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Dakota current allocates warehousing, distribution and order entry cost equally to each customer. DOP’s pricing system is generally independent of the specific level of service provided for customers. They just chose a single cost drive. However, it’s not believable and proper to use this simple method to analyze costs when costs are more complex. So we need to use activity-based cost system to chose different cost drives and allocate costs based on the activity.
We identify four different activities for all costs, order handling cost, ship carton cost or normal commercial shipment cost, desktop delivery cost, and order processing cost.
As we noticed, the distribution center team reported 90% of their workers proceed carton in and out of facility. So, the total cost for order handling is $4,160,000, which is the sum of 90% of warehouse personnel expense and warehouse expenses (excluding personnel). This cost only depends on the number of cartons moved in and out of storage. So the total handling cost need to be allocated by the number of cartons processed in year 2000, which is 80,000 cartons.
Then we get the overhead rate for handling cost that is $52.00 per carton. We only have the freight cost that is associated with normal shipment. We divide total cost $450,000 by the number of carton shipped only through normal shipment, which is 750,000 cartons. Then, we get the overhead rate for ship carton, which is $6.00 per carton.
We also have desktop deliver option for customer. The total cost for 2000 delivers during 2012 is the sum of 10% of warehouse personnel expense and delivery truck expenses, which is 0,000.
The overhead rate for desktop deliver is $220 per deliver. As order processing cost, we use weight average method, based on the hour used to divide this cost into three part, manual order limitation, line times manual order and EDI checks. We calculate total cost for manual order limitation $160,000 and it had 16,000 orders. So the overhead rate for manual order limitation is $10 per order. Total cost for line items is $600,000 and it had total 150,000 lines. The overhead rate for line item is $4 per line item. Total cost for EDI checks is 400,000 and it had 8,000 checks. The overhead rate for EDI check is $ 50 per order.
According to the Exhibit 3, we find the number of each activity provided to customers A and B during year 2000. We use these number multiplies each overhead rate to get overhead costs for each activity. For customer A, we have gross margin $18,000 and other costs including, order handing cost $10,400, ship carton cost $1,200, manual order cost $60, line items $240, and EDI orders cost $300. Customer A also has interest expense based on his average accounts receivable within 30 days, which is $9,000 and annual interest rate is 10%. Therefore, the interest expense for customer A is $75. We use gross margin $18,000 subtracts total other cost including interest expense $12,275 to get profit for customer A, which is $5,725. We use the same method to get gross margin for customer B is $19,000 and total other cost including interest expense is $19,020. So customer B loses $20.
Customer A use normal shipment and most of orders are EDI orders. These two could save more spend and is more profitable for the company. However, customer B have 25 desktop deliveries. This cost is about 6.47% of cost of items purchased. Also, customer B uses traditional manual order and manual line items order that cost more. Additionally, interest expense for customer B is also very higher because of his payments always after 90 days with a higher payment amount. Total other cost for customer B is 1.55 times of customer A. Therefore, customer A is more profitable and customer B loses $20.
The only limitation for customer A is manual order and line items. We suggest customer A use EDI orders instead of these two. It could save cost and make more profit. For customer B, the cost for desktop deliveries is very high and customer B use traditional manual order entry without EDI. It costs a lot for customer B. We recommend customer B decrease the desktop deliveries or increase the price for desktop deliveries to cover the cost. We also suggest customer B switch traditional manual order entry and line items to EDI orders. This technology would help save cost and be more profitable for custer A and B.
Under activity-based costing, we allocate all costs into different activity. So, we could easily see the cost for each activity related to our cost of items purchased. We can figure out which activity is more costing and take control this cost to increase our profit.
If a major customer switches from placing all its orders manually to placing all its orders over the internet site, we will spend more workers’ hour on EDI checks. We use weight-average method to allocate order entry expenses into three activities, manual order, line items, and EDI checks. So, the expenses for manual order and line items could be decrease and expenses for EDI checks increases. We need to recalculate the overhead rate for both three activities. Additionally, the cost for EDI checks is more cheaper than the other two. So, if a major customer places all order over internet site, it would save cost and make more profit for company.
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