Exercise 15.19 and 15.

20 with solutions

15-19 Customer profitability, customer-cost hierarchy. Enviro-Tech has only two retail and
two wholesale customers. Information relating to each customer for 2017 follows (in thousands):

Enviro-Tech’s annual distribution-channel costs are $33 million for wholesale customers and
$12 million for retail customers. The company’s annual corporate-sustaining costs, such as salary
for top management and general-administration costs are $48 million. There is no cause-and-
effect or benefits-received relationship between any cost-allocation base and corporate-
sustaining costs. That is, Enviro-Tech could save corporate-sustaining costs only if the company
completely shuts down.
1. Calculate customer-level operating income using the format in Exhibit 15-3.
2. Prepare a customer-cost hierarchy report, using the format in Exhibit 15-6.
3. Enviro-Tech’s management decides to allocate all corporate-sustaining costs to distribution
channels: $38 million to the wholesale channel and $10 million to the retail channel. As a result,
distribution channel costs are now $71 million ($33 million + $38 million) for the wholesale
channel and $22 million 1$12 million + $10 million) for the retail channel. Calculate the
distribution-channel-level operating income. On the basis of these calculations, what actions, if
any, should Enviro-Tech’s managers take? Explain.
4. How might Enviro-Tech use the new cost information from its activity-based costing system
to better manage its business?

(30 min.) Customer profitability, customer-cost hierarchy.

1. All amounts in thousands of U.S. dollars

Wholesale Retail
North America South America Green Global
Wholesaler Wholesaler Energy Power
Revenues at list prices $375,000 $590,000 $175,000 $130,000
Price discounts 25,800 47,200 8,400 590
Revenues (at actual prices) 349,200 542,800 166,600 129,410
Cost of goods sold 285,000 510,000 144,000 95,000
Gross margin 64,200 32,800 22,600 34,410
Customer-level operating costs
Delivery 4,550 6,710 2,230 2,145
Order processing 3,820 5,980 2,180 1,130
Sales visit 6,300 2,620 2,620 1,575

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 Total customer-level oper. costs 14,670 15,310 7,030 4,850
Customer-level operating. income $ 49,530 $ 17,490 $ 15,570 $ 29,560

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2. Customer Distribution Channels
(all amounts in $000s)
Wholesale Customers Retail Customers
South
Total Total North America America Total Green Global
(all customers) Wholesale Wholesaler Wholesaler Retail Energy Power
(1) = (2) + (5) (2) = (3) + (4) (3) (4) (5) = (6) + (7) (6) (7)
Revenues (at actual
prices) $1,188,010 $892,000 $349,200 $542,800 $296,010 $166,600 $129,410
Customer-level costs 1,050,860 824,980 299,670a 525,310a 250,880 151,030a 99,850a
Customer-level operating
income 112,150 67,020 $ 49,530 $ 17,490 45,130 $ 15,570 $ 29,560
Distribution-channel costs 45,000 33,000 12,000
Distribution-channel-level
oper. income 67,150 $ 34,020 $ 33,130
Corporate-sustaining costs 48,000
Operating income $ 19,150
a
Cost of goods sold + Total customer-level operating costs from Requirement 1

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3. If corporate costs are allocated to the channels, the retail channel will show an
operating profit of $23,130,000 ($33,130,000 – $10,000,000), and the wholesale
channel will show an operating loss of $3,980,000 ($34,020,000 – $38,000,000). The
overall operating profit, of course, is still $19,150,000, as in requirement 2. There is,
however, no cause-and-effect or benefits-received relationship between corporate
costs and any allocation base, i.e., the allocation of $38,000,000 to the wholesale
channel and $10,000,000 to the retail channel is arbitrary and not useful for decision
making. Therefore, the management of Enviro-Tech should not base any performance
evaluations or investment/disinvestment decisions based on these channel-level
operating income numbers. They may want to take corporate costs into account,
however, when making long-run pricing decisions.

4. Enviro-Tech could use activity-based cost information to better manage its business
by evaluating the customer-level costs and determining which activities are providing
a value to the customer that they are willing to pay for. For example, costs of sales
visits for the North America Wholesaler are $6,300, which is more than double the
cost for the South America Wholesaler. Enviro-Tech should evaluate the efficiency
and effectiveness of this activity for this customer group. Enviro-Tech could also
extend its ABC methodology to the distribution channel costs to determine if any
cause-and-effect relationships exist between these costs and the customer types.

