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[Solved] Dakota Office Products Case Study: Activity-Based Costing

Dakota Office Products Case Study is a Case on increasing profitability and activity-based costing from HBR. The Case can be interpreted from pricing strategy, Profitability and pricing, and the impact of innovation on pricing

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Dakota office Products Case Study Solution

Dakota Office Products Case Study: Introduction

Dakota is a distributor of office supplies, and its top management is worried about the company’s first loss. Given the current state of affairs, This article delves into the role of activity-based costing in distribution firms, as well as the methods used to gauge customer profitability. Dakota’s clientele is increasingly demanding individualized attention and tailored services like desktop delivery.

Not all of our customers have made the switch to placing orders online; in fact, some of them still use the old-fashioned phone method. To arrive at the final price, we add a set percentage to the item’s final cost. Managers believe that the fixed markup may not compensate them for the higher costs associated with processing orders by hand and delivering them to customers’ desktops. The financial manager initiates the process of cost estimation for the various order types so that she can calculate the profitability of specific customers based on their actual order patterns.

The General Manager of Dakota Office Products (DOP), John Malone, oversees the business as a whole. Distributor of Office Products (DOP) is a regional provider of office products to commercial and institutional clients. A new website and Electronic Data Interchange (EDI) were both launched by the company in the year 2000. This is done to make ordering and receiving goods as easy as possible for the consumer. There was optimism that the introduction of digital services would boost profit margins, but the company reported a net loss in 2000 despite rising revenue.

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Dakota Office Products Case Study: Objectives

  • To be able to understand the company’s current situation and be able to point out possible reasons for the company’s net loss for the year.
  • To be able to recommend actions to aid DOP to gain back its profitability.
  • To be able to recognize the relationship of cost management and customer profitability to proper pricing.
  • To appreciate ABC costing in a non-manufacturing company like DOP.

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Dakota Office Products: Situation Analysis

Operating Expense Calculation

Because DOP is a retail business, all of its operating expenses (other than the cost of goods sold) are considered indirect costs.

Product Innovation

Variations in Product and Customer Demand Caused by New Innovations Such as Desktop Delivery and Electronic Data Interchange and the New Internet Site Commercial shipment delivery, desktop delivery, manual order processing, and electronic data interchange are now available as delivery options for customers. The individual customer’s demand for a wide range of services also impacts pricing. The current pricing structure does not do enough to address this issue. The organization has not yet revised its pricing strategy to reflect this development.

In addition to the direct costs that are associated with the sale of its products, DOP is a retailer, so it must also account for many indirect costs.

Product Costing

Second, the launch of brand-new technological advancements, such as the desktop delivery option and electronic data interchange (EDI), in addition to a completely redesigned website, has resulted in an extensive variety of product and customer requirements. Customers now have the option of selecting either the conventional method of delivery via commercial shipment or the more convenient method of delivery via desktop, as well as selecting either the conventional method of ordering or the electronic data interchange method. And the wide variety of services that each person necessitates has an effect on the price that they pay overall as a customer.

The problem has not been solved by the pricing structure that is currently in place. This innovation-driven shift has not yet been accounted for in the business’s cost structure, which means that adjustments need to be made.

Additionally, the implementation of the desktop delivery option and EDI has resulted in overlapping operating expenses between activities. This has brought about the third problem, which is the pricing of products. We have drivers whose responsibility is to bring orders to the desks of our customers, and we have an operator who is responsible for processing both manual and EDI orders from the warehouse. It is essential to keep in mind that it is not very rational to simply add up all of the costs and distribute them across all of the activities in this scenario, especially if those costs are indirect costs.

Keeping this in mind is very important. Under the current DOP system, Customers A and B will each be responsible for paying the exact same amount for warehouse, distribution, and order entry (Exhibit 1). It does not take into consideration which services A or B utilized during that time period.

Product Mix

Calculating and attributing the product’s direct cost, which is also referred to as the cost of sales, is a straightforward endeavor. However, it was difficult to quantify and assign responsibility for indirect overhead costs. As a result of this, the company ought to make use of a costing system that is specifically designed for the industry in order to arrive at per-unit costs that are more accurate.

 Customer ACustomer B
Order SizeFew large ordersMany more orders
Order PlacementUses EDIManual Order
Order DeliveryCommercial ShipmentDesktop delivery option
Time to pay billsWithin 30 days90 days or more
Ave A/R Balance$9,000$30,000

Using the data in this table, we can compare and contrast Customers A and B. Customer A saves money by using EDI and commercial shipment (EDI, fewer labor hours for processing orders and cheaper delivery cost if commercial). The cost to serve Customer B is slightly higher than that of the other delivery methods because Customer B places their orders manually and chooses desktop delivery (Manual – longer time to process orders and additional premium for desktop delivery). It’s clear from this data that servicing Customer A is cheap compared to servicing Customer B.

From this data, it is clear that Customer A is a great payer because it has a shorter average payment term than Customer B. While B has the highest cost to serve and thus the highest cost of sale, it also has the highest amount of unpaid invoices and receivables and thus is unable to contribute to the company’s bottom line.

Pricing Analysis

Products were previously priced at a simple markup over cost, which was DOP’s previous pricing structure (with a small premium for desktop delivery). This system functioned on the assumption that DOP’s running costs were proportional to the cost of goods acquired for processing and delivery to customers. In order to cover the costs of storage, shipping, and distribution, the final price of the product is marked up by a whopping 155 percent, which is completely unreasonable.

The pricing structure did not factor in the supplementary costs incurred from catering to such a large and diverse clientele. A standard markup-based pricing strategy will fail to recoup costs from customers with high cost-to-serve while overcharging customers with low cost-to-serve, as customer diversity grows.

