BACKGROUND OF CHOOSING THE SUBJECT

Allied Office Products was a corporation in business forms and specialty paper products, such as writing paper, envelopes, note cards, and greeting cards. In 1988, the company had expanded into business forms inventory management services that Allied believed it could offer value-added service to differentiate it from other business forms manufacturers. The forms manufacturing business was mature by 1988, and all competitors were seeking ways to generate sales growth.

Allied embarked on a campaign to enroll its corporate clients in a program which it called “Total Forms Control” (TFC) and Allied had established a separate company within the business forms division to handle these accounts. The services provided under TFC included warehousing and distribution of forms (including inventory financing) as well as inventory control and forms usage reporting.

Allied used a sophisticated computer systems network to monitor a client’s forms inventory, forms usage, and ordering activities. They provided this
information to their clients via comprehensive yet simple-to-read management reports. As part of its distribution services Allied offered:
•“Pick pack” service, where trained workers actually opened full cartons to pick the exact number of forms requested by the clients.
•“Desk top delivery” service, where Allied personnel would distribute the forms to individual offices (forms were usually delivered only to the loading dock).

Allied operated its forms manufacturing and TFC activities as separate profit centers. The transfer of product to TFC was at arm’s length with the transfer price set at fair market value. Although the company encouraged internal sourcing for customer orders, TFC salespeople had the option of outsourcing product if necessary.
The clients who participated in the forms management program were charged a service fee to cover the cost of warehousing and distribution based on the standard charges of 32,2%, regardless of the specific level of service provided to that clients. The sales force then marked up the cost of products and services by an average of 20%.

PROBLEM STATEMENT

The Business Forms Division in 1988 earned a 20 percent Return on Investment (ROI). But returns have been dropping for several years. TFC is projected to earn an ROI of only 6 percent for 1992. TFC profitability was suffering in October 1992. It tells that Allied is not managing this business very well. It seems that the charge for services needs closer scrutiny.

General Manager John Malone believes that the charges should have nothing to do with the cost of product. Allied should charge their clients for the services they use. It doesn’t seem fair that if two clients buy the same amount of product from Allied, but one keeps a lot of inventory at our distribution center and its constantly requesting small shipments and the other hardly bothers Allied at all, both should pay the same service fee.

Under the current system, these accounts carried the same service charges. These accounts were similar only in the value of the product being sold, they were different on the level of service they required from Allied.

The Allied’s felt that there had to be a better way of charging out distribution service to make TFC become profitable. They had a much better understanding of the driver of costs involved in distribution services by using ABC system. But they also knew that it wouldn’t be easy getting the sales force on board with an activity-based pricing program. Some accounts would see increases because of additional distribution charges under a Services Based Pricing (SBP) scheme. These salespeople wouldn’t be vary happy. On contrary, some salespeople may see their margins increase. It will lead to an organizational problem.

They were also not convinced that overall profitability would improve without significant changes in marketing strategy. They were still wondering how to use their new ABC analysis to improve the profitability of TFC.

As a way of understanding cunstomer profitability, TFC management reworked the information in the database as if accounts had been charged service fees based on actual usage, leaving net sales and product cost the same as before. They recalculated contribution based on these figures and tried to analyze it.

In general, the big problems faced by Allied are:
•“Customer Profitability.” Not all customers are profitable but very often without ABC, it is very difficult to know which ones are profitable.
•“Pricing.” Charges for services needed closer scrutiny. It is not fair for two clients who buy the same amount of product but uses different level of services to pay the same service fee.

ANALYSIS

The setting is a company which sells inventory management services as an add-on to the business forms business. The company's strategy is simple-differentiate a "commodity" product-business forms-with value-added services-forms inventory management, named TFC (Total Forms Control).

We will summarize the Current Cost Accounting System (Traditional Cost System) of TFC:
•Forms manufacturing and TFC activities are separate profit centers.
•Transfer of product to TFC is at arm’s length with transfer price set at fair market value.
•Clients in forms management program keep an inventory of forms at one of Allied’s 10 distribution centers. The forms are distributed to the client as needed.
•If a TFC client made use of any of the distribution services, they were supposed to be charged a price for the forms which was high enough to allow for an additional 32.2% of product cost to cover warehousing and distribution expenses.
•The cost of capital is tied up in inventory and freight expense.
•Cost of product is marked up by 20% on average.
The cost charged to customers based on current cost accounting system:
Accounts A Accounts B
Annual sales $79.320 $79.320
Cost of product 50.000 50.000
Cost of warehouse/distribution (20,5%) 10.250 10.250
Cost of inventory financing (4,7%) 2.350 2.350
Cost of freight (7%) 3.500 3.500
Gross Profit $13.220 $13.220
Percentage of Profit 16% 16%

Now, we will analyze the cost that should be charged to customers based on ABC system. In a business organization, Activity-based costing (ABC) is a method of allocating costs to products and services. It is generally used as a tool for planning and control. TFC management called the ABC based pricing stystem SBP (Service Based Pricing). SBP is a base price for number of customers plus a charge for additional services or meter points.

