Dakota Office Products

Why was Dakota's existing pricing system inadequate for its current operating environment? 

Dakota Office Products has a range of items and provides delivery services to its customers. The desktop delivery option has additional overheads compared to commercial flight deliveries. The accounting system used to determine the desktop delivery system's pricing does not factor in the additional labor and other overhead but only the transport cost of product delivery. Other problems with the current costing regime are that it only realizes profit only when customers place many orders, and when orders are small, the profits drop drastically. The additional labor is needed in the warehouse to move the packages and do a manual entry of orders, especially for customer B. The differences in handling and delivery for the manually entered orders is not different from those processed through Electronic Data Interchange. The company's current pricing regime is based on the purchasing cost, which does not allow for adequate profits for orders processed differently. This approach is the traditional costing system with total costs, both indirect and direct, allocated to the products order and delivered. An adequate pricing regime should determine product markup based on the total cost of processing an order. The focus should be on labor hours used per order. Activity-based accounting is suitable for the company because it uses the level of activities and resources used in determining product costs. 

Provide a brief analysis of the attached activity-based costing system. Do you agree with the activities and cost drivers identified for each activity? Why or why not? 

The costing system shows the company's operating costs and their respective cost drivers and the proportion of cost allocation to the cost driver. Then each activity's cost is used to determine the charges on the product. The freight cost is allocated to the shipped cartons, and since it is a direct cost, its allocation to the cost driver is at 100per cent. Warehouse costs are allocated to the number of processed cartons in a proportion of 100percent since it's a direct cost. These direct costs are allocated to all customers irrespective of the delivery method chosen. Warehouse distribution personnel as an indirect cost is allocated to the desktop delivery customers and the regular ones. The most significant proportion of the warehouse distribution, at 90 percent, is allocated to processing cartons and 10 percent to the desktop delivery since the warehouse personnel make deliveries. Delivery trick expenses are all allocated to the desktop delivery services as a direct cost. Order entry costs are allocated to three cost drivers; process manual orders, enter items ordered, and process EDI orders. The criteria for cost allocation are the time spent for each activity, processing of manual orders taking 20percent of the time while entering items ordered, and EDI consume 75per cent and 5per cent of the total time. 

The ABC system described is correct and appropriate for DOP's operational activities. Each expense is allocated to the most appropriate cost driver, resulting in an accurate estimation of cost per activity. However, the criteria for apportioning warehouse distribution personnel are not refined because it provides 10per cent of the staff to desktop deliveries while 90per cent do carton deliveries. The staff available can do either of the tasks, truck deliveries, or carton processing. What would happen if desktop deliveries increase and more trucks and personnel are needed? Would the ratio applicable remain 10per cent? Likewise, delivery trucks' expenses are allocated in full to desktop deliveries, which may not utilize their full capacity. If customer B desktop deliveries slow or stop, would the trucks depreciation expense base remain the same? Allocating all depreciation costs to a single customer even when the trucks' full capacity is not reached creates imbalances. 

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) 

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 key contributors to the difference are the desktop delivery service, time used in the processing of manual orders, the cost of manually inputting the manual orders, and the interest charges on due accounts receivable. 

A major limitation is in the desktop delivery services, which has fixed cost components and would deform profitability estimates if included in the cost allocation to the customers. If Dakota's working capital is financed through bank loans, then the interest on overdue accounts, receivable represents an opportunity cost since the company is already covered. An investment return of 10percent for free working capital is difficult to get at the prevailing market conditions, and such funds can be applied in financing the $30000 in receivables. 

Assume that Dakota applies the analysis done in question 3 to its entire customer base. How could such information help Dakota managers increase company profits? 

The analysis conducted shows that the company experience losses on customer B at a margin of -3 percent. To rectify the situation, Dakota may have to adjust customer B services' pricing structure so that each sale results in a profit. There should be a premium for manual orders and desktop deliveries to cover order processing and related delivery overheads and overturn the losses.