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15-21 Customer profitability, distribution. Best Drugs is a distributor of pharmaceutical
products. Its ABC system has five activities:

Rick Flair, the controller of Best Drugs, wants to use this ABC system to examine individual
customer profitability within each distribution market. He focuses first on the Ma and Pa
single-store distribution market. Using only two customers helps highlight the insights
available with the ABC approach. Data pertaining to these two customers in August 2017 are
as follows:

1. Use the ABC information to compute the operating income of each customer in August
2017. Comment on the results and what, if anything, Flair should do.
2. Flair ranks the individual customers in the Ma and Pa single-store distribution market on the
basis of monthly operating income. The cumulative operating income of the top 20% of
customers is $58,120. Best Drugs reports operating losses of $23,670 for the bottom 40% of
its customers. Make four recommendations that you think Best Drugs should consider in light
of this new customer-profitability information.

(2025 min.) Customer profitability, distribution.

1. The activity-based costing for each customer is:

Ann Arbor San Diego

Pharmacy Pharmacy
1. Order processing,
$42 × 13; $42 × 7 $ 546.00 $ 294.00
2. Line-item ordering,
$5 × (13 × 11; 7 × 19) 715.00 665.00
3. Store deliveries,
$47 × 5; $47 × 7 235.00 329.00
4. Carton deliveries,
$4 × (5 × 21; 7 × 18) 420.00 504.00
5. Shelf-stocking,
$13 × (5 × 0.5; 7 × 0.75) 32.50 68.25
Operating costs $1,948.50 $1,860.25

The operating income of each customer is:

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 Ann Arbor San Diego
Pharmacy Pharmacy
Revenues,
$2,600 × 5; $1,900 × 7 $13,000.00 $13,300.00
Cost of goods sold,
$2,100 × 5; $1,700 × 7 10,500.00 11,900.00
Gross margin 2,500.00 1,400.00
Operating costs 1,948.50 1,860.25
Operating income $ 551.50 $ (460.25)

San Diego Pharmacy has a lower gross margin percentage than does Ann Arbor [10.5%
($1,400 ÷ $13,300) vs. 19.2% ($2,500 ÷ $13,000)] and consumes a lot of resources to
obtain this lower margin. Serving San Diego necessitates more deliveries and delivery
of more line items in each order, albeit lower-priced ones that don’t contribute much to
Best Drugs’ income. Overall, Ann Arbor is a profitable customer, while San Diego is
not.

Ways Best Drugs could use this information include:

a. Pay increased attention to the top 20% of the customers. This could entail
asking them for ways to improve service. Alternatively, Best Drugs may want
to highlight to their own personnel the importance of these customers; e.g., it
could entail stressing to delivery people the importance of never missing
delivery dates for these customers.
b. Work out ways internally at Best Drugs to reduce the rate per cost driver; e.g.,
reduce the cost per order by having better order placement linkages with
customers. This cost reduction by Best Drugs will improve the profitability of
all customers.
c. Work with customers so that their behavior reduces the total “system-wide”
costs. At a minimum, this approach could entail having customers make fewer
orders and fewer line items. This latter point is controversial with students; the
rationale is that a reduction in the number of line items (diversity of products)
carried by Ma and Pa stores may reduce the diversity of products Best Drugs
carries.

There are several options here:

 Simple verbal persuasion by showing customers cost drivers at Best Drugs.
 Explicitly pricing out activities like cartons delivered and shelf-stocking so
that customers pay for the costs they cause.
 Restricting options available to certain customers, e.g., customers with low
revenues could be restricted to one free delivery per week.

An even more extreme example is working with customers so that deliveries

are easier to make and shelf-stocking can be done faster.

d. Offer salespeople bonuses based on the operating income of each customer

rather than the gross margin of each customer.

Some students will argue that the bottom 40% of the customers should be
dropped. This action should be only a last resort after all other avenues have
been explored. Moreover, an unprofitable customer today may well be a

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profitable customer tomorrow, and it is myopic to focus on only a one-month
customer-profitability analysis to classify a customer as unprofitable.

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