After analyzing the two customers using ABC system, we find the results surprisingly. Company A costs Allied less money to service, they are also a much smaller source of potential growth for the company. Company B on the other hand utilizes far more services and has the potential to earn Allied much greater revenue. With the information we have from the new ABC costing scheme we now know that Allied should be charging far more for the services rendered to company B, and less for the services used by company A. Current information shows that company B utilizes $13.825 more in service costs than we were previously charging them, while company A is utilizing $ 5.567 less. If we use an internal focus, and analyze the customer profitability based on the result of the numbers from our ABC system, we will think that A type customers are profitable. On the other hand B type customers are unprofitable and hence we should drop them.

However, if we move our focus from “internal” to “customer”, we will see that B type customers are good. The level of services they use is considered higher when compared to type A customers. The fact that we are billing them wrong is our own fault. B type customers are quite dependent on our firm. On the contrary, the level of services used by A is low, and there is a risk that they can drop out easily.

Our strategy would be to maintain the level of B type customers’ usage and increase their level of pay. In addition, maintain the level of pay for A type customers and increase their usage. Using the traditional system, A type customers are subsidizing B type customers while B type customers are exploiting the firm.
Now we will analyze the value chain of TFC. Value chain is the flow of activities from basic material to the end user, where each activity adds value to the previous one. The key is providing additional value in each step of the value chain.

The process of value chain start from natural resources like papers and pulps then manufacture produce standard computer printout paper and fax paper to custom-designed forms tailored to meet the exact business needs of the client. From the forms manufacturing, the products move to forms sales. Allied expanded its business by making warehouse and distribution network.

For customer who face problem with inventory, Allied build TFC to facilitate it. TFC itself had a value chain starting from storage and inventory financing, requisitioning, stock selection and pick-pack, order entry billing, desk top delivery, and freight. TFC has no uniqueness on its product. Its competitive advantages is on its TFC services. Through the whole value chain, customers can strategically source many distinct product categories with one order, one delivery, one invoice, and one remittance, all orchestrated by one salesperson.

CONCLUSION AND RECOMMENDATION

Today, Activity-Based Costing is widely adopted because it provides a more complete picture of the profits and costs of doing business than traditional cost accounting. It will help company to better understanding the true product profitability, customer profitability or customer life time value in any industry fundamentally.

We encourage TFC to implement SBP system. But it will not guarantee that it will improve the profitability of the division. ABC make situation better or not depends on how we analyze data from the system. Not all customers are profitable but very often without ABC, it is difficult to know who the profitable ones are.

We believe the gradual implementation of the SBP system could cost Allied a percentage of its customer base and subsequent revenue. A steady slow implementation of this pricing system will give Allied the chance to look at the current numbers and asses accurately whether or not the new system is profitable. If under the SBP system companies choose to discontinue a specific service, variable costs for the service will no longer be incurred.

Implementing SBP system will cause resistance in the organization, especially from salespeople. We can pursuade and give explanation about the purposes and benefits of implementing this new system. ABC system will help management to analyze the profitability of each customer, and hopefully it will restore the profitability of the company.

We believe that TFC can significantly improving profit by concentrating on individual account management. This can be done with the help of Services Based Pricing (SBP) scheme in identifying service costs, and then calculating contribution for each account and then ranking the accounts in order to identify the profitable ones.

However, don’t drop out the bottom 20 customers, because the total cost is still the same. Do not see the unit cost. The unit cost is unitized fixed cost. If TFC drop out the bottom 20 customers, unit cost will go up because the total cost is spread on the remaining customers. This will cause some of the remaining customers to look unprofitable. So, if TFC drop these customers, the unit cost will be higher.

TFC should charge its customers based on their service usage. We suggest TFC used cost plus pricing strategy. It means that the customers should be charged based on the cost of products plus service charge (based on SBP schemes) plus mark-up. So, it will be fair for customers that have the same sales but different level of services to be charged differently, based on the services they used.

Each segment in the value chain has input costs and output price. Difference is the value added. From the six segment in TFC value chain, we believe that only stock selection&pick-pack and desk top delivery that provide value added. We encourage TFC to provide additional value to customers for the other segments. We also suggest TFC to improve its efficiency and effectiveness on its value chain. It means that TFC should maintain and improve its value-added services and eliminate its non value-added services.