Time-Driven activity-based costing, activity-basedmanagement

Midwest Office Products 7 John Malone, general manager ofMidwest Office Products (MOP), was concerned about the financialresults for calendar year 2003. Despite a sales increase from theprior year, the company had just suffered the first loss in itshistory (See summary income statement in Exhibit).

Exhibit Midwest Office Products: IncomeStatement, January-December 2003

Sales	$42,700,000	122.0%
Cost of Items purchased	35,000,000	100.0%
Gross Margin	7,700,000	22.0%
Personnel expense (warehouse, truck drivers)	2,570,000	7.3%
Warehouse expenses (excluding personnel)	2,000,000	5.7%
Freight	450,000	1.3%
Delivery truck expenses	200,000	0.6%
Order entry expenses	840,000	2.4%
General and selling expenses	1,600,000	4.6%
Interest expense	120,000	0.3%
Net income before taxes	($80,000)	-0.2%

Midwest Office Products was a regional distributor of officesupplies to institutions and commercial businesses. It offered acomprehensive product line ranging from simple writing implements(such as pens, pencils, and markers) and fasteners to specialtypaper for modern high-speed copiers and printers. MOP had anexcellent reputation for customer service and responsiveness.

Warehouse personnel at MOP’s distribution center unloadedtruckload shipments of products from manufacturers and moved thecartons into designated storage locations until customers requestedthe items. Each day, after customer orders had been received, MOPpersonnel drove forklift trucks around the warehouse to accumulatethe cartons of items and prepare them for shipment.

MOP ordered supplies from many different manufacturers. Itpriced products to its end-use customers by first marking up thepurchased product cost by 16% to cover the cost of warehousing,order processing, and freight; then it added another 6% markup tocover the general selling, and administrative expenses, plus anallowance for profit. The markups were determined at the start ofeach year, based on actual expenses in prior years and generalindustry and competitive tends. Midwest adjusted the actual pricequoted to a customer based on long-term relationships andcompletive situations, but pricing was generally independent of thespecific level of service required by that customer, except fordesktop deliveries.

Typically, MOP shipped products to its customers usingcommercial truckers. Recently, MOP had introduced a desktopdelivery option in which Midwest personnel personally deliveredsupplies directly to individual locations at the customer’s site.Midwest had leased four trucks and hired four drivers for thedesktop delivery service. Midwest charged a price premium (up to anadditional 5% markup) for the convenience and savings such directdelivery orders provided to customers. The company believed thatthe desktop delivery option would improve margins and create moreloyal customers in its highly competitive office suppliesdistribution business.

Midwest had introduced electronic data interchange (EDI) in1999, and a new internet site in 2000, which allowed customerorders to arrive automatically so that clerks would not have toenter data manually. Several customers had switched to thiselectronic service because of the convenience to them. YetMidwest’s costs continued to rise. Malone was concerned that evenafter introducing innovations such as desktop delivery andelectronic order entry, the company could not earn a profit. Hewondered about what actions he should take to regainprofitability.

Distribution Center: Activity Analysis

Malone turned to his controller, Melissa Dunhill, and directorof operations, Tim Cunningham, for help. Tim suggested:

Distribution center manager, Wilbur smith, spoke with Melissaand Tim about operations at the center:

All we do is store the cartons, process the orders, and get themready to ship to customers, either by commercial freight or usingthe desktop delivery options.

Wilbur described some details of these activities:

The amount of warehouse space we need and the people to movecartons in and out of storage and get them ready for shipment fordepends on the number of cartons. All items have about the sameinventory turnover so space and handling costs are proportional tothe number of cartons that go through the facility.

We are commercial freight for normal shipments, and the cost isbased more on volume than on anything else. Each carton we ship bycommercial carrier costs about the same, regardless of the weightor distance. Of course, any carton that we deliver ourselves,through our new desktop delivery service, avoids the commercialshipping charges but does use our trucks and drivers.

The team talked with one of the truck drivers doing desktopdeliveries:

An average delivery takes about three hours. But delivery timescan be as short as 30 minutes for nearby customers, and up to eighthours for delivery to a distant customer. We also spend differenttimes once we arrive at a customer’s site. Some customers have onlya single drop-off point, while others require us to deliverindividual cartons to different locations at their site.

Melissa and Time next checked on the expenses of entering andvalidating customer order data and the distribution center. Theorder entry expenses included the data processing system, the dataentry operators, and supervisors. They spoke with Hazel Nutley, adata entry operator at Midwest for 17 years.

