined that the company’s customer service activities for the temporary business could be divided into three cost pools: filling work orders, hiring temporary employees, and processing payroll/billing customers. The following table shows the three cost pools and their annual capacity: Cost Pool

Total Cost

Annual Capacity

Filling work orders Hiring temporary employees Processing payroll/billing customers

$175,875 $ 81,125 $ 43,000

3,500 orders 2,950 applicants 215,000 hours worked

Time Solutions’ largest four customers account for about 42% of total sales, so Johnson has decided to analyze those customers’ accounts first to determine how much they are contributing to the bottom line. The gross margin the companies generate and the activities they use are as follows:

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Sales Cost of sales Wages Taxes and fees Total cost of sales Gross margin Temps ordered Applicants Hours worked

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Chemical Company

Trailer Manufacturer

Newspaper Publisher

Food Processor

$466,733

$145,764

$122,604

$167,327

341,620 65,366

110,473 24,350

92,205 18,621

120,451 23,411

406,986

134,823

110,826

143,862

$ 59,747

$ 10,941

$ 11,778

$ 23,465

88 74 47,370

56 48 15,115

928 794 13,000

332 284 22,765

Required a. Calculate the gross margin percentage for each customer. b. Determine the activity rates for each of the three cost pools. c. Determine the customer net profit and customer profit margin for each customer. d. What suggestions would you make for managing each customer’s profitability?

F5-8 Customer profitability (LO 1, 2) After attending a seminar on measuring customer profitability, Mason Ford decided to examine Olson Optics’ customers to determine if the company truly knew how profitable its customers were. Olson Optics already uses an activity-based costing system to determine the product cost of its two products: RF30 and LF45. Each RF30 sells for $15.00 and requires $7.05 in direct materials and $4.00 in direct labor. Each LF45 sells for $50.00 and requires $15.45 in direct materials and $14.00 in direct labor. The following table provides cost and activity information for manufacturing overhead for the two products.

Activity Cost Pool Packing Setup Assembly Finishing Total manufacturing overhead costs Units produced

Number of Activities

Cost Driver

Manufacturing Overhead Costs

RF30

LF45

Total

Cartons Setup hours Spot welds Machine hours

$ 200,000 450,000 730,000 300,000

500,000 10,000 125,000 25,000

300,000 27,500 240,000 75,000

800,000 37,500 365,000 100,000

600,000

200,000

$1,680,000

Based on what Ford learned at the seminar, he has gathered the following information about customer support activities. Activity Cost Pool

Cost Driver

Selling Costs

Order entry Customer support Sales calls Express shipping

Orders Support hours Sales calls Shipments

$200,000 150,000 250,000 140,000

Total selling costs

Driver Volume 40,000 5,000 2,000 7,000

$740,000

Ford wants to apply his new profitability analysis techniques to Infrared Technologies, a company he believes is representative of Olson’s average customer. Information about Infrared’s account activity is as follows. RF30 purchases LF45 purchases Orders placed Customer support Sales calls Express shipments

10,000 units 3,000 units 300 500 hours 24 250

Problems

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Required a. Calculate the activity-based product cost for RF30 and LF45. b. Calculate the cost pool rates for Olson’s customer service activities. c. Calculate the gross profit, customer net profit, and customer profit margin for Infrared Technologies.

d. Is Infrared Technologies a profitable customer? Why or why not? e. What actions could Ford take to increase Infrared Technologies’ profitability? Should these actions be applied to all of Olson’s customers?

F5-9 Customer profitability (LO 2) Ray Panneton, president of Okus Designs, met with his CFO and vice president of marketing to discuss the profitability of the company’s top 10 customers. These customers account for 80% of the company’s revenues. The following table was prepared by the accounting department to assist Ray in his decision making.

Customer Meredith’s Boutique Stewart Industries T&P Incorporated Talley Design Studios UPPtown Productions O’Brien’s Tavern House of Claire Copper Metalworks J Floral Designs Old Main Masonry Total/Average

Revenues

Cost of Sales

Selling Costs

Customer Net Profit

Customer Profit Margin

$ 5,000,000 4,890,000 4,500,000 4,200,000 4,100,000 3,900,000 3,850,000 3,700,000 3,625,000 3,500,000

$ 3,750,000 3,618,600 3,375,000 3,192,000 2,870,000 2,730,000 2,887,500 2,664,000 2,501,250 2,485,000

$ 750,000 978,000 1,129,500 378,000 902,000 1,365,000 885,500 888,000 1,486,250 770,000

500,000 293,400 (4,500) 630,000 328,000 (195,000) 77,000 148,000 (362,500) 245,000

10.00% 6.00% (0.10%) 15.00% 8.00% (5.00%) 2.00% 4.00% (10.00%) 7.00%

$41,265,000

$30,073,350

$9,532,250

1,659,400

4.02%

Required a. Ray is concerned about the customers with negative customer profit margins. If these b.

c. d.

e.

customers are dropped, what will be the new total customer net profit and customer profit margin (assume the cost of sales and selling costs can be eliminated)? Ray is also concerned about customers with customer profit margins below the current company average. If all customers with below-average profit margins are dropped, what will be the new total customer net profit and customer profit margin (assume the cost of sales and selling costs can be eliminated)? Compare your answers to parts (a) and (b). What do you notice? If Ray were to drop all customers with profit margins below average, how much in new customer revenues would need to be added to make the company as well off as it would be if it only dropped the customers with negative profit margins? Use an average profit margin for the new customers equal to the one you calculated in part (a). What action do you recommend Ray take?

F5-10 Customer profitability (LO 2) In 2005, electronics retailer Best Buy received a great deal of press about the changes managers were making to Best Buy stores. The company had profiled its customer base and identified four types of desirable customers: young customers who embrace technology, affluent male professionals, affluent suburban mothers, and family men. Because each type of customer was found to exhibit unique buying characteristics, the company designed a store for each one. This practice, referred to as customer centricity, identifies profitable customers, segments them, redesigns stores to target specific segments, and empowers employees to meet customers’ needs. In the quarter ended May 28, 2005, sales in Best Buy’s newly designed stores were up 8.4% over the same period in 2004. 416

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Required a. Explain how activity-based customer profitability analysis can assist in implementing customer centricity.

b. As part of this analysis, Best Buy identified customers who shopped primarily during sales events. Those customers, who purchased a large volume of merchandise, had been considered desirable customers. After the analysis, however, the company ceased to mail sales notices to them. Why would Best Buy decide to ignore those customers? c. Because sales were up in the newly designed stores, would you conclude that the move to customer centricity was a profitable one for Best Buy? How should the company determine the profitability of the change?

ENDNOTE 1. Larry Selden and Geoffrey Colvin, Killer Customers: Tell the Good from the Bad—And Dominate Your Competitors (New York: The Penguin Group, 2003). This book was originally published as Angel Customers & Demon Customers.

Endnote

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Managerial Accounting, chapter 5  

Managerial Accounting, chapter 5

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