Questions: Dakota Office Products 1. Why was Dakota’s existing pricing system inadequate for its current operating environment? Dakota’s existing pricing system was inadequate for its current operating environment because the pricing was based on traditional allocation of overheads. The result of which were that the actual costs incurred for fulfilling the orders of customers were not ascertained. There were two effects of this method. First, the overall prices of all the products increased. Second, those products that were more costly to produce were priced lower than their actual cost price. . Provide a brief analysis of the attached (page 2 of this document) activity-based costing system. Do you agree with the activities and/or cost drivers identified for each activity? Why or why not? The activity based costing divides the operating costs into five different areas and allocates the overheads based on the actual costs incurred by each activity. In this case the operating costs are divided into freight, warehouse rent & depreciation, warehouse distribution, delivery truck expenses, and order entry expenses.
The freight has been allocated on the basis of cartons shipped, the warehouse rent & depreciation has been allocated on the basis of the number of cartons processed, the warehouse distribution personnel cost 90% on the basis of cartons processed and 10% on the basis of delivery to desktop, the delivery truck expenses have been allocated on the basis of deliveries made to desktop, and the order entry expenses 20% on the basis of processing manual custom order, 75% on the basis of items ordered manually and 5% on the basis of processes EDI orders.
From this the per item cost is calculated. I agree with the allocation of shipping carton cost allocation, warehouse rent & depreciation allocation, and order entry expense allocation. The warehouse distribution personnel allocation may not be correct. 10 % of the personnel are used for delivery trucks when desktop deliveries are to be made. Otherwise these personnel are available for processing cartons. Also, how will the allocation be made if more desktop deliveries are to be made? The same number of personnel will use the delivery trucks to make deliveries.
Similarly, the full cost of delivery trucks is allocated to the delivery to desktop. This is the full capacity of delivery trucks, in reality only a part of the capacity may have been used for DtDs. supposing that customer B did not order any DTD delivery, still the trucks would have to be depreciated! It is unfair to allocate the entire deprecation cost to customer B. 3. Using the activity-based costing system from Question 2, calculate the profitability of Customer A and Customer B. Hint: This should be a relatively straightforward calculation given the ABC system in Question 2) Calculation of Profitability for Customer A and B ItemRate/$Cust. ACust. B Sales103,000104,000 Cost of Items Purchased85,00085,000 Gross Margin18,00019,000 Operating Costs:1283021520 Freight/Carton61200900 Processing/Carton521040010400 Delivery to Desktop/Delivery2205500 Process. CustomOrd/ManualOrd10601000 EnteringItemsManual/line4240720 Process EDI Order/EDI order530 Interest on Accounts Receivables10%9003,000 Contribution to general and 5,170-2,520 elling expenses and profits Profitability in percent5. 02-2. 42 The calculation shows a comparison of the profitability of Customer A and customer B. In the third column the profitability of customer A is calculated and in the fourth column the profitability of customer B is calculated based on the rates given in the operating costs diagram and in exhibit 3. The cost of average accounts receivable has been calculated at 10% as given in the case. 4. What explains any difference in profitability between the two customers?
What are the limitations, if any, to the estimates of the profitability of the two customers? The main reasons for the difference in profitability between the two customers are the cost of delivery to the desktop, the processing of manual orders, the cost of entering items manually, and the interest on accounts receivable. The limitation to the estimates of the profitability of the two customers is that the delivery to desktop customer costs includes fixed costs that Dakota would have to incur, to allocate it to a customer distorts the profitability.
Further, interest on accounts receivable may represent an opportunity cost if the working capital is financed by a bank loan. Usually, idle working capital cannot be invested at 10%. Part of the 30,000 receivables might have been financed by such funds. 5. Assume that Dakota applies the analysis done in Question 3 to its entire customer base. How could such information help the Dakota managers increase company profits? The Dakota managers would be able to price their products profitably.
For instance, in the analysis shown in question 3 we find that customer B has a negative profitability. In other words Dakota is actually incurring a loss on customer B. To rectify such situations, the pricing of products to customer B or the pricing of services like desk to desk deliveries can be modified so that sales to each customer earns a profit to Dakota. Activity based costing helps allocate costs more realistically to each product. The net result is that Dakota can change from a company whose profits are declining to a company whose profits are increasing.
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