All I do is key in orders, line by line by line. I start byentering the customer ID and validating our customer information.Beyond that, the only thing that really matters is how many orderlines I have to enter. Each line item on the order has to beentered separately. Of course, any order that comes in through theEDI system or Internet page sets up automatically without anyintervention for me. I just do a quick check to make sure thecustomer hasn’t made an obvious error, and that everything lookscorrect. This validity check takes about the same time for allelectronic orders; it doesn’t depend on the number of itemsordered.

Melissa and Tim collected information from company databases andlearned the following:

-The distribution centers processed 80,000 cartons in 2003. Ofthese, 75,000 cartons were shipped by commercial freight. Theremaining 5,000 cartons were shipped under the desktop deliveryoption. Midwest made 2,000 desktop deliveries during the year (theaverage desktop delivery was for 2.5 cartons).

-People felt that handling, processing and shipping 80,000cartons per year was about the capacity that could be handled withexisting people and space resources.

-The total compensation for truck driver was $250,000 per year.Each driver worked about 1,500 hours per year doing the desktopdelivery service. This was also the maximum time available for eachtruck, after subtracting maintenance and repair time.

-Midwest employed 16 order entry operators. The $840,000 oforder entry costs in Midwest’s income statement included thesalaries, fringe benefits, and supervision, occupancy, andequipment costs for operators.

-With vacations and holidays. Each operator worked about 1,750hours per year. But allowing for breaks, training, and other timeoff, the order entry supervisor believed that operators providedabout 1, 5000 hours per year of productive work.

-Operators required about 9 minutes (0.15 hour) to enter thebasic information on a manual customer order. Beyond this basicsetup time for a manual order, operators took an additional 4.5minutes (0.075) to enter each line item on the order. The operatorsspent an average of 6 minutes (0.10 hour) to verify the informationon an electronic order.

-Some customers paid their invoices within 30 days, while otherstook 90 to 120 days to pay. Midwest had recently taken out aworking capital loan to help finance its growing accountsreceivables balance. The current interest rate on this load was 1%per month on the average loan balance.

Understanding Order Costs and Profitability

Melissa looked through recent orders and found five that seemedrepresentative of those received during the past year (seeExhibit). The orders all involved cartons containing merchandisecosting about $500 to acquire form manufacturers to which thenormal 22% markup had been realized. Orders requiring directdelivery had an additional 4% to 5% surcharge. Although each ofthese orders had been priced in the standard way for cost recoveryand profit margins, Melissa wondered what profits Midwest OfficeProducts had really earned on each of these orders.

Exhibit Midwest Office Products: FiveOrders

Order	1	2	3	4	5
Price	$610	$634	$6,100	$6,340	$6,100
Acquisition Cost	500	500	5,000	5,000	5,000
Number of cartons in order	1	1	10	10	10
Number of cartons shipped commercially	1	0	10	0	10
Desktop delivery time (hours)	-	4	-	4	-
Manual order	No	Yes	No	Yes	Yes
Number of line items in order	1	1	10	10	10
Electronic order	yes	no	yes	no	no
Payment period (months)	1	4	1	4	4

Required

Based on the interviews and the data in the case, estimate thefollowing:

The cost of processing cartons through the facility

The cost of entering electronic and manual customer orders

The cost of shipping cartons on commercial carriers

The cost per hour for desktop deliveries

Using this capacity cost rate information, calculate the costand profitability of the five orders in Exhibit. What explains thevariation in profitability across the five orders?

On the basis of your analysis, what actions should John Malonetake to improve Midwest’s profitability? Include suggestions formanaging customer profitability.

Suppose that currently, Midwest processes 40,000 manual ordersper year, with a total of 200,000 line items entered, and 30,000electronic orders.

How much unused practical capacity does the company have?

If the company’s efforts to encourage customers who ordermanually to change to electronic ordering results in 20,000 manualorders per year (100,000 line items entered) and 50,000 electronicorders, how many order entry operators will the company require? Iforder entry resource costs can be reduced in proportion to thenumber of employees, what will be the cost savings for thechanges?

Returning to the original information in part D, if thecompany’s process improvement efforts result in a 20% reduction intime to preform each of the three order entry actives, how manyorder entry operators will the company require? If order entryresource costs can be reduced in proportion to the number ofemployees, what will be the cost savings for the processimprovement?