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Dakota Office Products Case Study: Costing Methodologies

Activity Based Costing

Adapting the ABC system will assign indirect costs properly per activity. DOP will assign costs only to the customer that requires the activity for production. This method eliminates allocating irrelevant costs to the products served to a customer. And therefore can give more accurate profitability informationRequires substantial resources in implementing the system
Information gathered using the ABC system are more reflection of the true cost of the products and services rendered to a customer since it assigns costs only relevant to a specific activity per customer demand. This will enable DOP management to have a greater understanding of overhead costs and aid in decision-making regarding pricing and costing a specific customer.Once implemented, an activity-based costing system is costly to maintain. Data concerning numerous activity measures must be collected, checked, and entered into the system
Allows to compute product line profitability and customer profitability, which permits the company to make better decisions about your sales ‘mix’ and marketing effortsABC produces numbers such as product margins, that are at odds with the numbers produced by traditional costing systems. Management might find it hard to adjust to the new costing system.
Helps the company set up a price structure that charges customers and clients according to the support required for their particular situation. We call it ‘just in time pricing.Activity-based costing data can be easily misinterpreted and must be used with care when used in making decisions. Costs assigned to products, customers and other cost objects are only potentially relevant
Dakota Office Products Case Study: ABC Pros and Cons

Current Costing Methods

No adjustments are to be done, therefore, no additional cost is to be incurredThe indirect cost will still be spread over all activities and therefore not allocating it properly.
 The wrong costing per customer will continue and the income statements in the years to come will be either understated or overstated.  
Dakota Office Products Case Study: Existing Costing Pros and Cons

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Dakota Office Products Case Study: Inadequacy of Current Pricing Methods

why was dakota’s existing pricing system inadequate for its current operating environment?

Some problems with the current operating environment include:

  • Profits only when clients placed large orders for cartons
  • A real drop of profit when many clients place small orders
  • Wrong cost determination for individual customers
  • Wrong cost determination for new services provided by DOP

Dakota Office Product uses a traditional costing system where direct and indirect costs are assigned and allocated to products and services delivered to customers. This is better for companies, where production operations are highly labor intensive and overhead costs, are a smaller part of total costs. Activity Based Costing is going to be better for Dakota Office Products. They will be able to calculate the cost of products and services in accordance with the activities involved and resources consumed.

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Dakota Office Products Activity-Based Costing Analysis

Activity cost-driver rates:

Activity One: process cartons in and out of the facility

Rate=(90% of Warehouse Personnel Expense + Cost of Items Purchased)/cartons processed Rate=(90%*2,400,000+35,000,000)/80,000= $464.5 /per carton

Activity Two: the new desktop delivery service

Rate=(10% of Warehouse Personnel Expense + Delivery Truck Expenses)/desktop deliveries Rate=(10%*2,400,000+200,000)/2000= $220 /per carton

Activity Three: order handling

Rate= (Warehouse Expenses + Freight)/ number of orders Rate=(2,000,000+450,000)/(16,000+8,000)=$102.08 /per order

Activity Four: data entry

Rate=Order entry expenses/Order lines Rate=800,000/150,000= $5.3 orders/per line

Dakota Office Products Calculate Profitability for Customer A and Customer B 

ActivityCost driver rateCustomer ACustomer B
Process cartons in and out of the facility$464.5 per carton92,900 (464.4*200 cartons)92,900 (464.4*200 cartons)
The   new   desktop delivery price (M)$220/desktop deliveries 5,500 (220*25desktop deliveries)
Order handling (N)102.08/per order1,224.96 (102.08*12 orders)10,208  (102.08*100 orders)
Data entry (O)5.3  per line item318  (5.3*60  line items)954  (5.3*180  line items)
Total Cost(A= (M+N+O)) 94,442.961,09,562
Sales (B) 1,03,0001,04,000
Profit (B-A) 8557.04(5562)

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Dakota Office Products Case Study: Explanation of Difference in Profitability  

The increase in cost due to the increase in the number of both manual and EDI orders has led to lower profitability of Customer B when compared to Customer A.

Dakota Office Products Case Study: Limitations to Estimations

One of the limitations would be to explore the various facets which comprise the processes or activity

  • Estimation of Cost Pools
  • Correct Estimation of Cost Drivers
  • Correct assessment of contributors to cost
  • Additional Information is required to calculate activity-based costs more accurately
  •  Knowing the profitability rate can help get higher sales per customer
  • Offerings could be personalized using the information as much as possible
  • They can also help in raising prices for profitable customers and in the process receive higher profits
  • They can also reduce prices on lesser profitable customers
  • They can define their customer service and pricing process based on this information

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Dakota Office Products Case Study: How will the analysis help manage Profits better

Dakota should do an analysis with all of its customers. This could identify the customers who they would profit from the most and then they could minimize services to the least profitable customers and concentrate on the more profitable customers. Also if they did an analysis, they would figure out that the delivery cost has some issues and the price for desktop delivery should be adjusted by the distance from the warehouse.

Dakota Office Products Case Study: Conclusion

As with any form of innovation, change is inevitable. A wide range of products and services are available to satisfy the needs of different consumers. And there will be extra costs associated with this change. To fairly compensate for increased expenses, it is necessary to readjust pricing strategies whenever new costs emerge. Knowledge of your customers and their ability to generate revenue is crucial for setting prices. Furthermore, precise costing results in precise pricing, which boosts profits.

In this case, a sizeable portion of DOP’s net loss for FY2000 can be traced back to the company’s erroneous approach to costing. The company continued allocating indirect costs to all of its customers despite the fact that the customer mix had changed as a direct result of the innovations it had introduced. It’s crucial that the company’s overall cost structure accounts for any price changes in products.

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